The Following is a NetworkNewsWire Exclusive Article – On June 17, 2016, the U.S. Securities and Exchange Commission made headlines when it approved the Investors’ Exchange (“IEX”) as a national stock exchange, marking the first time since July 2013 that the SEC has sanctioned a new trading exchange. Unlike existing markets such as the NASDAQ and NYSE, the IEX aims to even the playing field between high-frequency traders and traditional investors by eliminating the multi-microsecond advantage that’s often afforded to high-frequency traders. To do this, IEX purposely slows down trading, implementing an intentional ‘speed bump’ of about 350 microseconds that can’t be bypassed for any reason. The result is a market that protects traditional investors from the advantages afforded to high-frequency traders on other national exchanges, effectively strengthening investor protection across the board.
IEX was founded in 2012, as an Alternative Trading System operating in dark pools, or private exchanges for trading securities. While working for the Royal Bank of Canada, IEX founder Brad Katsuyama observed the advantage offered to high-frequency traders firsthand. Let’s take a closer look at how this works:
- First, a trade is entered on behalf of a client to buy a certain number of shares of stock. This request is quickly routed to one of 12 U.S. equity exchanges, such as the NASDAQ or NYSE, or an Alternative Trading System.
- The law requires the exchanges to remain connected in order to provide consistent pricing information. This system, known as the SIP, is in place to ensure that the buyer receives the lowest price across the exchanges. Since its common for no single exchange to have the full number of requested shares, orders can also be split up and fulfilled across several exchanges, but the one true market price, known as the NBBO, must be used by each exchange.
- Although the connection between each exchange is incredibly fast (with digital signals zipping between them at several miles per second), some exchanges communicate with Wall Street quicker than others. The BATS exchange in New Jersey, because of its close proximity to Wall Street, is normally the fastest by a few important microseconds.
- High-frequency traders have the option to pay a sizable fee (roughly $40,000 per month) for a direct connection to the BATS exchange. With this simple cable, these traders can see trades before they reach other exchanges, providing the foundation for their advantage.
- With information about in-progress trades, high-frequency traders are able to jump in front of these trades, sending buy requests for the stock at other exchanges that offer less-speedy connections. When the high-frequency trader buys this stock at the lower price, the original request can’t be completed, and the NBBO goes up.
- Almost immediately, the high-frequency trader sells the stock back to the original requester, but the price increases by a small percentage. The original trader typically completes the trade at the slightly higher rate, effectively paying a relatively small, but significant commission to the high-frequency trader.
- Rinse and repeat thousands of times each year, and these high-frequency traders are able to net millions of dollars annually without taking any real risk. Meanwhile, traditional traders are left footing the bill. In 2009, the practice netted an estimated $5 billion in profit for high-frequency trading firms in the United States, according to a report by Fast Company (http://nnw.fm/HZxs1).
To combat the high-frequency trader issue, IEX uses coiled cable connecting the location where the trade arrives to the location where matching the order with the available stock takes place. The physical distance covered by this coil delays each order’s entry into IEX’s matching system by 350 microseconds in each direction. To update its pricing feed, IEX uses a slightly faster 270 microsecond connection. The result is the intentional ‘speed bump’, which ensures that no one receives more up-to-date data than the IEX, keeping prices fair and accurate.
As a national stock exchange, brokers will be forced to use IEX if it offers the best prices. With IEX maintaining the NBBO of shares throughout the duration of a potential high-frequency trader advantage, the exchange should go a long way toward evening the playing field moving forward. IEX plans to implement trading in all stock symbols on September 2, 2016, discontinuing all operations in dark pools. After two years, the SEC will complete a study of the IEX exchange in order to determine if the integrated ‘speed bump’ has an effect on market quality.
For more information, visit www.iextrading.com
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