Perhaps one of the more historic public fights in “Wall Street” history might be coming to a conclusion. The impending Securities and Exchange Commission approval or disapproval of the “Flash Boys” stars and their IEX Exchange, founded by Brad Katsuyama, is reaching a higher crescendo, if such a point in this emotionally charged battle is possible. Key variables being considered are the advent of a “speed bump” to slow down trading from the stand point of market security, what is permissible under SEC rules known as “Reg NMS” and, perhaps a guiding principle: what is in the best interest of long-term investors? But a key behind the scenes milestone is also being achieved: regulators might clearly state investor protections are their top priority as transparency and three significant journalistic enterprises played a role in changing the Wall Street culture on the issue.
IEX “speed bump,” the meaning of SEC regulations and core principle of putting the investor first are being decided by SEC
At the center of controversy within the IEX exchange application submitted this past September is an intentional trading delay of 350 microseconds in the design. This “speed bump,” as it is known, is intended to level the playing field between sophisticated speed-based traders, who pay exchanges for a technical advantage, and more traditional investors who often use slower, more traditional trade execution techniques.
The Michael Lewis book “Flash Boys: A Wall Street Revolt” created a firestorm when it spotlighted high frequency trading firms that pay exchanges millions in rental fees and technology expenses to receive preferential treatment. Flash Boys followed other books that highlighted a system that violated fundamental regulatory principles of exchange transparency into order types, paying for preferential treatment and, at times, pointed to illegal behavior that was damaging to market security. Using undisclosed order types and essentially seeing other orders enter the trading arena and paying for the ability to trade in front those orders — something human pit traders thought was illegal — the computer-based arbitrage players took a fraction of a penny on each “scalp” trade. Lewis was not the first to expose this practice, but the book shined a spotlight to an extent Wall Street had seldom seen. This resulted in an odd effect. Democracy and regulators potentially not acting in the interests of the industry but focusing instead on investors — a historic, if under reported moment — might just be part of the story, which is exposing odd alliances among elites as a rare public questioning of the sanctioned established stock exchanges is currently taking place.
When Wall Street issues are settled behind the scenes, they often lead to financial self-interest winning in the shadows
Five years ago would a mundane exchange application have gained any press attention? When the concept of dark pools being allowed to trade stocks was first approved, did it receive the same press attention as a recent investment bank comment letter on the IEX application did? The concept of creating so many multiple trading venues was rejected in the derivatives industry, but very little attention was paid when regulations initially changed.
But now, so much has changed.
On a day when Goldman Sachs makes news for endorsing the one-time nascent David of the Investors Exchange, IEX, who challenged Goliath competitors, those nuanced alliances were perhaps most clear.
“We fully support approval of IEX’s application to be a stock exchange,” Paul Russo, Goldman’s managing director, equities, wrote in a widely read comment letter posted on the SEC web site Wednesday. “In addition, we urge the Commission to address conflicts such as exchange routing and to encourage criteria beyond price and speed as the default working definition of best execution.”
Separate analysis indicates it is that notion of “best execution” for long-term investors, how existing regulations are interpreted and what actually might, or might not, damage market structure are likely to tip the scales in this fight.
“As exchanges facilitated trade matching based on price time priority, access speed emerged as the primary differentiator in the marketplace,” the Goldman letter stated. “Participants responded by optimizing the geographic location of their servers and building infrastructure that leveraged faster market data feeds as well as advanced hardware and connectivity. These changes have effectively placed others with less sophisticated infrastructure at a disadvantage.”
Goldman does not provide unqualified support to IEX however. “…We are concerned that exchange-affiliated routing broker-dealers may have access to and use the proprietary market data of the exchange to benefit their own order routers,” the comment letter stated. “Consistent with the themes raised by the industry in the SIFMA letters, we urge the Commission to undertake a review of the structure and operations of exchanges to ensure that there are adequate regulations enforcing the arms-length separation between their operations as public exchanges and those as non-public broker-dealers”
“Reg NMS” has two parts, a primary ruling where the word “microsecond” is not used to define a speed limit, and a supplemental component where language indicates that exchanges are advised to dispense market information without delay
Many issues were discussed in a highly unusual number of comment letters on an exchange application. In the past, such exchange decisions would have taken place behind the scenes without much media fanfare. After all the shouting has ended, the issue is boiling down to a handful of points, some of which center on a complex set of rules under the Regulation National Market System, rules that govern automated trading also known as “Reg NMS.”
Both IEX advocates and those opposed to the exchange point to Reg NMS rules to bolster their claims. IEX backers are quick note the word “microsecond,” a key measurement of time, is not contained in the primary SEC regulatory document. Supporters of IEX say the SEC’s own rules and stated goal to protect investors first should guide their decision to approve the application. They say the SEC is clear and industry best practices should use a millisecond as the lowest common measure of speed.
Some detractors say that the current high frequency trading system has resulted in the lowest cost to investors in history regardless of the “scalping” method that takes place. They complain that IEX might create an unfair advantage if their exchange proposal is approved and doing so might be illegal, a point hotly debated.
“Reg NMS is clear,” said Nanex President Eric Hunsader, a vocal HFT critic and IEX supporter. “Reg NMS does not address microsecond timing, only the longer millisecond increments and that the regulation must come down on the side of investors. Investors must be the top priority.”
IEX backers point to an adopting release from the SEC as supporting the interest of long-term traders, IEX and investors. “Should the overall efficiency of the NMS defer to the needs of professional traders, many of whom rarely intend to hold a position overnight?” the SEC document stated, referring to high frequency traders. “Or should the NMS serve the needs of longer-term investors, both large and small, that will benefit substantially from intermarket price protection?” The document said NMS “must meet the needs of longer-term investors,” noting that any other outcome “would be contrary to the Exchange Act and its objectives of promoting fair and efficient markets that serve the public interest.” The IEX exchange application is noted for having support in terms of comment letters from dozens of well-known long-term institutional investors.
Voice to those opposing IEX: Creates an unfair advantage, violates Reg NMS and could damage market structure
The only major institutional investor to oppose IEX is Chicago-based alternative investment firm Citadel, which operates a significant market making business under its Citadel Securities division. The firm also runs several well-regarded noncorrelated hedge funds with varying investment time horizons. Ken Griffin, the fund’s founder, is respected inside the hedge fund community as well as among exchange officials and regulators. His firm’s opinions are closely considered, as two recent meetings between Citadel and the SEC illustrate.
A key footnote in one of several Citadel comment letters is sets up a key legal argument opposing the IEX proposal, according to multiple sources. “Simply approving the Application in its current form, which contradicts the plain language of Regulation NMS and the Regulation NMS Adopting Release, would be a clear violation of the Administrative Procedures Act, absent a request for an exemption from IEX from the relevant provisions of Regulation NMS and issuance of an exemption by the Commission supported by the required findings,” the Citadel comment letter said. Citadel sides with other major stock exchanges which oppose IEX. IEX detractors point to the SEC’s regulation’s supplementary documentation itself which says exchanges should release information to the public without delay as not allowing IEX and its intentional speed bump to proceed.
A cage match worth the price of admission: Eric Hunsader vs Larry Tabb
A Twitter debate partner with Hunsader over the IEX issue is the generally soft-spoken Larry Tabb, president of the market structure consultancy Tabb Group. He notes that, while the primary Reg NMS doesn’t mention microsecond time frames, only noting millisecond increments, supplemental documentation submitted as adjoining to the Reg NMS, calls for price and quote decimation without delay. “Quotes needs to be decimated as fast as technologically possible, which is to say a speed bump isn’t OK,” he said. “A speed bump opens a can of words. It moves us one step closer to getting rid of order protection,” pointing to a slippery slope.
“Everyone needs to display in real time or we should just get rid of order protection,” Tabb said. Order protection ensures that exchanges route orders to the most advantageous prices but some critics charge it has resulted in unintended consequences. “Don’t mandate how the exchanges route orders. Let arbitrage take care of any discrepancy.” Tabb emphasizes that he agrees with Hunsader on several issues, their primary goal being market security. Hunsader, who initially challenged Tabb to a debate on the issues, which was accepted by Tabb, says a microsecond shouldn’t matter, a common voice among IEX supporters. The debate was originally planned to be recorded in the Chicago studios of industry publisher John Lothian, but Hunsader is still yet to agree to this venue and the debate format. The material relevancy of the IEX speed bump when compared to the speed bump between Chicago and New York, or along the New Jersey coast, will likely to be a key topic if such a debate were to take place.
“The stock which trades most frequently (SPY) trades only once every 80,000 microseconds on average,” analyst Gene Noser wrote in a comment letter. “A delay of 350 microseconds is not of consequence when we examine trades not quotes, which are 95% canceled with no money changing hands.”
Current regulations require that the trade be routed to the exchange with the best pricing. But what if a speed bump creates a momentary, microsecond illusion of the best price? “Am I routing an order based on yesterday’s newspaper?” Tabb questioned, pointing to microsecond outdated quote information. “Which of the quotes are real?
Impairing price discovery functionality is also concern with regulators, as is pointed out in Reg NMS:
Impaired price discovery could cause market prices to deviate from fundamental values, reduce market depth and liquidity, and create excessive short-term volatility that is harmful to long-term investors and listed companies. More broadly, when market prices do not reflect fundamental values, resources will be misallocated within the economy and economic efficiency – as well as market efficiency – will be impaired.
The key question is: Will the microsecond speed bump impair price discovery and be harmful to long term investors?
Does the IEX speed bump even matter?
To provide perspective, it takes 300 to 400 milliseconds to blink an eye. A millisecond is one thousandth of a second. A much smaller microsecond is one millionth of a second. Does this micro time increment, never mentioned in the primary Reg NMS documentation, matter? Goldman seems to think the race for speed has its speed limit.
“The U.S. equities markets are mature and move in sub-thousandths of seconds, which forces firms like ours to invest in lower latency technology to remain competitive,” the letter said. “However, the value to investors from this non-stop race for faster speeds may have reached a point of diminishing marginal returns for market efficiency and stability.”
Hunsader, for his part, thinks the speed bump issue is a non sequitur. “Every exchange has a delay coil as part of their design,” he said. The delay between the Chicago Stock Exchange and New York can be up to 8,000 microseconds, a much more significant speed bump the 350 microsecond speed bump being proposed by IEX, Hunsader noted. Opposing market structure experts observe a speed differential between southern and northern New Jersey, where different stock exchanges have their computer servers located, also provides a speed bump, making the IEX speed bump mute.
IEX detractors don’t see it this way.
“IEX will have an inherent competitive advantage over the other exchanges. IEX routes in real time but everyone routing to IEX will have a 350 microsecond delay,” Tabb said. “IEX can take NASDAQ liquidity in real time but NASDAQ can’t take IEX liquidity in real time.”
Tabb notes with concern market structural issues. “If IEX speed bump is approved, there are 4 or 5 other exchanges that have de minimis level of market share that could easily be re-engineered to create similar speed bumps,” he said. “What happens if an exchange creates a nefarious speed bump? What if five different exchanges all create different speed bumps, are you routing to them based on real quotes (or when they go to execute a trade that advertised price will be gone)?”
It is unclear if an IEX speed bump would lead to such issues. “This debate is like recognizing the speed limit is 55, but we’re debating about why we can’t go 85 miles per hour,” Hunsader said. “We can go 85, we just have to change the law to make 85 the speed limit.”
Analysis and opinion: IEX and a unique moment in Wall Street history
The SEC clearly has a difficult task ahead. However it adjudicates, powerful forces on both sides of the situation could turn to the courts to decide the issue if they lose. For its part, the SEC is likely not intimidated by threats of a lawsuit, according to a source. They could end up using this as an opportunity to clearly define regulations based on core principle, an old school tactic. The SEC may say its highest priority is to protect investors and ensure market structure security first, above the interests of financial professionals. As such, don’t be surprised to see the SEC forge its own path and define the future independent of powerful lobbying groups. This would be part of the historic aspect of the IEX exchange application.
There is an unwritten history on Wall Street. Unwritten because a powerful establishment is allowed to control, keeping a lid on questionable issues. In part, when influential organizations such as Goldman Sachs back IEX, its sends a message. The subtle and generally respected investment bank is known for a relatively even handed treatment of industry issues. Behind the scenes in the MF Global fight, for instance, Goldman executives were said to privately argue in favor of protecting investors, while publicly they voiced support for the Chicago-based derivatives industry culture at a CFTC forum. Michael C. Dawley, Goldman’s managing director and rumored to be in line to succeed Christopher K. Hehmeyer as chairman of the National Futures Association, is generally respected by reformer voices and establishment forces inside the financial services industry, for example. That’s a reasonably difficult feat. Goldman’s clear voice of support for IEX is likely to carry significant weight in the matter across all industry participants.
Another noted voice with significant exchange experience is Virtu Financial, a firm said to be a two-sided market maker with deep derivatives exchange experience as well as key former JPMorgan executives backing the firm. “We understand that other participants have expressed concerns regarding the market impact of such a ‘speed bump’ on a registered stock exchange,” Douglas A. Cifu, Virtu’s chief executive officer, wrote in a comment letter. “While we encourage the Commission to study and review its potential impact on the national market system and its compliance with relevant SEC rules, we express no view on the efficacy or consequence of this feature given its lack of impact on our business and trading strategies.”
But perhaps the most historic aspect of the IEX story is how the bright lights of media attention and transparency impacted outcomes. As much as certain establishment figures are loathsome to give author Michael Lewis any credit, the issues driving this deliberative process are illustrative of the fact that transparency and journalism are key to a properly functioning democracy. Lewis wasn’t first on the issue, as the revealing book from Sal Amuk and Joesph Saluzzi, “Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio,” deftly outlined the situation first. They were then joined by respected Wall Street Journal reporter Scott Patterson, who authored “Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market.” Patterson relentlessly wrote about market structure, uncovering many issues through his writing, but for some unexplained reason he was transfered to covering the mining industry for the Wall Street Journal while history is being made in the world of The Quants.
Brad Katsuyama speaks: How history would have been different if a spotlight was not present
How would the IEX issue have been decided if these authors were not allowed to have a voice? IEX founder and Flash Boys hero Brad Katsuyama, the modest Canadian who took on the most powerful establishment in modern capitalism, knows how a democracy should work.
“The scariest part of starting IEX was not whether we were right or wrong,” Katsuyama said in an interview with ValueWalk. “My biggest concern was: will anyone care?”
When issues are handled behind the scenes, when industry participants without financial interest in the issue fail to take an interest, powerful forces who have financial self-interest tend to win. In the end, when issues are discussed in public, the truth tends to come out in the wash. That is, in part, what Michael Lewis and his team are accomplishing across several levels at this historic moment in time.
“Michael Lewis and Flash Boys changed the game for us and IEX’s public profile is helping us tremendously at this exact moment and bringing attention to this fight,” Katsuyama said. “I think we would have been easy to stamp out without the book, but that isn’t the case and we aren’t going away. We will fight this as long as it takes because we feel confident that the truth will win in the end.”
The post IEX Debate Reaches New Crescendo, Decision Will Pave Future Industry Path appeared first on ValueWalk.
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Mark may hold positions in one or more of the companies mentioned in this article.