Question

Please explain in extensive detail as well as give and explain the pros and cons of Flash Trading and Dark Pools. How and should the U.S. government regulate them?

Answer 1

Flash trading is a computerized trading technique offered by some exchanges to a select group of market makers usually for a fee. All exchanges are mandated to make any buy/sell order public which cannot be executed on that exchange itself. This may happen in case of limit orders wherein the trade is subject to a particular price set by the trader while entering the trade. If a favourable price is not available on that exchange, the exchange has to make the order public. However, some exchanges 'flash' these orders to all traders with subscription for this service for a fraction of a second before making it public. Now, these traders are generally large firms with high-frequency trading facilities. They sense the direction of market movement a fraction of a second before the rest of the market and might engage in trading ahead of these orders using ultra-fast computers and thus make profits. This is also called 'front-running'.

Pros:

1. Liquidity - By flashing the order, an exchange is actually giving a chance to the traders to take the contra-side of this trade. Any trader who is willing to do so (may be a trader wants to get rid of a stock or is desparate to buy a stock), will post the contra-order and execute the trade. This helps the exchanges as it increases the liquidity of the sotck on their exchange and they make money from it instead of sending the trade to a rival exchange.

2. Market share - Flash trading increases the chances of execution of a trade on that exchange itself and hence, it helps the exchange maintain/increase its market share of trading volume.

3. Sensing the direction of the market - Some traders send flash orders for a fraction of a second and cancel it before it gets executed. This helps them gauge the market as their sophisticated computers can somehow figure out if there was any interest to their flash orders.

Cons:

1. Market manipulation - Engaging in trade ahead of the actual trade order may distort the prices and hence, may tantamount to market manipulation. High-frequency trading has been under the scanner by the authorities for the same reason.

2. Diffrentiates between traders/investors - As certain important market moving information is made available to only a select few, it creates an uneven playing field which is not good for the overall financial market. It may increase inefficiencies in the system.

3. Flash crash - If a large order for sell is received by any exchange, there is a likelyhood that these high-frequency traders will prempt this trade and start selling ahead of that order. This might lead to a large scale sell-off and can trigger a stock market collapse. In May 2010, a similar flash crash happened in US market due to an erroneous order.

DARK POOLS - They are an Alternative trading platform where the details of the orders are not revealed. They are mostly used by institutional investors in order to execute large trades without moving the price of the stock.

Pros:

1. Limiting the market impact - Since the order size and price is not revealed to all, the chances of adverse price movement is limited. In case the price and size of the order is revealed and if the order is huge (buy/sell of millions of shares), the execution of this trade will take time. Any other trader may take advantage of this information by taking the contra side of the trade and then squaring off his position at the end of the complete execution of the original trade.

2. Better prices - It is said that the trades are executed generally at the mid-point of the bid-ask spread which is benficial for both the buyer and the seller.

3. Costs are lower - For trades executed in Dark pools, the exchanges do not charge any fees and hence, the traders' costs are reduced.

Cons:

1. Disadvantage to retail investors - Since the price of execution of a trade inside the dark pool is not revealed, it is possible for large instituional clients to sell off a large chunk of shares in the dark pook while the retail investors will have no clue about such an important trade of a stock they hold/track.

2. Conflict of interest- The proprietary traders of the dark pool providers may execute trades based on the trade orders in the pool. They may even trade against the pool clients which cause conflict of interest.

3. Unfair trading practices - Some high-frequency trading firms use a technique known as 'pinging' to search for any large orders in the dark pool. They send small orders for a lot of stocks and if enyone of the orders gets executed, it implies that there is a large order from an institutional client in the dark pool. So the high-frequency trader will take a large contra position in that stock with an intention to sell it to that institutional client.

Regulation:

The government should regulate flash trading and dark pools as they provide avenues for market manipulation. The sheer lack of transparency should be reason enough for bringing it under the purview of law.

A good way to regulate this market would be to disclose the trades executed on a dark pool on a periodic basis (at the end of every month or quarter) to a regulatory body which may or may not choose to make it public.