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.