The investment management industry has a lot at stake in the flash order controversy. The freedom to acquire and dispose of one's property is a fundamental right, and property owners must be allowed to determine the methodology by which they will acquire or dispose of their assets. Have you ever been called by a real estate broker who tells you a home you are interested in will be coming on the market soon? That's a form of flash trading. Long before we had electronic trading, we had block desks. These desks often called customers they believed might have the other side of an order before sending the order to the floor. That's a form of flash trading. On the NYSE floor, a floor broker might decide to leave a small bid on the public order book, but whisper to the specialist that he has an interest in size. The specialist might discreetly shop that interest, or discreetly begin to acquire shares in "stabilizing transactions" in order to accumulate enough shares to make an offer in size. Sounds like flash trading, doesn't it?
After the PC was developed, portfolio managers were able to use optimizers to generate hundreds of orders at a time. The original electronic dark pools, POSIT and The Crossing Network, sprang up to help traders defray the cost of executing these orders. Typically, the order list was shown to the dark pool, and the residual was taken to the floor for execution. Dick Grasso at NYSE argued this created fragmentation (the "F" word) and was bad for markets. We electronic traders argued it was the "S" word--segmentation, or "different strokes for different folks." Investment managers, with a fiduciary obligation to obtain best execution, began to have an increasing number of alternative venues on which to place their orders, and the ability to decide which one was best for each of their orders.
Senator Schumer's "little guy" benefited from this enormously. Years ago the little guy called a broker, who took his order over the phone, then walked it down to the wire operator, who sent it to the exchange. Eventually a report came back to the branch, and hopefully the broker called his client to provide the report. Today's little guy sends the order in on his PC and gets a report as fast as browser can switch to the order status page. And instead of quarter-point spreads, the little guy is paying a penny or two in large-cap stocks. A more robust system for handling institutional orders might mean that a 200,000 share order creates less market impact, which protects the little guy, who apparently can't stand the volatility these orders create. In any case, the little guy's feedback loop on an order today is at worst a few seconds longer than an institution's, rather rather than several minutes.
Thirty years ago, most of the trading happened at the NYSE post or in the upstairs market. The upstairs market was fragmented and tricky, as traders had to figure out who really might have the other side of the trade: Goldman, Morgan, Jefferies, or Cantor, etc. If you guessed wrong you could be embarrassed as someone else found a seller first and sopped up the liquidity you were looking for. That's no less an issue today--which dark pool or ATS has the other side? Flash orders are a legitimate technique for finding the liquidity you need. Any trader knows they aren't for all situations, just as any homebuilder knows some jobs take a hammer, while others take a screwdriver.
I'm dismayed by the knee-jerk reaction by the SEC to all of this. Mary Shapiro must have spent too much time at CFTC, where futures exchanges was monoploy contracts could change the rules at will and the customers were stuck with them. Stocks can trade anywhere, and if the SEC is disregards economic necessity and prohibits what are essentially long-standing, sensible trading techniques, that trading could easily move offshore. It's all a matter of where the servers are. And Shapiro was an SEC commissioner from 1988 to 1994, when the electronic markets were first developing. She should understand that traders are for the most part evolving electronic trading structures that replicate techniques developed in the old Analog" days.
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