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September 23, 2009 |
Schiff Hardin LLP Securities and Futures Regulation Group Update SEC Action on Flash Orders On September 18, 2009, the Securities and Exchange Commission ("SEC") issued a proposal to amend Rule 602 of Regulation NMS under the Securities Exchange Act of 1934 ("Exchange Act") to eliminate an exception for the use of "flash orders" by equity and options exchanges. See Exchange Act Release No. 60684 (Sept. 18, 2009), 74 FR 48632 (Sept. 23, 2009). Rule 602 generally requires exchanges to make their best bids and offers in U.S.-listed securities available in the consolidated quotation data that is widely disseminated to the public. Paragraph (a)(1)(i)(A) of Rule 602, however, excludes bids and offers communicated on an exchange that either are executed immediately after communication or cancelled or withdrawn if not executed immediately after communication. Rule 602 has included this language since the original adoption of its predecessor rule in 1978. The exception was intended to facilitate manual trading in the crowd on exchange floors by excluding quotations that then were considered "ephemeral" and impractical to include in the consolidated quotation data. Over the past few years, this exception has been extended to a new type of automated order, called "flash orders," which are displayed for a brief period of time to a select group of market participants. The SEC is concerned that the exception for flash orders, whether manual or automated, from Exchange Act quoting requirements is no longer necessary or appropriate in today's highly automated trading environment. The SEC believes the consolidated quotation data is designed to provide investors with a single source of information for the best prices in a listed security, rather than forcing investors to obtain such information by subscribing to all of the data feeds of the many exchanges and alternative trading systems ("ATSs") that trade listed securities. The SEC asserted that the flashing of order information could lead to a two-tiered market in which the public does not have access, through the consolidated quotation data streams, to information about the best available prices for U.S.-listed securities that is available to some market participants through proprietary data feeds. In addition, while recognizing that flash orders may offer benefits to certain types of market participants, the SEC asserted that flash orders may significantly detract from incentives for market participants to display their trading interest publicly by placing limit orders. The SEC therefore is proposing to delete paragraph (a)(1)(i)(A) of Rule 602 to eliminate the exception for flash orders. In response to public concerns about flash orders, the Nasdaq Stock Market LLC and the BATS Exchange, Inc. recently eliminated the ability to use flash orders on those exchanges. If the SEC adopts the proposed amendment to Rule 602(a)(1), the SEC would apply Rule 301(b) of Regulation ATS under the Exchange Act in a consistent manner to ATSs that use flash orders because ATSs are not subject to the requirements of Rule 602(a)(1). Rule 301(b) sets forth requirements for ATSs, including order display and execution access. Paragraph (b)(3)(ii) of Rule 301 requires an ATS that meets a 5% volume threshold in an NMS stock ("threshold ATS") to provide to a national securities exchange or national securities association the prices and sizes of the orders at the highest buy price and the lowest sell price for such NMS stock that are displayed to more than one person in the ATS, so that such orders can be included in the quotation data made available by such exchange or association pursuant to Rule 602. Accordingly, if the proposed amendment to Rule 602 is adopted, orders that a threshold ATS displays to more than one person in the ATS that are immediately executed or withdrawn if not immediately executed would be required under Rule 301(b)(3)(ii) to be provided to a national securities exchange or national securities association for inclusion in the consolidated quotation data. In addition, if the SEC adopts the proposed amendment to Rule 602(a)(1), the SEC would apply the restrictions on locking or crossing quotations in Rule 610(d) of Regulation NMS in a consistent manner to prohibit the practice of displaying marketable flash orders. Rule 610(d) requires each national securities exchange and national securities association to establish, maintain and enforce rules that, among other things, prohibit members from engaging in a pattern or practice of displaying quotations that lock or cross a "protected quotation" as defined in Rule 600(b)(58) of Regulation NMS. Under the proposed amendment of Rule 602, flash orders would no longer be excepted from the requirement to include best-priced quotations and orders in the consolidated quotation data. Accordingly, quotations that are immediately executed or withdrawn if not immediately executed would be subject to the locking and crossing restrictions of Rule 610(d) like any other quotation required by Rule 602(a) to be included in the consolidated quotation data. The SEC seeks comment on a variety of issues raised by the proposal. For example, the SEC requests comment and data on the use of flash orders by exchanges for listed options and whether concerns about flash orders should be assessed differently in that context. The SEC also requests comment and data on regulatory approaches narrower than a complete elimination of the exception for flash orders from Exchange Act quoting requirements. In this regard, the SEC requests comment on issues relating to manual trading floors and the extent to which such floors, as they currently operate, continue to need the exception for flash orders. Comments on the proposal are due on November 23, 2009. The SEC also announced that it is actively reviewing other forms of "dark" trading interest (that is, trading interest that is not included in the consolidated public quotation data) that may be detrimental to the fairness and efficiency of the national market system. Dark trading interest is not generally available to the public. The SEC requests comment and data on the use of flash orders as a mechanism to interact with dark liquidity and whether other mechanisms for accessing dark liquidity either do or do not raise policy concerns that are analogous to flash orders. The SEC stated that it is developing initiatives in this area and is reviewing other related market structure issues, including Regulation ATS thresholds, direct market access, high frequency trading and co-location. For questions regarding the topics addressed in this Update, please contact any of the attorneys in Schiff Hardin's Securities and Futures Regulation Group. ABOUT SCHIFF HARDIN LLP Schiff Hardin is proud to have nationally recognized expertise in the regulation of securities and commodity exchanges and markets and the professional participants in those markets. For more information, contact us.
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