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Wednesday, August, 26, 2009

High-frequency trading that enables a specific subset of buyer and sellers a preview of what other buyers and sellers are willing to pay or accept for a stock before those orders are routed to the market for execution.

Just wanted to get to this subject before it doesn't exist anymore, seeing as the NASDAQ is banning flash trading as of September 1, and the SEC is in the process of doing so on a market-wide basis. There's yet another money-making trading scheme Pocket MBA couldn't get in on while the going was good. Flash trading sounds like some kind of unthinking baseball wheeling and dealing of the kind the Chicago Cubs have engaged in to get rid of players destined for greatness (Lou Brock, Greg Maddux, Dennis Eckersley, Bill Madlock, Bruce Sutter, Ken Holtzman, Andre Thornton, Dontrell Willis, Willie Hernandez, and on and on.) Alas, that's still just bad management. Flash trading of the type that's been in the news the past few weeks—since New York Senator Charles Schumer decided to make it news—involves brilliant management of stock trades. The kind of management that allows a good trader with access to the right equipment to shave fractions of pennies off equity prices and make bundles, while the rest of us wonder why the price always drops after we hit the buy signal.

Almost everything Pocket MBA has learned about flash trading came from a recent article in Trader magazine's July 2009 issue entitled "Flash Point". Remember from prior issues on trading that the aim of market makers is to ensure that market participants get the national best bid or offer (NBBO) combined with relative rapidity of execution. Flash orders circumvent this system somewhat by letting some people get a brief look, "or flash" at the prices people are bidding for a stock and more or less let them underbid (or overbid on a sell) the market. These privileged traders (and they're actually computers) are connected with the four exchanges that enable flash trading. The process is accomplished "by briefly displaying information about the order to the venue's participants and soliciting NBBO-priced responses. If there are no responses, the order can be canceled or routed to the market with the best price." All this is accomplished via computer and complex algorithms—with multitudes of these orders being submitted and cancelled until the price of a stock becomes what the trader wants it to be, and then the computer executes the trade. The flash itself lasts a maximum of 500 milliseconds, which serves the purpose of complying with SEC Rule 602.

Rule 602(a)(1)(i)(A) on "dissemination of quotations in NMS securities" states in relevant part:

i) Each national securities exchange shall at all times such exchange is open for trading, collect, process, and make available to vendors the best bid, the best offer, and aggregate quotation sizes for each subject security listed or admitted to unlisted trading privileges which is communicated on any national securities exchange by any responsible broker or dealer, but shall not include:

(A) Any bid or offer executed immediately after communication and any bid or offer communicated by a responsible broker or dealer other than an exchange market maker which is cancelled or withdrawn if not executed immediately after communication

Basically, what that means is that any order executed or cancelled "immediately" is not subject to the NBBO rules. The SEC considers under half a second to be "immediate," hence the 500 millisecond maximum on flash trading.

Flash trading is a small subset of what is known as high-frequency trading (HFT)—a process made possible by the high-speed computers mentioned above (that means better than a Mac) that literally execute thousands of trades in seconds. HFT is estimated to account for as much as 70% off all trades, with flash trading accounting for 2.4% of the total in June 2009. Most HFT hasn't run afoul of market watchers; it's just the logical end of technology and its ability to act faster than a human being. Nobody is seriously considering trying to put an end to that, although some have suggested that once you ban flash trading, you have to take on dark pools, as well. See Pocket MBA, Vol. 5, No. 45. In any event, what has irked critics of flash trading, followed by Senator Schumer, as well as the NYSE (which doesn't support flash trading) and now the SEC, is that the practice basically amounts to front running. Even if we're talking about milliseconds, it still gives a privileged few an advantage—the ability to know bids ahead of the broad market and to act upon that knowledge. And when you're buying and selling over and over in the same day based on this information you reap outsized gains that others cannot. And that just doesn't seem fair.

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