By Roberta Rampton, Rachelle Younglai and Jonathan Spicer
WASHINGTON/NEW YORK (Reuters) - U.S. regulators probing the May flash crash are focusing on a trading practice known as "quote stuffing", in which large numbers of rapid-fire orders to buy or sell stocks are placed and canceled almost immediately.
CFTC commissioner Scott O'Malia told Reuters on Thursday that the futures regulator was reviewing data from Nanex LLC, a trade database developer that issued a study suggesting that computer algorithms used quote stuffing to gain an edge during the May 6 crash.
The U.S. Securities and Exchange Commission, which is investigating the crash jointly with the Commodity Futures Trading Commission, is looking at quote stuffing and something called "sub-penny pricing", a person familiar with the flash crash probe said.
The Nanex study uses market graphics and playful names to illustrate quote stuffing, arguing that high-frequency trading firms do this to flood the marketplace with bogus orders to distract rival trading firms.
Investors could make trades under the false impression that those orders were legitimate, only to see liquidity disappear and the market move against them when the orders are canceled -- all in the blink of an eye.
"If traders are flooding the market with orders with the intention of slowing other traders down, then we should consider addressing this under new disruptive trading practices authority," O'Malia said.
O'Malia serves as head of the CFTC's technology advisory committee, which in July raised concerns about what effect quote stuffing has on investors and prices.
"I don't see how quote stuffing as a trading practice benefits futures markets," O'Malia said.
The SEC and the CFTC have yet to explain what caused the crash that drove the Dow Jones industrial average down some 700 points in minutes, before sharply rebounding. The SEC still is requesting "a huge amount of general data" from exchanges and other trading venues, a second person familiar with the investigation said.
Quote stuffing happens regularly, causing the prices of stocks that appear to have a deep order book of interest to move very quickly, a third source familiar with the investigation said.
Nanex has supplied the SEC with its computer programing application, which in combination with other data, can allow authorities to identify who is behind the disruptive trades, Nanex founder Eric Hunsader said on Thursday.
"This whole business of sending in 5,000 quotes in one second to one stock is usually confined to half a dozen stocks at any given moment. If it happened in 50 stocks in the same second, it would overwhelm the system," Hunsader said.
The SEC is also looking at "sub-penny pricing" in the wide-ranging investigation, the first source said.
In sub-penny pricing, non-exchange venues including anonymous dark pools quote and execute orders priced in increments as small as one-tenth of a cent. Exchanges are not allowed to do this, but have considered asking regulators for permission.
A sub-penny order sitting in a dark pool, where prices are not publicly displayed, can trade before orders in displayed markets, possibly giving a false impression of the degree of buying or selling demand.
An SEC spokesman declined to comment.
Regulators plan to issue a follow-up report on the flash crash this month.
(Additional reporting by Herbert Lash in New York, Sakthi Prasad in Bangalore; Editing by Tomasz Janowski, Derek Caney and Ilaina Jonas)