Minggu, 20 September 2009

Are flash orders really so bad?

I confess I don't know much about flash orders, not being one of the Big Boys on the Street, until I read that the SEC is banning them. (For a clear diagrammatic explanation of flash orders, see here. For a refutation of some of the myths and misunderstanding surrounding flash orders, see here.)

It seems to me that flash orders can be understood as "request for liquidity" issued to various potential market makers/liquidity providers, not unlike the usual "request for quotes" (RFQ) common in other industries. They are issued when there is not enough liquidity on a specific exchange to satisfy an investor's need, and they ultimately benefit investors by lowering their transaction costs. The fact that high frequency traders are able to make lots of money by providing this liquidity is besides the point. Liquidity providers are supposed to make money by providing liquidity!

Some people, including Senator Charles Schumer and this New York Times op-ed, believe that flash orders are akin to front-running, a clearly illegal trading activity. But they are wrong. Front-running means that if you know someone is going buy a stock, you step in front of them
and buy it cheaply first, hoping to sell it to this slower buyer at a higher price. In the case of flash orders, the high frequency traders are instead selling this stock to the original investor, often at a lower price than available elsewhere and thus benefiting this investor, hoping that the prices will come down in the future after this liquidity need subsides. This is manifestly not illegal. This is what a market is built for!

Another way to understand that flash orders are not at all front running is that anybody, including you and me, are free to put in limit orders at the same price as those of the high frequency traders, way ahead of time, in a specific exchange, and become liquidity providers ourselves. You don't have to wait for a "request for liquidity" before doing so. And presumably you will reap the same benefits as the high frequency traders. You are not taking any additional risks over the HF traders either, since if no requests for liquidity ultimately arrive, you are not any worse off for wear. You cannot begrudge the profits of the HF traders just because you didn't put the limit orders in place beforehand!

Maybe there are some other angles which I miss which can convince me that flash orders are evil. But until my kind readers convince me otherwise in the comments section, I will regard this piece of legislation as another SEC attempt at demagoguery.

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