On Flash Trading

by Don Boudreaux on September 15, 2009

in Complexity and Emergence, Frenetic Fiddling, Hubris and humility, Regulation

In this letter appearing in today’s Wall Street Journal, Chris Hynes and Donald Luskin explain why government should not prevent “flash trading”:

We are replying to Sen. Chuck Schumer’s Sept. 4 letter concerning our Aug. 27 op-ed, “In Defense of ‘Flash’ Trading.”

Sen. Schumer makes the incendiary charge that flash trading “seriously undermines market integrity” by leading to front-running. If it did, then no trader in his right mind would ever enter a flash order, because he would be the first to be victimized. Flash trading is, in fact, a solution to front-running that improves market integrity.

An institutional trader with a million-share order never puts the entire order into the market all at once, for fear of market impact. Typically, a succession of smaller orders is placed in various markets, and at any given time the bulk of the order is not revealed. So of necessity, all other market participants are at an information disadvantage to the trader with the large order. Yet if he puts his entire order into the market at once—say, to buy one million shares—other traders would run ahead of the order by bidding higher prices. Their bids would mask the million-share order, and sellers would only see the smaller, higher bids, and be enticed to sell, not realizing a huge buyer lurked.

To protect against such front-running, traders typically withhold information about their own trading intentions, and there is nothing wrong with that any more than there is in keeping your cards close to your vest when playing poker. New trading technologies such as flash orders and “dark reserve” orders on the New York Stock Exchange—a limit order that is not displayed, to which apparently Sen. Schumer has no objection—are ways of accomplishing this.

Customers, not senators, should decide which of the many new trading technologies they wish to use. If Sen. Schumer is sincerely interested in promoting fairness and liquidity, we suggest he train his fire on the proposals currently being floated in the House of Representatives to impose an 0.25% tax on securities transactions.

Chris Hynes

Edwards, Colo.

Donald L. Luskin

Menlo Park, Calif.

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  • Why am I not surprised that Chuckie Cheese Schumer (a man who has never had a real job in his life) doesn't understand the issue? He doesn't seem to understand Reg NMS, nor does he understand what "front running" means. Hynes and Luskin use the term differently from Chuckie.

    Chuckie objects to illegal front running - when a broker dealer gets a large customer order and then trades for its own account ahead of the order because it knows the order is large enough to drive the market price. That has nothing to do with flashes.

    Flash orders are limit orders - so, Chuckie's assertion that they would be done at a better price by being sent to the floor as one order is bogus. In fact, the opposite is true. If the market sees a giant bid sitting on the books, not only will market makers bid smaller in front of it, but they will also raise their offers. Depending on how liquid the security is, the customer can drive the price way up by doing that.

    Flashes are seen by all the membership of the exchange and we have the option to provide liquidity at that price or not - but only for a second. The customer doesn't want his order sitting on the book so that market makers can lean all over him. I don't see the problem with that. Trading is like poker. Every order carries information to the other players. From the customer's perspective the less information he gives the market, the more advantage he retains.
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