Credit Suisse's Take on Flash Trading, Dark Pools and National Market Regulation

Includes: CS, GS, RTK
by: Tyler Durden

Dan Mathisson of Credit Suisse (NYSE:CS) held a conference call with clients yesterday, providing an update on his views of Flash Trading and Dark Pools.

The debate over Flash orders and Dark Pools has been heating up. Politicians have been railing against high-speed trading, the SEC has hinted at new impending rules, and some exchanges have voluntarily withdrawn their flash order type. Meanwhile, thrown into the regulatory mix are possible changes to Reg ATS and Reg NMS, new short- selling disclosure rules, and a new uptick or circuit breaker rule.

While Dan did have some harsh words for the media world, stating that a lot of misinformation has been spread, in an ironic twist he agreed tacitly with all the allegations that Zero Hedge and others have presented.

But let's back up: Dan did correctly indicate that anyone can have access to the BATS datafeed for a nominal fee. However, the question arises how many people have the capacity to actually utilize this information, and especially in a way that conforms with existing trading infrastructure.

A firm like RenTec (NYSEMKT:RTK) , Getco and Goldman (NYSE:GS) which has spent billions on trading facilitation hardware will of course be the first in line to see what happens in the 25 ms period when trading intentions are being solicited, while the vast majority of the trading world has no way to capitalize on this absent substantial CapEx investments to the tune of tens of millions of dollars.

What Dan, however, did highlight as the gist of the problem was the following: "flash trading gives out one's trading intention to the whole world, and the latter can trade ahead of you" - when you are dealing with hundreds of thousands of blocks hitting advance notice concurrently, it would be foolish to assume that this does not provide a major informational advantage.

Indeed, Dan himself highlighted the tradeoffs: positive - collecting a rebate; negative - someone can step ahead of "your" order. Does not seem like that much of an exciting trade off. And Zero Hedge completely agrees with Dan's statement, that this becomes a major problem when this is done by brokers getting ahead of their own clients: "Clients get traded ahead of, while the broker saves money (or collects it via rebates)." Alas, this is exactly what is happening en masse.

Another point that Dan highlights is that Flash trading implicitly violates the spirit of Reg NMS, as a Flash order for the most part creates a locked market where an incoming bid is for a brief period of time at the same level as the offer, indeed one of the issues NMS has riled against.

Bottom line: Flash is done, and according to Credit Suisse's DC Liaison and Head of Public Policy, Mary Whalen, the SEC will ban it shortly, especially as a function of the abnormally short time frame provided for comments (brings back flashback tears of joy to when the SLP was jammed down the throats of the investing public).

Some other, more relevant data points:

Credit Suisse notes that in addition to Flash, Actionable IOIs are next on the chopping block. While different from the IOIA page Zero Hedge discloses every now and then when JPM's ETF desk goes on full buying tilt in 10k blocks of SPYs, these are advance indications of trading interest (analogous from Flash) however which unlike Flash even, are completely hidden from the public view.

Actionable IOIs are also over per CS. Amusingly, a client asked on the call how Actionable IOIs are any different from a call a broker places to his top 5 hedge fund clients while the smaller clients have no awareness of the best bid/offer presented by said broker. The response had to do with a semantic play in that IOIs are "messages intended to trigger a negotiation", which is not applicable to the broker example.

Of course, this is a joke, and is a very critical angle of attack going forward as it very obviously disadvantages one set of clients (i.e. those who do not have a $10mm plus softdollar account with an i.e., Goldman Sachs) over those who, like PIMCO and Blackstone, spend billions a year in commissions to the biggest Broker Dealers. If one wishes a truly democratic market, this is a key area that also has to be revamped as it creates the most uneven, two-tiered market structure possible - granted not so much in equities but in other OTS instruments such as options and CDS. This will be a topic that Zero Hedge will definitely delve into much more in depth in the coming weeks.

On the topic of Dark Pools there was less conclusive findings, but the consensus was that the SEC will demand much more increased disclosure, potentially including real-time printing and a designator highlighting on which ATS a given trade was done. The pros: can see where a given trade was done, cons: the whole world will be aware of what trade occurred where (post facto), in essence limiting some of the major advantages of dark liquidity. As CS points out - "the loss of anonymity will hurt institutions, and the SEC may mandate regular reporting of volume as well."

Additionally, CS notes that the Reg ATS Fair Access Rules will likely have to be redone, as ATS now can decide which participants to kick off for any and no reason. In an effort to make markets more democratic this particular rule will end up being overhauled as well.

Of course anything that benefits the common traders to the detriment of the big institutions will likely not be received too well by Wall Street's lobby powers, so expect the dark pool fight to be quite intense, although at this point it seems that Schapiro is set on providing substantial color here as well. Even Credit Suisse points out that it does "not believe it is the SEC's view to disband dark pools." With a little prodding the regulator's view may change.

The most relevant take home message from the call, however, was CS' disclosure that there will likely be a major change to Reg NMS itself, specifically that displayed liquidity will be protected over non-displayed. This means that any NBBO quotes (either bid or offer) would be protected, and any sweep below or above the NBBO would need to take all the offered liquidity. In an example: a bid offer is at 34x35 (the NBBO): post amendments a trade would not be able to occur at 36 absent sweeping all the offered liquidity at 35. Zero Hedge agrees with Credit Suisse that this will be a "huge change to the trading landscape" and together with regulatory changes to dark pool implementation, this will be the most relevant development to keep track of.

Of course, the fact that Reg NMS allows this to happen currently is very troubling indeed, as it explicitly renders the whole concept of the NBBO if not useless, then quite close to it, to the benefit of advantaged and privileged players who can completely bypass the NBBO if and when this suits their interests.

Lastly, CS thinks there will be no major changes to HFT, collocation, etc. Zero Hedge would beg to differ on this one.