Monday, June 20, 2016


Don't worry, all those acronyms may (eventually) make sense.

With the recent news that IEX is approved to change from an ATS to an NSE under NMS in the face of persistent objections from other HFTs, we need to see what we can do to unpack this all.

So, let's go back a little more than 10 years, to 2005, when Regulation NMS was established. As a regulation, it is a set of rules:

National Market System (NMS) is a set of rules passed by the Securities and Exchange Commission (SEC), which looks to improve the U.S. exchanges through improved fairness in price execution as well as improve the displaying of quotes and amount and access to market data.

One of those rules, in particular, is Rule 611, commonly known as the Order Protection Rule:

Rule 611, among other things, requires trading centers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent "trade-throughs" -- the execution of trades at prices inferior to protected quotations. To be protected, a quotation must, among other things, be immediately and automatically accessible and be the best bid or best offer of a national securities exchange or national securities association

As I understand it, the basic idea of Regulation NMS is to modernize the system, to enable greater efficiency but also to improve the access to the market by encouraging competition.

Competitors can be of several types. Nearly 20 years ago, the SEC introduced the notion of Alternative Trading Systems: SEC Modernizes Regulations for Alternative Trading Systems

The Commission adopted a new regulatory framework for alternative trading systems. The low cost of technology has allowed new, automated markets -- or alternative trading systems -- to develop. These systems compete directly with the more traditional exchanges, and now account for about 20% of transactions in Nasdaq securities and 4% of transactions in listed securities. Although these alternative trading systems are markets, they have been regulated as traditional broker- dealers, resulting in certain regulatory gaps. The framework adopted by the Commission today, better integrates alternative trading systems into the regulatory framework for markets, and is flexible enough to accommodate the business objectives of, and the benefits provided by, alternative trading systems.

That competitive framework apparently worked, for as of 2014 there were hundreds of Alternative Trading Systems known to the SEC.

Down in the middle of that list, you may see: IEX ATS / IEX Services LLC, which is the particular Alternative Trading System that we're interested in.

Why are we interested in IEX? Well, for that, we need to give credit to the well-known writer, Michael Lewis, whose book, Flash Boys: A Wall Street Revolt dragged IEX out of the depths of obscurity and into the media spotlight.

Who knew that High Frequency Trading could be that sexy?

Michael Lewis just has that effect on people, and organizations.

Anyway, many people think Flash Boys was a wonderful book, while others, including the sober and well-informed Felix Salmon, are not so impressed, but the bottom line is that all of a sudden the people and organizations in the book got a LOT of attention.

The people and organizations in the book include, in particular, Brad Katsuyama, founder of IEX. Yes, that IEX, the Alternative Trading System.

So once Lewis's book was out, and once 60 Minutes aired Katsuyama's story, people started to pay attention to his ideas about what an "alternative" trading system might look like. Which, as Matt Levine explains, is something like this:

The idea is that if you're a big mutual fund and you submit an order on IEX, that order will not provide any information to high-frequency traders for almost a whole millisecond. (A shoebox full of wires is involved, which everyone else seems to find more interesting than I do.) The result is that HFTs won't be able to react to your order by moving up prices on other exchanges, and you'll be able to execute more shares at the displayed price.

It's actually slightly more than "a shoebox full of wires," it's "a coil of fiber-optic cable 38 miles long that slows quotes and trades by 350 millionths of a second," but that's really just a nit. Conceptually, it's just a mechanism, and the more interesting thing is the concept behind IEX.

And that underlying concept is all about High Frequency Traders. As Levine points out, HFT is a matter of quite some controversy:

There are two ways of characterizing high frequency trading. In one, HFTs are front-running big investors, rigging the game against them and making the stock market illusory. In the other, HFTs are reacting instantly to demand, avoiding being picked off by informed investors and making the stock market more efficient.
but, moreover, says Levine,
You don't have to be absolutist about this either way. Whether or not HFTs' behavior of quickly adjusting quotes to market conditions is "predatory" in some moral sense -- and whether or not it ultimately makes markets more or less efficient on balance -- it is clearly annoying to a lot of institutional investors. So those investors like having the option of trading on IEX. And there's no obvious reason to think that the current market structures and rules are the "right" rules, or that high-frequency traders aren't sometimes gaming those rules in not-so-socially-optimal ways.

That is, there is a strong argument to be made for choice, and for options, and for competition: if we don't know, and can't prove, which exact way of operating a trading system is the One True Right Way, then why not allow competitive approaches, and gain some experimental evidence.

That's clearly how the SEC felt, back in 1998, and hence the establishment of IEX in 2013.

IEX proceeded along for a couple years as an ATS, but then, about a year ago, IEX announced that they wanted to change from being an ATS to being a national securities exchange. What does that mean? Dani Burger and Jeremy Kahn of Bloomberge describe it this way: ‘Flash Boys’ Heroes Ask For Stock Exchange Status:

When an exchange has the best price for a stock at any given moment, orders must be routed its way. Lightly regulated alternative platforms, which is what IEX legally is today, don’t enjoy that same advantage. Even with that headwind, IEX has won about 1.4 percent of U.S. equities trading less than two years after launching.

"Right now, IEX is a choice that people may or may not make," Katsuyama said. "As an exchange, you’re part of the National Market System. It becomes an obligation if you’re the best price to send the order. It goes from optional to mandatory."

That is, it's all about Rule 611 (the "Order Protection Rule"). Remember that bit back at the beginning, about how Rule 611 involves " a national securities exchange or national securities association?".

Well, if IEX is an Alternative Trading System, then Rule 611 does not apply, but if IEX is a national securities exchange, then Rule 611 DOES apply.

Time for Matt Levine to spell it out for us again: The 'Flash Boys' Exchange Is Growing Up

I should say that this rule, the "order protection rule," annoys a lot of people. It is sometimes blamed for the market's current fragmentation and opacity. Instead of everyone choosing what market(s) they want to trade in, investors are forced to route their orders to a bunch of smaller venues, giving an advantage to traders with fast computers and a deep understanding of market architecture. But it's the rule: If you're an exchange, and you display the best price, everyone else has to route to you.

In other words, it's competition between exchanges, except that Rule 611 rather strictly constrains the competition.


Matt, can we please have a little bit more detail?:

IEX's quotes, which are effectively 350 microseconds in the past, would be protected along with other exchanges' quotes, which are ... well, they're not exactly in the present. They're some variable amount of time in the past. Every exchange has some delay in processing orders; nothing happens instantaneously, and it's hard to synchronize anything to the microsecond. If IEX is faster at other operations than other exchanges are, then its quotes may be more current than theirs. Its intentional delay might be shorter than their accidental delay.


Other exchanges also have delays between receipt and execution of orders; that is just how physics works. And those delays might be comparable to, or even longer than, IEX's. But they're not intentional.

So, uhm, it's complicated. And controversial.

And, so, the SEC invited comments, and discussion.

Which went on, and then went on some more.

And some of this was a discussion about Rule 611, but other parts of it, as Robin Wigglesworth observes, was a broader discussion about what we know, and still don't know, about High Frequency Trading:

the latest study, by the UK’s Financial Conduct Authority, is not so sure. It looked specifically at the latency arbitrage/front-running issue, and here is what they concluded.
We do not find evidence that HFTs systematically anticipate near-simultaneous marketable orders sent to different trading venues by pure non-HFTs. But when analysing longer time periods (measured in seconds or tens of seconds), we do find patterns consistent with HFTs anticipating the order flow of pure non-HFTs. However, we cannot say whether this is due to HFTs reacting more rapidly to new information, or to order-flow anticipation.


It doesn't appear that that it will be Science To The Rescue here, because this is not science, exactly: it's politics, and society, and Rules and Regulations.

So time passed, and comments were received, and discussion happened.

And time passed.

And, after nine months of this, the SEC apparently decided that, well, the whole point of Regulation NMS was to encourage competition, and innovation, and well, here was some competition, and some innovation, after all.

So, in a 122 page announcement the SEC explained that

For the reasons set forth below, and based on the representations set forth in IEX’s Form 1, as amended, as supplemented in IEX’s responses to comments included in the public comment file, this order approves IEX’s Form 1 application, as amended, for registration as a national securities exchange.

Katsuyama, naturally, is ecstatic:

This is a milestone for all of those who have supported IEX and we look forward to becoming a stock exchange, which will provide us the opportunity to have an even greater impact on the markets.

Meanwhile, existing exchanges such as Citadel and the NYSE are furious:

"Our markets work extraordinarily well for retail and institutional investors, and we need to be vigilant in identifying any unintended consequences of the approval," Jamil Nazarali, head of execution services at Citadel Securities, said in an interview.

Stacey Cunningham, chief operating officer of NYSE Group Inc., said the exchange objected to IEX’s proposal because they were "looking for exemptions to existing rules."

BATS, meanwhile, was initially happy, then was mad, but maybe is feeling a bit more accomodating now:

BATS Global Markets, initially supported the IEX application, but earlier this year withdrew its support, pointing to "gross omissions of fact" by IEX. BATS wrote that the problems "call into question the applicant’s professional judgment."

On Friday, a BATS spokesman, Randy Williams, said that the company "congratulates IEX and appreciates the significant changes they made to their application to address industry concerns."

And some traders are downright delighted: Flash Boys Hero Wins, Wealth Funds Rejoice

Sovereign wealth funds, which own large portfolios of listed equities, are eager to work with platforms like IEX given their concerns with high-frequency trading (HFI). For example, in a comment letter to the SEC, Norges Bank Investment Management (NBIM), the manager of Norway’s sovereign wealth fund stated, "We would expect that the ‘speed bump’ as well as other proposed features of IEX, such as the relative simplicity of available order types, would mitigate the potential for such rent extraction."

In some ways, the reactions are about as you would have predicted, observes Ben Popper at The Verge: The startup trying to clean up Wall Street just became an official stock exchange

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 a lot of well-funded, high-strung, complicated institutions here: stock exchanges, sovereign wealth funds, institutional investors, high frequency traders. All of them are extremely wealthy, all of them are interested in making themselves more wealthy, and none of them are particularly known for charitably lending a helping hand to the little guy, nor for explaining in Plain Language what it is they are doing and why they are doing it.

Of course, that is nothing new; that is the way of capitalism, I'm afraid.

For my own part, I am hopeful that the SEC know what they are doing. They certainly know much more then me. So when they say

Within two years of the Commission’s interpretation, staff will conduct a study regarding the effects of any intentional access delays on market quality, including asset pricing and report back to the Commission with the results of any recommendations. Based on the results of that study, or earlier as it determines, the Commission will reassess whether further action is appropriate.
I feel like I'm willing to extend to them the trust to keep that promise.

High frequency trading is fascinating, and bizarre. Is it becoming any less bizarre?

Apparently not.

But at least it is also still remaining fascinating.

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