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This evening the Securities and Exchange Commission approved an application by a startup called IEX to become a full-fledged stock exchange. By approving IEX, the SEC was giving its stamp of approval to one of the most high-profile challenges to the current Wall Street regime. Co-founded by a Canadian trader named Brad Katsuyama, IEX is designed to be a market free from high-frequency traders who use their speed to skim profits off the orders from ordinary citizens.
The company, and Katsuyama in particular, rose to prominence as the stars of Michael Lewis' best-selling book, Flash Boys. Lewis argued that modern markets were rigged, allowing high-frequency traders to pay for fast access and use that speed to front-run other traders. As a trader, Katsuyama dealt with the problem first hand. He would place a bid for a stock at a price he saw listed, and then find there were no shares available at that price. "They could detect my order at BATS, race me to the next exchange, and cancel their sell orders while buying whatever is left, then turn around and try and sell stock back to me at a higher price," said Katsuyama.
Katsuyama and his team devised a speed bump to block these kinds of tricks. At a time when everyone was getting faster, IEX decided to get slower, delaying each trade by 350 millionths of a second, a fraction of the time it takes to blink your eye. No human would notice the difference, but it was enough to throw off systems that were trying to read and then outrun buyers. Suddenly, when Katsuyama went to purchase shares, he no longer found them purchased and flipped back at a higher price. "We solved the problem. We have a product."
The system, which opened for trading in October of 2013, proved very popular, drawing praise and business from big banks like J.P. Morgan and investors like Franklin Templeton. On the average day, 280 million shares are now traded through IEX, making it the second-largest platform for trading stocks outside of the traditional exchanges. But as long as it remained an alternative trading system, sometimes called a dark pool, IEX could never grow as big as full-fledged stock exchanges. So, last year IEX put in an application to become a stock exchange.
Not surprisingly the incumbent exchanges — NYSE, NASDAQ, and BATS — all mounted a case against IEX. So did high-frequency trading shops like Citadel and Hudson River Trading. The normally sleepy process of approving an exchange application became a heated public battle, playing out in comments to the SEC, editorials in the press, lobbying in Washington, and legal threats. The SEC, under intense pressure from lobbying groups backed by the incumbents, delayed the process twice, extending it six months past the original deadline.
The ability for HFT firms to front-run orders has been widely established, but allowing them to operate can be profitable for nearly everyone but the client who wants to execute a trade. Over the last decade, a new practice has emerged: payment for order flow. Firms like Citadel and KCG pay brokers to get lots of orders, volume which high-frequency traders can then skim profits from. Meanwhile, the HFT firms pay the exchanges for data feeds, faster speeds, and even placement of their hardware next to the computers that run the exchange, allowing them to eliminate latency and more easily outmaneuver the average trader. This revenue has become the principal driver of growth for exchanges. IEX, by contrast, does not pay for order flow, and does not sell “feeds or speeds” to traders.
As IEX has grown in size and prominence, many of the predatory practices it shuns have come under scrutiny from law enforcement. In January, Barclays and Credit Suisse both settled with the New York state attorney general after being accused of misleading investors, essentially routing their orders to dark pools where they were picked off by high-frequency traders. Barclays admitted to violating securities laws and misleading investors. In May, news broke that Citadel and KCG, another massive high-frequency trading firm, were under investigation by the Justice Department. Senators and many others have called for an end to payment for order flow, a practice pioneered by none other than Bernie Madoff.
So what's stopping the SEC from approving IEX? The main argument made by opponents is that its speed bump will interfere with the smooth functioning of today's fast-moving markets. “The proposed IEX Access Delay and IEX protected quotation status would degrade market efficiency and unnecessarily interfere with trading and quoting on other venues,” wrote Citadel in its comment to the SEC.
“The way a properly functioning market operates is by ensuring that the orders go to the markets where the orders are the best. By slowing down their outgoing market data, it becomes very difficult to determine who has the best price, and where to send that order to,” says Larry Tabb, CEO of an influential market research firm. “While it's going over the speed bump, no one knows that this order exists.” By that logic, the IEX speed bump could hurt investors whose trades are sent awry.
But many market participants don't buy the argument at all. “We're taking about a delay of 350 microseconds or less,” says Eric Hunsader, CEO of Nanex, a market research firm. “Most of the exchange clocks will easily ebb and flow by that amount over time. So it's complete horseshit.” Sal Arnuk, the co-founder of Themis trading, concurs. “That's a shiny lure the detractors are trying to use to draw attention from the real argument,” Arnuk said. “There are plenty of three- and four-millisecond latencies already out there in everyday trading. It's laughable.”
The comment letters for and against IEX are telling. In favor are individual investors, academics, former market regulators, and even some large brokers and high-frequency trading shops. In opposition you find only the high-frequency traders who have been profiting off the current state of affairs and the exchanges that would compete directly with IEX for business. “There are people that were able to take advantage of the situation for a long time, and make tremendous amounts of money,” says Alex Finkelstein, an investor with Spark Capital, who led IEX's last round of funding. “We're attracted to companies that want to take on big companies. It seems scary, but those are the opportunities we love to back.”
And while incumbents have been criticizing IEX's methods during the months that passed while the SEC delayed its decision, exchanges like NYSE and NASDAQ have been playing catch-up, building their own versions of the speed bump, although none have yet deployed them. “All the big exchanges have now adopted IEX's methods,” says Hundstader. But he says most people aren't convinced by these proposed changes, because the exchanges are continuing to sell data and speed to the HFT shops. “They are too conflicted. They are arms dealers. The income is all coming from selling direct feeds. It's hard to switch over and become a diplomat.”
The about-face from the big exchanges is a testament to the success of a startup not many people thought would succeed. Matt Harris, an investor with Bain Capital who backed IEX, remembers getting the pitch for the first time and thinking, “It's just yet another trading venue that was going to try to change things. A category that, for good reason, most people, including myself are very skeptical about.” Exchanges are perhaps the purest example of a business driven by network effects, making it very hard for newcomers to offer clients a better product.
“There's this kind of deathless phrase: liquidity breeds liquidity,” says Harris. To suffer through slower trade and less precise prices, customers would need a powerful motivation. The publication of Flash Boys was the wake-up call that galvanized opposition to the status quo, and opened the door for IEX. “You can imagine that conversation where the portfolio manager reads the book on the beach in Aspen and comes in and then there's the trader,” says Harris, visualizing the moment of truth. “We've been getting our faces ripped off for seven years? You're going out to dinner with all these guys? What the fuck?”
After the SEC decision arrived, late on a Friday evening after the markets were closed, Katsuyama sent along the following statement. “We are grateful and humbled by the support we’ve received from the investor community, without it, we may have faced a different result.”
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