SEC Considers Banning Flash Trading

The Securities and Exchange Commission is examining a stock trading technique that gives certain high-volume traders an advantage over smaller investors. "Flash orders" allow traders to freeze a buy or sell order for as long as half a second. Critics say the technology gives a select group of traders a window into the direction of the market. Advocates say the technology behind "flash" helps traders get better prices.

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Stock market regulators have begun to wonder if the markets are a little too fast. The Securities and Exchange Commission is supposed to help investors play on a level field. That means they regulate a market that relies, like the rest of the world, now, on a daily flow of instant information. Turns out that some traders get that information a little more instantly than others. They're using super fast computers to do something called flash trading. It allows the traders to snap up the best prices before other investors even know they are available.

NPR's Jim Zarroli explains how it works and why it draws regulators' interest.

JIM ZARROLI: To understand flash trading, you have to start by understanding the way stock exchanges work. Let's say an investor goes to an exchange like NASDAQ to buy shares of stock. But let's say no one on that exchange will sell the stock at the price the investor wants. Charles Jones, professor of finance at Columbia University, says when that happens the exchange is supposed to do something.

Professor CHARLES JONES (Finance, Columbia University): The way our system is set up in the U.S., is that exchanges are supposed to compete on price. And so if you don't have the best price, you're supposed to send the order to the exchange that does have the best price.

ZARROLI: Now stock exchanges don't like to send their orders onto other exchanges because they lose profits. So, they figured out a way to take another swing at the ball. This is the office of Direct Edge in New Jersey, one of the fastest growing electronic stock markets in the world. William O' Brien is the company's CEO.

Mr. WILLIAM O' BRIEN (CEO, Direct Edge): We are the country's third largest stock market. We can execute over two billion, that's with a B, shares per day.

Mr. O'BRIEN: Everyday, Direct Edge gets lots and lots of orders it can't fill, and so it sends them onto other exchanges like it's supposed to. But before it does, it does something else. It gives certain customers a split second to look at the orders and decide whether they want to fill them. Direct Edge can do this, partly because it has come up with computer technology that it sells to lots of very big investors like hedge funds and mutual funds. Again, William O' Brien.

Mr. O' BRIEN: It's really about creating bridges between the exchange world and the non-exchange world that never existed before.

ZARROLI: And that means those hedge funds and mutual funds get a tiny head start over other investors. They can jump on orders ahead of everyone else. Direct Edge is one of several companies that offer flash trading technology. Customers say the technology has widespread benefits. If Direct Edge can avoid sending orders into the broader market, it saves money, and those savings filter down to investors. Chris Nagy is managing director of order strategy at the big online brokerage firm TD Ameritrade, which is a Direct Edge customer. Nagy says flash trading ultimately lowers trading costs for its many retail customers.

Mr. CHRISTOPHER NAGY (Managing Director, Order Strategy, TD Ameritrade): Contrary to it being demonized in the press and other venues, we have actually found that it provides benefit to the retail client in terms of overall price improvement in the market place.

ZARROLI: The problem, U.S. officials say, is that not everyone can afford to pay for this new technology and those who can't miss out on a lot of trades. It creates a two tiered market, says Columbia's Charles Jones.

Prof. JONES: You have to be a subscriber to the system of whatever exchange is doing these flash orders. So, it means that some people can have a chance to match this price, but other people don't have a chance to match it, and that runs counter to the principles of the U.S. system, which are open access.

ZARROLI: Last week, the head of the Securities and Exchange Commission, Mary Shapiro, said her agency would conduct a review of flash trading and she made clear she is considering a total ban on the practice. Direct Edge officials say flash trading needs to be seen in context. They say it's part of a wave of automation that has swept through the markets in recent years, and on balance, this automation has brought lower costs and greater access to many investors. But with the controversy growing, two of the exchanges that now sell flash trading technology, including NASDAQ, said last week they would voluntarily stop offering it.

Jim Zarroli, NPR News, New York.

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