Michael Lewis’ bestseller “Flash Boys: A Wall Street Revolt” stirred a hornet’s nest by shining the spotlight on the controversial subject of high-frequency trading (HFT). The book chronicles the journey of a small group of intrepid individuals on Wall Street who stumble across predatory behavior by high-frequency trading firms, and in a bid to provide a more balanced marketplace, create an exchange named IEX. Here’s how IEX is attempting to combat predatory trading.
What is IEX?
Launched on October 25, 2013, IEX is an Alternative Trading System (ATS), an electronic trading platform that matches buyers and sellers of stocks. Three people are the driving force behind IEX – Brad Katsuyama, president & CEO; Rob Park, chief technology officer; and Ronan Ryan, chief strategy officer. Katsuyama and Park had previously worked together at RBC (Royal Bank of Canada) Capital Markets, where they headed its electronic sales and trading, and algorithmic trading, respectively.
IEX is owned by leading mutual funds and hedge funds including Greenlight Capital, Capital Group, Brandes Investment Partners, Pershing Square, and Third Point Partners; IEX’s employees and individual investors also have a stake in IEX. As Lewis noted in his book, company executives wanted to call the new exchange the Investors Exchange, but because of the obvious problem caused by its online address (investorsexchange.com), settled for the abbreviated name IEX.
IEX caught on fast. On April 9, 2014, it handled 23.9 million shares, a 27% increase from the daily average in March. Although that volume accounted for less than 1% of total U.S. stock volume, IEX had already surpassed four of the 13 American exchanges by that date, including the NYSE MKT, the Chicago Stock Exchange, the National Stock Exchange, and the CBOE Stock Exchange.
Genesis and growth of predatory trading
High-frequency trading in and of itself is not abusive or manipulative, and a number of prominent market players believe that HFT adds liquidity and shrinks trading spreads. The problem is with a subset of HFT that IEX calls “predatory trading,” which exploits a loophole in Regulation National Market System (“Reg NMS”) that was passed by the Securities and Exchange Commission in 2005 and implemented in 2007.
Reg NMS requires brokers to obtain the “best price” for their client orders. The best price is defined by the National Best Bid and Offer (NBBO) for a stock. The NBBO is calculated by a computerized system called the Securities Information Processor (SIP), which aggregates the bids and offers for all U.S. stocks from the 13 exchanges and continuously disseminates the NBBO for them.
According to Lewis, the loophole exploited by high-frequency traders is that Reg NMS failed to specify the speed of the SIP. It takes a finite number of milliseconds for stock prices to be collated and organized from the 13 exchanges, and then calculated and disseminated by the SIP. High-frequency traders jumped the gun by setting up their own blindingly fast computers inside the exchanges (a practice known as “co-location”) and getting a view of the market much faster than the SIP could provide it. Lewis contends that at times the gap between the HFT view of the market and that of ordinary investors was as much as 25 milliseconds, which can be an eternity in an environment where speed is measured in the microseconds (one-millionth of a second).
The NBBO caused client orders to be routed to more exchanges than would otherwise have been necessary, which worked to the HFT firms’ advantage. For example, assume a client puts in a market order to buy 20,000 shares of XYZ. Suppose 100 shares of XYZ are offered on Exchange O at $10.01, 400 shares on Exchange P at $10.02, and 25,000 shares on Exchange Q at $10.04. The broker is required to first buy the 100 shares offered on Exchange O at $10.01 and 400 shares offered at $10.02 on Exchange P, and then buy the remaining 19,500 shares on Exchange Q at $10.04. The HFT firms exploit this market fragmentation by placing bids and offers in very small quantities (typically 100 shares) for every listed stock, in order to gauge buying or selling interest in a stock.
Thus in this example, if the 100 shares of XYZ were offered by a HFT firm, and it believed that this tiny order was only the tip of a much larger order, it could race ahead to Exchange Q and scoop up all the shares on offer at $10.04, and offer them back to the broker at $10.06. That amount of scalping or skimming may not seem like much, but when done tens of thousands of times a day (note that HFT trading is estimated to account for 50% of U.S. daily stock trading volumes), can add up to billions of dollars annually.
Predatory trading activities
IEX defines predatory trading as the following three activities –
- “Slow market arbitrage:” Because of the dazzling computing power at their fingertips, HFT firms can arbitrage minute price differences for stocks between various exchanges. For example, assume fictitious company UVW is trading at $20.00/$20.01 on all exchanges, but because of sudden large-scale buying on the Nasdaq, jumps to $20.03/$20.04 on that exchange. HFT firms would use their superior speed to instantaneously buy large numbers of UVW shares at $20.01 from the other exchanges and sell them at $20.03 on the Nasdaq. This arbitrage would push up the price of UVW on the other exchanges and drive it lower on the Nasdaq, resulting in a new equalized price of say $20.02/$20.03.
- “Electronic front-running:” This is the trading activity described in the earlier example of stock XYZ.
- “Rebate arbitrage:” Many exchanges offer a small payment as inducement for offering liquidity and charge for taking liquidity. For a stock trading at $20.00/$20.01, buying at the offer price of $20.01 or selling at the posted bid of $20.00 would amount to taking liquidity, while putting in an order to buy at $20.02 or sell at $19.99 amounts to making liquidity. With rebate arbitrage, HFT firms try and capture as much of the rebates as they can without actually providing liquidity.
The IEX solution
IEX aims to combat predatory trading through the following measures:
- 350 microseconds of latency – Since predatory activity such as front-running and arbitrage is facilitated by orders arriving at different exchanges at different times, IEX introduces 350 microseconds of latency (the difference between the time a signal is sent and the time it is received) for all orders. This gives the IEX Matching Engine (which matches all buy and sell orders) a head start and ensures that it has sufficient time to receive and process changes to the NBBO before a HFT firm can receive and act upon the change on the IEX. While that is a miniscule amount of time, this latency has the effect of nipping predatory trading activity in the bud.
- No co-location – IEX does not permit HFT firms or other entities to share space on its premises. Co-location has become a huge and lucrative business for many exchanges, since the closer HFT firms are to an exchange’s SIP or Matching Engine, the bigger advantage they have in getting a sneak peek at market action ahead of time.
- No special access to data – HFT firms are willing to pay tens of millions for the privilege of viewing customer orders from brokers and exchanges. In fact, U.S. Senator Charles Schumer had in July 2009 urged the Securities & Exchange Commission (SEC) to ban the practice of “flash trading,” which gives advance knowledge of stock orders to certain traders. Schumer’s concerns surrounded special programs offered by exchanges like Nasdaq, BATS and the DirectEdge trading platform, which – in exchange for a fee – would “flash” information about buy and sell orders for a few fractions of a second before the information was made publicly available. IEX does not provide special access to data to any party.
- No kickbacks or rebates – IEX does not offer any special kickbacks or rebates for taking or making liquidity. Instead it charges a flat 9/100th of a cent per share (also known as 9 mils) for buying or selling a stock.
- Only four types of orders – IEX eschews certain types of orders that were created to accommodate the HFT crowd, such as the Post-Only order and “Hide Not Slide” order. Instead it offers only four basic types of orders – market, limit, Mid-Point Peg, and IEX Check (Fill or Kill). The Mid-Point Peg gives the investor a price between the current bid and offer for the stock.
- No proprietary trading affiliates – One problem with “dark pools” – private exchanges operated by big banks and brokerages – was that because they are not transparent by nature, there is no way of knowing whether the banks and brokerages’ proprietary trading units are taking undue advantage of the information provided by customer orders in such pools. IEX avoids this conflict of interest by not engaging in proprietary trading or having any “prop trading” affiliates.
- Investor-owned only – In order to avoid any perceived conflicts of interest, IEX is owned only by investors (individual and buy-side institutions) who first need to hand their orders to brokers. IEX does not permit any entity that could trade directly on the exchange – such as a bank or brokerage – to take a stake in it.
The Bottom Line
While other trading venues or dark pools may attempt to replicate its methods, IEX does have “first mover” advantage. The increase in trading volumes is a promising sign for IEX, and proves that its measures to combat predatory trading have been well received by the large institutions who have been victimized for years by these activities, which has collectively cost them in the billions.