Many investors have a feeling that Wall Street is ripping off the little guys. This notion is reinforced by the plethora of scandals that seem to go on and on without end. The latest Wall Street inequality revolves around flash trading, and it's so shameful that many of its perpetrators are halting the practice even as regulators close in with threats of banning it. (Learn more about uncovering a scandal, read Playing The Sleuth In A Scandal Stock.)
Flash Trading Basics
Flash trading involves the use of high-speed computers to gain a trading advantage measured in fractions of a second. The process unfolds when a firm that is seeking to buy or sell shares or stock posts the information only on a specific stock exchange before sending the trade information out the broader public markets and making it available to all potential investors.
If a deal can be struck between recipients of the flash trade, the result is a locked market with guaranteed pricing on the order. On some trades, it also results is better profits for the firms making the trades, as the firms often get rebates or lower fees for flash trades when the deal completes on the home exchange and doesn't get posted on rival stock exchanges.
The maximum time delay is 500 milliseconds before the trade must be executed, canceled or made available on rival exchanges. The average time delay is 30 milliseconds. To most investors, these times are so short as to be meaningless. To flash traders using high-speed computers, 30 milliseconds might as well be 100 years. It's more than enough time to make a private market for securities and rack up serious profits without violating the Quote Rule, which requires broad public dissemination of bid and offers.
Flash Trading History
The practice began more than a decade ago when the Chicago Board Options Exchange began using it as a way to improve the speed of trade execution. It remained a legal yet obscure practice until 2006, when the Direct Edge trading platform began employing the practice more broadly.
Direct Edge quickly captured market share from rivals as their share of matched trades soared from 1% of the industry's volume to 12%. The firm quickly became one of the top three largest stock trading platforms in the country based on the volume of trades it handled. Other firms quickly adopted flash trading to keep competitive.
Emboldened by their success, Direct Edge put forth an application to become an official stock exchange. Seeing a powerful competitor on the rise, NYSE Euronext and market-making firm GETCO complained loudly and publicly about flash trading. They sent their complaints to the Securities and Exchange Commission (SEC) and were joined by New York Senator Charles Schumer who also wrote to the SEC. In response, SEC Chair Mary Schapiro was ready to ban the practice. (Learn more about the SEC in Policing The Securities Market: An Overview Of The SEC.)
The Future of Flash Trading
The increased regulatory scrutiny has already convinced several firms, including Nasdaq OMX Group and Bats Global Markets, to ban their brokers from engaging in flash trading. Sadly lost in all the noise is the reality that rivalry among Wall Street firms is the only reason that this issue is getting any attention at all. It's not because anyone is looking to help the little guy avoid yet another Wall Street ripoff that most of us weren't aware was occurring. (Read more in Who's Looking Out For Investors?)