IEX Stock Exchange Is Open for Slower Public Business
After a nearly yearlong struggle for approval from the Securities and Exchange Commission, Investors Exchange Friday became a public stock exchange, like the New York Stock Exchange and Nasdaq.
Unlike other exchanges, IEX intentionally slows trading, requiring all trades to go past what the firm calls a speed bump — hardware that adds a tiny delay just long enough to stymie some of the strategies the exchange’s founders say high-speed traders use to prey on big investors.
The new exchange says that levels the playing field between long-term holders of stock and the high-frequency traders that make money by rapidly trading shares and making tiny profits on each trade.
In an age of near-instant trading, that notion has rankled some traders and exchange operators who argued that the SEC would be creating a more complicated market, and not necessarily a fairer one, if it approved IEX.
The SEC disagreed and signed off on the application in June, clearing the way for IEX to become the nation’s 13th public exchange.
Since 2013, IEX has operated as a private exchange and, on the typical day, handles about 1.5 percent of total U.S. stock trades. As a public exchange, it will be able to host initial public offerings and handle more trading volume.
The fierceness of the opposition to IEX is thanks in part to the almost evangelical tone that Brad Katsuyama and his co-founders have taken in describing what they see as a rigged stock market, in which established exchanges have created advantages for some investors at the expense of others by selling faster access to their data feeds.
The debate has had an unusually high profile thanks to Michael Lewis’s 2014 book, which delved deep into the vagaries of the stock market, painting Katsuyama and his co-founders as heroes while casting much of the rest of Wall Street — not just high-speed traders — as villains.
Katsuyama said the book has been a huge positive for IEX, bringing public attention to the exchange and creating an outcry over Wall Street practices that otherwise probably wouldn’t have materialized.
“Without that, the opposition would have been just as fierce, but it would have been done privately and without public attention,” he said.
Perhaps more important than the book, though, were investment firms that backed IEX early on and gave Katsuyama and his team the capital they needed.
Katsuyama said he ran the idea of creating a new stock exchange by Los Angeles investment company Capital Group in 2011. The next year, the company took the lead with a few other big institutional investors in a $9.4 million funding round. The exchange went on to raise millions more from venture capital and private equity firms and from casino magnate Steve Wynn.
Matt Lyons, Capital Group’s global trading manager, said he and others at Capital Group knew Katsuyama from his days as a trader at Royal Bank of Canada, and they both trusted him and thought his ideas would address at least some of the problems they saw in the market.
But he said Capital Group’s investment in IEX was about more than that.
“We felt it was important, if not to solve the problem, to at least let our investors know Capital Group was concerned about what was happening,” Lyons said.
Capital Group is manages nearly $1.4 trillion in assets for tens of millions of investors. Most of its business is mutual funds, the type of investments that form the backbone of many Americans’ retirement savings.
With that much to invest, when Lyons buys and sells stock for the firm, he’s often looking to buy or sell hundreds of thousands, even millions, of shares — something that comes with risks not shared by the casual investor.
The trick for Capital Group is to make those huge moves without tipping off the rest of the market. Let everyone know there are 1 million shares for sale and the price could fall. Let everyone know you’re looking to buy and prices would climb.
“If you demand more than the available supply, you’re going to change the price,” Lyons said. “Traders try not to tip off the market that there’s a large demand for these securities. They try to hide our intent in the marketplace.”
But starting nearly a decade ago, Lyons said, it seemed like other traders knew what Capital Group was up to whenever it made big trades, with stocks suddenly changing price just as the firm moved to buy or sell.
“We saw movement in stocks that was unexplained other than by there being someone out there who understood what we were trying to accomplish,” he said. “People anticipated what we were doing.”
When Katsuyama was a trader at Royal Bank of Canada, one of the firms that executed stock trades on Capital Group’s behalf, he noticed the same thing. He’d place an order for Capital Group or another big investor and see the price suddenly shift.
Those people, Katsuyama said, weren’t people at all but computers. And they weren’t anticipating Capital Group’s moves but outrunning them.
Say Katsuyama was looking to buy 10,000 shares of a particular stock for Capital Group. He might see 10,000 shares for sale, but those shares would be listed on any number of stock exchanges.
To get those 10,000 shares, Katsuyama would have to send electronic trading orders to several exchanges, with each order arriving at a slightly different time.
A signal might have to travel through 10 miles of underground cable to reach one exchange and 30 miles to reach another. The fractions of a second difference it takes for an electronic signal to travel that extra 20 miles turns out to be a big deal.
Katsuyama said high-speed trading firms — using computers hooked directly into the stock exchanges — could see that someone had bought up all the available shares on the first exchange, then quickly snap up shares on other exchanges. It’s what Lyons and others call “information leakage.”
“They’re racing us to those exchanges, buying stock ahead of us and then attempting to sell it to us at a higher price,” Katsuyama said.
Speedy investors can get the upper hand on slower traders in other ways too, he said, including by taking advantage of tiny differences in prices between exchanges — differences that last for just fractions of a second.
All of this has a few effects on the market. For one, it means that Capital Group and other big firms might not get the best possible price when buying or selling stock, cutting into returns.
Though Lyons can’t put a dollar figure on those reduced returns, he said a trading system that doesn’t telegraph Capital Group’s intentions should benefit investors through fairer pricing.
“It’s leveling the playing field,” Lyons said. “There’s no advantage based on how quickly you can get to one place versus someone else.”
In a letter urging the SEC to approve IEX as a full exchange, the Teacher Retirement System of Texas, a pension fund that manages more than $125 billion, suggested that trading through IEX could save the system millions of dollars a year.
IEX slows all of the trades that go through its system with a 38-mile coil of fiber-optic cable between the outside world and the exchange’s main computer.
It takes trading signals 350 millionths of a second to get through the coil. That’s a tiny delay — it takes hundreds of times longer to blink — but it’s enough to take away the advantage of speedier traders.
Jatin Suryawanshi, an IEX board member and head of global quantitative strategy at stock brokerage and investment bank Jefferies, said the additional time allows an investor’s order to be executed on IEX before high-speed traders can start racing that order to other exchanges.
“The client’s order comes in, IEX holds the execution by 350 microseconds, then executes the order, then holds the trade report by another 350 microseconds,” he said. “It’s giving the client a cushion and protection.”
The NYSE and other IEX critics have argued that the delay could hurt rather than help investors. In letters to the SEC objecting to IEX’s application to become an exchange, NYSE officials said allowing an exchange to intentionally slow down trading could lead to investors getting stale information or, perhaps worse, could make the stock market more complicated.
“We believe that allowing exchanges to intentionally delay access to the protected quotations is not in the interests of investors,” NYSE Group General Counsel Elizabeth King wrote in April.
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