MutualFundWire.com: Schumer to Schapiro: Ban Flash Trading

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Monday, July 27, 2009

Schumer to Schapiro: Ban Flash Trading

High-speed trading may soon be the latest subject of SEC scrutiny, and attendant press coverage of the issue has ramped up considerably over the past few days. In addition, Senator Chuck Schumer (D-NY) on Monday released the text of a letter he sent last Friday to SEC chairman Mary Schapiro urging the SEC to ban the practice of "flash-trading" offered on the NASDAQ and BATS exchanges and DirectEdge platform.

The New York Times devoted an article last Friday to explicating the practice of high-speed trading and the "dark pools" created by automated trading systems that do not reveal public quotes, and mentioned that flash trading is often criticized for making stock prices more volatile and boosting costs.

Andrew Brooks, head of U.S. equity trading at T. Rowe Price, was quoted in the NYT article as saying that trading innovations should be encouraged, but not to the degree that they create unfair advantages that could compromise markets.

"You want to encourage innovation, and you want to reward companies that have invested in technology and ideas that makes the markets more efficient," said Brooks. "But we're moving toward a two-tiered marketplace of the high-frequency arbitrage guys, and everyone else. People want to know they have a legitimate shot at getting a fair deal. Otherwise, the markets lose their integrity."
Schumer echoed Brooks' sentiments in his letter to the SEC.

"While pre-routing programs can benefit markets by providing additional liquidity, this kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions," Schumer noted. "If allowed to continue, these practices will undermine the confidence of ordinary investors, and drive them away from our capital markets."

In his letter, Schumer also outlined his plans if the SEC does not act upon his suggestions.

"If the SEC fails to curb this practice, I plan to introduce legislation in the U.S. Senate to prohibit the use of flash orders in connection with optional pre-routing programs in order to ensure that trading in U.S. public capital markets is fair and transparent for all market participants," Shumer said.

Meanwhile, Bloomberg reported that more than 75 percent of hedge funds, pensions and mutual- fund companies use computer-driven strategies because they reduce costs, citing a report by Stamford, Connecticut-based consulting firm Greenwich Associates. The same report showed that 73 percent of such companies use dark pools -- with the current proportion of overall dollar volume done via dark pools resting at 13 percent for 2009. The report also notes that this figure is expected to rise to 17 percent in three years.

Schapiro told the WSJ last month that the issue of dark pools may soon be presented for public comment by the SEC.

WASHINGTON, DC—U.S. Senator Charles E. Schumer (D-NY) announced Monday that he has urged the head of Securities and Exchange Commission (SEC) to ban the practice of so-called “flash trading” that gives advance knowledge of stock orders to certain traders. Schumer added that if the SEC fails to act, he would consider introducing legislation to ban the practice.

“This kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions. If allowed to continue, these practices will undermine the confidence of ordinary investors, and drive them away from our capital markets,” Schumer wrote in a letter Friday to SEC Chairman Mary Schapiro.

Schumer’s concerns regard special programs offered by exchanges such as NASDAQ and BATS, as well as an electronic trading platform called DirectEdge. Each of these marketplaces currently allow sophisticated high-frequency traders to gain access to trading information before it is sent out widely to other traders. For a fee, the exchange will “flash” information about buy and sell orders for just a few fractions of a second before the information is made publicly available. These traders, using super-fast computers, can then act on that early information to trade ahead of the pending orders. The practice can influence the pricing of stocks, experts say.

“Flash trading” is a type of high-frequency trading, a technique that has gained attention recently for contributing to the spike in trading volume and, according to critics, increased volatility on U.S. exchanges. According to one industry estimate, high frequency trading accounted for $21 billion in profits in 2008.

A copy of Schumer’s letter to Schapiro appears below.

July 24, 2009

Mary Schapiro

Chairman

Securities and Exchange Commission

100 F Street, NE

Washington, DC 20549

Dear Chairman Schapiro:

I write today out of concern that the integrity of our capital markets is being compromised by the ability of some insiders to view order information before it is available to the entire market, and use electronic trading strategies to profit from that information at the expense of other investors

Specifically, I request that the Securities and Exchange Commission (“SEC”) act to prohibit the use of so-called “flash orders” in connection with optional display periods currently permitted by DirectEdge’s Expedited Liquidity Program, NASDAQ’s Flash order program and BATS’s Bolt Optional Liquidity Program. Flash orders allow certain members of these exchanges to obtain access to order flow information before that information is made available to the public, allowing those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity.

While pre-routing programs can benefit markets by providing additional liquidity, this kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions. If allowed to continue, these practices will undermine the confidence of ordinary investors, and drive them away from our capital markets.

If the SEC fails to curb this practice, I plan to introduce legislation in the U.S. Senate to prohibit the use of flash orders in connection with optional pre-routing programs in order to ensure that trading in U.S. public capital markets is fair and transparent for all market participants.

I look forward to hearing from you regarding your plans to address the concerns expressed above. If you have any questions regarding this letter, please contact my staff at 202-224-6542.

Sincerely,

Charles E. Schumer

United States Senator