Summer School is in session folks, and today we have a Flash Lesson In Market Structure History!

Who here remembers Flash Order types? Who remembers the explanation from the Daily Show’s piece on High Frequency Trading, with their Cash Cow, Samantha Bee: Cash Cow High Frequency Trading Video? I loved this quote:

“Wait, if I know about a stock’s activity a day before (and act on it) it’s called Insider Trading but if I know about its activity a second before (and act on it) it’s called High Frequency Trading?”

Flash Orders were pioneered by the CBOE stock exchange and later Direct Edge, and have been a major source of controversy since their inception. Flashing refers to the practice by market centers of, contrary to REG NMS’s spirit, taking marketable orders and for a brief instant, showing that order to the market center’s business partners (liquidity providers), for the potential of their matching the public quote, before sending it to the NBBO. In reality, the business partners of the market center occasionally will provide 1/1000th of a penny price improvement, or when it suits their “model”, front-run the flashed order. This is all part of the Sweaty Handshake we frequently write about.

In one industry conference in May 2009, the NYSE’s Larry Liebowitz and Direct Edge’s William O’Brien nearly engaged in fisticuffs over the topic of Flashed orders! Liebowitz leveled the first blow by stating that DE’s ELP (Enhanced Liquidity Provider) program was really the Enhanced Look Program. O’Brien countered by shouting “Slander! And the NYSE has more tiers than Yankee Stadium!” Please know that the ARCA, a NYSE exchange, has a liquidity partner program today. Your orders are still blanket-opted in to this program, unless you opt-out of the program, which you can only do on an individual order basis, and not as a blanket opt-out.

By latter 2009, BATS, Direct Edge, the CBOE, and NASDAQ were all flashing orders to their special friends. NASDAQ actually had the stupidity to, on an SEC roundtable panel, state that flashing orders was wrong and bad for the markets; they just had to do it because BATS started them, and NASDAQ was losing market share (whatever that means). Nice corporate leadership, eh?

Even Chuck Schumer wrote a letter to the SEC stating how wrong Flash orders were. This was before he mysteriously dropped the issue and backed off. Perhaps his New York based financial firms asked him to politely shut up.

Then the SEC proposed banning Flashing in September 2009: See SEC Rule Here!

Then, Republican Congressmen Bachus and Hensarling wrote a letter in favor of Flashing orders, on Barney Frank’s Stationary, (Read Bachus Hensarling Pimping their House Financial Committee Power Here), which, rumor has it, had Senator Schumer mumble, “$hit. If they gave me more money I could have written a letter too. Damn.”

Then in November 2009, the SEC sharpened its pencil, and wrote a new rule meant to govern non-public trading interest (the dark pool proposal). This is the one that had One-Large-Crossing-Network-That-Used-To-Be-About-Getting-Institutions-The-Best-Prices sleeping on The Mall every other night, waiting to protect their business model. You can read that SEC rule here: SEC Non-Public Trading Interest Rules. Please allow us to draw your attention to page 14:

“The public, however, does not have access to this valuable information concerning the best prices and sizes for NMS stocks. Rather, dark pools transmit this information only to selected market participants. In this regard, actionable IOIs can create a two-tiered level of access to information about the best prices and sizes for NMS stocks that undermines the Exchange Act objectives for a national market system.24 The consolidated quotation data is intended to provide a single source of information on the best prices for a listed security across all markets, rather than force the public to obtain data from many different exchanges and other markets to learn the best prices.25 This objective is not met when dark pools or other trading venues disseminate information that is functionally quite similar to quotations, yet is not included in the consolidated quotation data.”

So there you have it, in those two rules. The SEC knows that flashing orders is wrong. The SEC know that “actionable IOI’s” are wrong. So flash orders are banned now, right? And Actionable IOI’s are really orders that belong in the public quote, right?

Umm. No. Still no action. And yet the SEC is still alarmed at the growth of dark pool volume, and the effect of that on public markets and price discovery.

Tomorrow we’ll do Part II of this lesson, which is how flashing orders, a practice that most of the market centers have abolished, still have not been abolished, rather just renamed. Today we just wanted to give a little background, and keep the information digestible for your trading day.