What is Flash Trading?

Flash trading is a controversial practice where preferred clients, with access to sophisticated technology, can view orders before the entire market.

Key Takeaways

  • Flash trading is a controversial practice where preferred clients, with access to sophisticated technology, can view orders before the entire market.
  • Proponents of flash trading say that it provides greater liquidity in secondary market exchanges, while opponents believe that it gives an unfair advantage and can lead to higher risk of flash crashes.
  • Due to a wave of criticism, especially after several market roiling events, flash trading has been voluntarily discontinued by most of the exchanges, though it is still offered by some stock exchanges.

Understanding Flash Trading

Flash trading uses highly sophisticated high-speed computer technology to allow market makers to view orders from other market participants, fractions of a second before the information is available to the rest of the traders in the marketplace. This gives flash traders the advantage of being able to recognize movements in market sentiment and gauge supply and demand before other traders.

Proponents of flash trading believe that it helps to provide greater liquidity in secondary market exchanges. Opponents of flash trading believe that it gives an unfair advantage and can lead to higher risk of flash crashes. Many critics also compare flash trading to front running, which is an illegal trading scheme that relies on non-public information.

Flash trading became a highly debated topic in 2009 before it was facilitated on most market exchanges. In 2009, the Securities and Exchange Commission (SEC) proposed rules to eliminate flash trading, though these rules were never passed. Due to a wave of criticism, especially after several market roiling events, flash trading has been voluntarily discontinued by most of the exchanges, though it is still offered by some stock exchanges.

Flash Trading Processes

Flash trading on exchanges was offered to most market makers for a fee. Subscribed market makers were given access to trade orders a fraction of a second before these orders were released publicly. Sophisticated traders used flash trading subscriptions in a process known as high-frequency trading. This trading process incorporated advanced technologies to take advantage of the flash quotes and generate greater profits from the spreads.

Flash trading for high-frequency market makers was easily integrated into the standard market making exchange process. Through this process market makers match buy and sell orders by buying at the lowest price and selling at a higher price. This process forms the basis for bid/ask spreads, which generally fluctuate based on market supply and demand. With flash trading subscriptions, large market makers, such as Goldman Sachs and other institutional traders, were able increase the spread on each trade by one to two cents.

Is Flash Trading Legal?

The concept of flash trading was highly debated in 2009, resulting in elimination of the offering. The Securities and Exchange Commission issued a proposed rule, which would eliminate the legality of flash trading from Regulation NMS. While the flash trading elimination rule was never fully passed, most market exchanges chose to relinquish the offering for market markers.

The release of the 2014 book Flash Boys: A Wall Street Revolt by Michael Lewis detailed the processes of high-frequency trading and the use of flash trading by Wall Street traders. Lewis takes a deeper look at the availability of flash trading, its uses by high-frequency traders, and some of the practices that are now illegal, such as spoofing, layering, and quote stuffing.