The Future of Flashed Options

With the ban of Flash orders in equity markets now practically a done deal, politicians, and hopefully regulators, will start focusing their attention on Flash derivative products which facilitate not only a two tiered market but potential market abuse by the privileged few who have access to advance looks in assorted securities classes.

While dark pools will ultimately be the critical focal point of tiered market differentiation, it seems the next immediate area of focus will be flash orders in option trades. As before, a major opponent of Flash, NYSE Euronext, provides a few on why flashed options afford club members the opportunity to sniff out larger market moves. From Traders Magazine:

[Ed Boyle, who runs NYSE Euronext's U.S. option business] argues notes that flashed orders can enable participants receiving the flashes to trade ahead of customers whose orders are flashed, either in the stock market or in options. "When an order is flashed, there's often not a lot of contracts available at the best price," he said. "It's when the market is moving fast that a customer is likely to be disadvantaged [by flash orders]." He added that flash orders proliferated in 2007 when the penny pilot began. Arca has price-time priority and maker-taker pricing for penny-quoted options.

On the other hand, conflcited defenders of option flash include the International Securities Exchange, which is a 32% owner of the Flash trading ECN Direct Edge.

The International Securities Exchange and the Chicago Board Options Exchange argue that flash orders benefit customers. "Customers like this functionality," said Boris Ilyevsky, managing director of the ISE Options Exchange. "They see a direct economic benefit."

He notes that flash order types in options are technically similar to those in equities, although the benefits are different. "Our market makers and members can match the away price through a flash auction," Ilyevsky said. "That gives the customer the away price without paying a take fee that could, on some markets, be 45 cents per contract. The customer fee on the ISE is zero." If there's no response, the ISE's primary market maker in that symbol seeks the best price through a linkage order.

Other defenders appear in the form of the CBOE, whose flash order type will make fans of Isaac Azimov and insane computers everywhere rejoice.

The Chicago Board Options Exchange makes the same argument. Its flash order type is called HAL, for Hybrid Agency Liaison. "Prior to outbound routing, orders are flashed to market participants at the CBOE with the opportunity to match the NBBO and keep the order at the exchange," said Edward Tilly, executive vice chairman of the CBOE.

And the oddest defense of option flashing comes from Will Easley, the vice chairman of the Boston Options Exchange.

Easley suggests that concerns about being traded ahead in options as a result of the information being flashed are minimal for a couple of reasons. First, he said, the other firm would have to take out all the volume at the best price in away markets, which could be costly. And second, orders that are flashed are typically for small size. Easley also notes that options prices do not move as quickly as the underlying price and are less sensitive to those movements in some cases. Even in penny names, it's not a 1:1 move, he said.

The second argument is laughable. The take home message however, is the acknowledgement of the optionality to trade on an exchange away from the host flashing exchange with the gleaned information (in other words, it happens all the time).

Whether it is costly is debatable - once a firm has set up the relevant infrastructure via collocation and other front-end loaded costs, the marginal expenditures are negligible. However, it goes to show how deep two-tiered information flow across the markets truly goes: over the past 10-15 years as a result of escalating IT efficiencies, the complicity of exchanges and broker/dealers as well as market neutral funds to operate in a higher plane of faster, advance-looking (and potentially abusive) information, on exponentially increasing stock volume, has been taken to an artform, and the net results have been such market aberrations as flash trades, dark pools, collocation, and ultimately a market, in which trading and liquidity provisioning are dominated by algorithms and other computer controlled processes.

What politicans and regulators need to, and are gradually starting to figure out, is that Flash is not a separate issue - it is analogous to the loose strand in the proverbial sweater: once you start unravelling it, eventually the entire thing collapses. And this is what is notable of Schumer's campaign - the initial focus on Flash will gradually develop into the biggest two-tiered market discovery process, a process which is long overdue. And speaking of long overdue things, the SEC's eventual acknowledgement of Flash (and many more topological concepts to come) as being a detriment to investors, will likely set off a sequence of legal actions, which if nothing else will try to identify who, if anyone, has benefited over the years since Flash (in both equities, options and other products) has been active. Quite a few relevant names come to mind.

Comments

[Leftfield:]

Like Judge Rakoff's refusal to sign off on a typically pathetic love-tap punishment between the SEC and BAC due to.......The Public Interest(!), investigation here may unravel enough to start a ball rolling. Some in crucial positions must want to do their jobs and care enough about the country and the people.
It's a far cry from Watergate when there were whistleblowers and investigative journalists abounding, but the crisis fails anyone's honest smell test by now. Now we have the internet and the blogosphere. Where adults can exchange information and judge it for themselves. Thanks again for the update, Tyler.

Aug 09 10:28 PM

[untrusting ...:]

Good information. Thanks Tyler. Let's hope our journalists pursue this like Watergate because "Goldmangate", HFT, algo trading, flash trading, etc has a lot bigger effect on every American (pension funds, mutual funds, endowments, insurance funds) than a few Watergate minor crooks ever had. Watergate pales in comparison to the hundreds of billions these financial engineers skim off the markets and the trillions of dollars in losses they have had a major hand in orchestrating.


On Aug 09 10:28 PM Leftfield wrote:

> Like Judge Rakoff's refusal to sign off on a typically pathetic love-tap
> punishment between the SEC and BAC due to.......The Public Interest(!),
> investigation here may unravel enough to start a ball rolling. Some
> in crucial positions must want to do their jobs and care enough about
> the country and the people.
> It's a far cry from Watergate when there were whistleblowers and
> investigative journalists abounding, but the crisis fails anyone's
> honest smell test by now. Now we have the internet and the blogosphere.
> Where adults can exchange information and judge it for themselves.
> Thanks again for the update, Tyler.

Aug 09 11:20 PM

[Moon Kil Woong:]

Flash and dark pools, anything stripping away price discovery and real market trades and replacing them with program trading and HFT are a detriment to investors as much as they are a detriment to the concept and functioning of our stock markets.

Tyler Durden is once again right when he says this is like a loose thread on a sweater. Once people realize that such behavior is not only a threat to market exchange systems but also unfairly benefits the few at the cost to the market and the many (the only reason something is being done is because of the harm it does to themarket) those troblesome questions as to who has been doing flash trading and how they profit begin to emerge. Thus the tremendous pressure against such reform is always ever present. Although I am sure there will be wording to protect the past behavior of flash trading in any new regulations, it is a worthwhile price to pay for a healtier market.

I'd love to see dark pools and ban's preventing brokers from acting as market makers for their own client's trades but I guess that will have to wait until another day. Thanks Tyler for putting up the good fight.

Aug 09 11:50 PM

[zorkfin:]

There are too many conspiracy theories here. Since each exchange does its own thing I will concentrate on the one I know best, ISE. The trigger for the flash order is the existence of a better price at a remote exchange. Without it, the customer would get a worse execution at ISE. Since there are multiple market makers and regular members at best price which receive the order simultaneously, everyone trying to act on it takes a risk, especially since the order is outside their parameters for that option at that time. It would not pay to try to game the system.

Aug 10 01:12 AM

[doubleguns:]

I wonder if the thread in the sweater will lead back to the PPT at some point. My guess the govt cuts the thread prior to that point.

Aug 10 08:27 AM

[MarkitWacha:]

'I want to be enabled for Flash trading' has the same ring to it as 'Where's my #$@#$ bailout?'

Once again, the retail investor, the commoner, is punished for being small. ECNs are colluding to skim.

BAC is trading at $16 today. Pure politics is holding it up. Time for the government to sell (I hope). I wonder what Congressmen will say when they start closing thousands of banking centers and axing thousands of jobs because the 'scan-check for deposit at the ATM' is so successful. 170,000 employees before. How many after? ~130,000 is my guess.

Aug 10 11:05 AM

[PaperGains:]

There's a simple argument here. Any formal structure that gives one party an advantage over another in this business is wrong. It erodes the confidence participants should have in the system. This isn't about who's smarter, but about who has more influence and $$.

Some people think the equity markets are crooked. Those people never traded in the derivatives market.

papergains.blogspot.com/

Aug 10 12:04 PM

[John McLeod:]

doubleguns, last week's showdown between Melissa Hathaway and Larry Summers strongly supports your assertion about the PPT.

Tyler, it's "Isaac Asimov," and I still cherish the D+ I got in the '60s for handing in a 10 page character sketch of the Mule to my High School English teacher.

Aug 10 12:44 PM