Beginning in late August, US brokers will have a new, and quite different, choice for making their trades. The Securities and Exchange Commission (SEC) today voted to allow Investor’s Exchange (IEX) to operate as a public stock exchange. It will be the first public exchange to employ techniques specifically designed to thwart manipulative strategies used by high-frequency traders.
IEX’s application to the SEC has been the source of unusually passionate debate on Wall Street, in the form of blog posts, white papers, comment letters, New York Times editorials, and SEC committee meetings. Even individual pensioners have weighed in, concerned that their retirement accounts are being fleeced by high-frequency traders. The campaign by IEX’s founders against such high-frequency trading—which uses speed to gain an advantage in the market—was chronicled by Michael Lewis in his best-selling book Flash Boys.
Most arguments have centered on IEX’s “speed bump,” a coil of fiber-optic cable 38 miles long that slows quotes and trades by 350 millionths of a second. This bit of hardware is aimed at keeping high-frequency traders from racing ahead of ordinary investors and taking advantage of that speed to profit before others can react. Though not IEX’s only distinguishing feature, it is the one that was most difficult to square with existing regulation.
In a ruling issued in parallel with IEX’s approval, the SEC clarified that speed bumps under one millisecond will be allowed—subject to review of their intended purpose. This clarification ends a contentious regulatory debate about whether or not IEX’s approval would allow other markets ability to implement similar measures.
In 2013 IEX began operations as a private exchange, more commonly called a “dark pool.” In this less-regulated environment, IEX has grown to handle between 1.5% and 2.0% of all US trading volume. Speaking to Quartz on June 16 before the SEC announcement, IEX CEO Brad Katsuyama said that it would have preferred to launch as a public exchange, but knew that it first needed to prove to the SEC and others that its approach could work.
Now that the SEC has approved IEX’s operating as a public stock exchange, the question is how that decision will affect the rest of the market. Katsuyama stresses that IEX’s innovations were conceived to fit into current regulations. As a result, it’s unlikely this will open the flood gates to a wave of innovative new exchanges.
“If you look at the battle that has ensued over 350 millionths of a second…it gives you pause to appreciate how powerful vested interests are in preventing disruption,” he said. Nevertheless, the decision does set a precedent for having one exchange which is markedly different from the others. Other upstarts, such as the Long Term Stock Exchange project backed by Silicon Valley luminaries, have been closely watching IEX’s experience.
The other outstanding question is how the NYSE, Nasdaq, and the other established exchanges will react to IEX’s regulatory coup. At least for a little while, the speed bump is likely to offer IEX an advantage over its competitors. Institutional investors, such as pension funds, might send their trades to the new exchange in an effort to circumvent high-frequency traders. That may not last long, however, as those other exchanges have reportedly flirted with speed-bump proposals of their own. The tricky problem for them will be to neutralize IEX’s advantage without forfeiting the lucrative business they’ve built selling speed-related services to traders, such as renting locations to traders in the exchange data centers so their trade instructions arrive faster. Alternatively, they might just sue the SEC to try to get IEX’s approval thrown out.
Though today’s vote is a clear win for market competitiveness, ordinary investors shouldn’t get too excited yet. As I wrote earlier this week, the inequities of the modern stock market go much deeper than IEX can hope to fix. In recent years SEC has shown little willingness to address those more fundamental issues. If we really want a stock market that’s fair to all participants, there is a lot more left to be done.
The image at the top of this post was shared under a Creative Commons license on Flickr. It has been cropped.