IEX debate: calls for lawmakers to amend market rules
IEX Group has responded to criticism over its application to become a registered US stock exchange, stating it offers a solution that counteracted the advantages that high-speed trading firms have gained over other investors. Its speed-bump concept, currently used on its private trading venue has won the support of many large institutional investors, but funds that use high-frequency trading software and a number of exchanges claim it could hurt smaller investors. The debate raises larger questions about the best way to improve a market which has become increasingly fragmented over the last decade, with some calling on lawmakers to change the rules that gave rise to all of this complexity.

Last week we wrote to you contrasting the SEC Comment letters on IEX’s stock exchange application from two different high speed traders – Virtu and Citadel. Since that note both NASDAQ and NYSE have published comment letters recommending that the SEC not approve IEX’s exchange application as is.

Additionally, late Friday IEX responded with its own Comment Letter Response. This morning, we thought you would find it useful for us to highlight their viewpoints for you. We include links to the NASDAQ and NYSE letters, and we attach the IEX response in PDF form.

NASDAQ

IEX’s application has some aspects that are contrary to past interpretations by the SEC of Reg NMS. IEX also has some features that are not adequately explained in its application.

Regarding order types, IEX’s Form 1 has much less detail than the detailed order type explanations that are required by the SEC for public exchanges – like NASDAQ. NASDAQ points out that price-time priority on IEX is vague:

“due to the way in which IEX processes actions to resting orders, specifically when re-pricing, orders’ relative time priority is generally preserved”

NASDAQ wonders under what circumstances time priority is not preserved.

Regarding D-Peg, NASDAQ points out that IEX has a “proprietary mathematical calculation” that at times prevents an execution when IEX determines that the NBBO is not stable.

NASDAQ takes issue with IEX’s POP delay. They ask the SEC if, under Reg NMS, quotations should be granted protected status, and require routing to, if they are artificially delayed. They quote Reg NMS:

The Commission stated: “The definition of automated quotation as adopted does not set forth a specific time standard for responding to an incoming order. The Commission agrees with commenters that the standard should be “immediate” – i.e., a trading center’s systems should provide the fastest response possible without any programmed delay”

NASDAQ points to its 2012 SEC proposed 5 millisecond delay for PSX, where staff of the Commission’s Division of Trading & Markets opined that this programmed delay would cause PSX’s quotations to lose their status as protected quotations.

NASDAQ states that IEX does not disclose how it deals with colocation in its data center. Does it make sure all participants use equidistant cables? If a third party locates at or near the POP, what prevents them from selling their “faster access”, if it exists, to the highest bidder?

NASDAQ also states that IEX doesn’t say whether they disseminate their market data and quotes with the 350 microsecond delay. Additionally, even if there is no delay in IEX’s updating the SIP, the speed difference between the SIP and the actual accessibility of IEX’s quotes create confusion for the market. They believe that IEX’s delay will cause more locked and crossed markets.

NASDAQ questions IEX’s treatment of its own router. If its own router is not exposed to the POP delay, then IEX members could access liquidity at other venues more easily (faster) than it can at IEX. An ISO originating at IEX would have an advantage over an ISO at a competing exchange.

Finally NASDAQ points out that IEX does not afford odd lot orders the same priority as it does round lots, and that this can disadvantage small retail investors.

NYSE

NYSE invokes Seinfeld:

“Like the “non-fat yogurt” shop on Seinfeld, which actually serves tastier, full-fat yogurt to increase its sales, IEX advertises that it is “A Fair, Simple, Transparent Market,” whereas it proposes rules that would make IEX an unfair, complex, and opaque exchange.”

NYSE proceeds to go on the offensive against “The Pop”, and claims that its operation is vague. It lays out 8 questions it wants answered about the POP delay:

Do all incoming messages, including those to cancel or modify an order, go through the POP?

Do all outgoing messages, including order acknowledgement messages, go through the POP?

Do IEX quote and trade reports to the SIPs go through the POP?

Does quote and trade data disseminated by IEX through its proprietary data feeds go through the POP?

Does the incoming market data that IEX receives from other markets, either via direct feeds or the SIP, go through the POP?

Are the prices of pegging interest resting on IEX’s book (all of which is undisplayed) updated based on away market protected quote changes that go through the POP?

Do orders that are sent from the IEX matching engine to its affiliated router, or from IEX’s affiliated router to the IEX matching engine or to away markets, go through the POP?

Must market participants, including vendors and other exchanges that subscribe to IEX’s proprietary market data feeds, connect through the POP?

NYSE also claims that the IEX Router has access to trade execution information that IEX is withholding, and that IEX explicitly states in its marketing that its router has an informational advantage, and that this advantage is discriminatory:

“the IEX patent pending PoP is designed to enable IEX’s SOR to interact with all protected markets before market participants can react to fills received on IEX or other market centers.”

NYSE also takes issue with the 350 microsecond POP delay, and says it will result in investors receiving stale and misleading quotes. NYSE asserts that IEX quotations cannot be considered fully automated quotations.

NYSE also states that “IEX’s POP Functionality Creates an Unfair Advantage for Orders on IEX’s Book and Harms Investors With Orders on Other Markets.” NYSE understands how IEX protects orders on its own book, but says that puts orders on NYSE’s and other exchange books at a disadvantage.

NYSE believes IEX is disingenuous regarding the claim that it is a “fair, simple, and transparent market”, as IEX has numerous order types and modifiers, just like the other exchanges do, as the number of order type permutations is in the hundreds.

Additionally, NYSE claims that the IEX “recheck” process is unfair, as IEX does the recheck without delay, while any participant that may wish to cancel an order on IEX must go through the delay. Accordingly, market makers would be unlikely to place lit orders on IEX that could be protected, and therefore IEX would remain a predominantly dark market place, and would not therefore enhance public price discovery.

IEX

IEX has not responded to the NASDAQ and NYSE comment letters (yet), although it has responded to the BATS, Citadel and FIA letters.

IEX calls out the conflicted practice of selling colocation, and they ask why there should not be room in a national market system for an exchange to counteract latency arbitrage:

IEX’s “speed bump” is a simple, fair, and transparent means of providing access to the exchange that is narrowly tailored to protect investors from systemic inefficiencies. The ability of users to access IEX’s quotations will be comparable to that provided by other exchanges. In contrast to other exchanges, IEX’s model is offered as an alternative to their conflicted practices of selling access and technology.

The point out that their “coiled cable design” is similar to NASDAQ’s, and IEX quotes Bob Greifeld:

“…in our data center, we call it a delay coil. So this is a – we took it out of the data center last

night. If you’re 31 meters away from the matching engine, all right, you have this length of delay

coil, right. And again, each foot is a billionth of a second differential. If you are – now this is if

you’re closer, you have a longer delay coil.”

IEX points out that the difference is only that IEX coils cable to make sure all participants are treated fairly, and not just the ones who are paying exorbitant colocation fees.

Additionally, IEX confirms that it does not update the SIP on a delayed fashion; that dissemination is immediate. IEX also states that it routes to away markets without any delay. IEX provides the ability for a market participant to sen an order to IEX and to away markets at the same time, without the risk that the order execution on IEX will provide a signal to market participants to cancel their orders on away markets to avoid execution.

IEX also addresses the point raised in those three letters that IEX’s delay is “deliberate”; IEX asks what is the difference between such a physical cable delay whether it is coiled (like IEX’s), or physical (like the Chicago Stock Exchange)? IEX further states:

“In our view, excluding IEX quotes from the NBBO based on its time delay would be to suggest that all exchanges providing inputs into the NBBO must have all of their operations consolidated into a single data center.”

IEX also states that Reg NMS adopts a one second standard (not an actual rule that regulates speed) with respect to the order protection rule (the flickering quote exception). IEX wonders how these other market participants can be ok with that one second standard to fill investors, which results in stale fills, and proclaim to be concerned about a 350 microsecond POP.

IEX argues that saying that the IEX 350 microsecond POP delay should be prohibited, while the Commission allows quotes by those that decline to pay for colocation be delayed… is highly incongruous.

IEX also states that NASDAQ’s proposed PSX 5 millisecond delay back in 2012 imposed the delay on only liquidity taking orders, and on a subset of the exchange participants. IEX’s delay applies to all market participants. Similarly, the Canadian Alpha speed bump, which is not protected, is not protected as it exempts some participants and does not apply to all participants. IEX says its POP delay is different because it does apply to all participants equally, and so there is fair access.

Finally, IEX tries to answer more general questions posed in the various comment letters about its 250 microsecond POP delay:

First, the POP’s 350 microsecond delay is not material in relation to existing market‐wide latency differences. As noted above, the Chicago Stock Exchange by geographical design creates a much longer latency period in order to access certain NMS stocks.

Any calculation of the NBBO, whether observed by a market center, broker‐dealer, or other market participant, depends on the observer collecting and aggregating quote updates generated by sources in different geographical locations, and thus the updates will inevitably be “delayed” to various degrees when the receipt of each is compared to the event that caused it.

The comment letters by BATS, VIA, and Citadel seem to imply that IEX will delay updating the SIP. IEX will not delay SIP updates. The SEC has permitted exchanges to use the SIP as a yardstick on how to define their view of the market. IEX’s POP – SIP delay is much shorter than the other exchange’s direct feed-SIP differentials; what’s the problem?

IEX says that the claims that its POP delay is unfair, and based on a false premise:

Finally, we believe that these objections fundamentally rest on a false premise, namely, that in order for an entity to be approved as a national securities exchange, the entity cannot adopt any means to counter latency arbitrage or, conversely, that exchanges are required to enable individual trading firms to gain an advantage in any circumstance in which their technology (coupled with the exchange’s own technology) will permit. For the reasons described above, we believe this reflects a fundamental misreading of Section 6 of the Exchange Act and Regulation NMS and the Commission’s announced purposes in adopting it.

IEX responds to the suggestion that its router receives additional information, as NYSE suggests in their letter, and denies this is the case:

IEX will not provide IEXS with any greater access to information or other advantage over any of

its other members…. IEXS, the routing broker‐dealer, does not route to IEX and all orders, routable or otherwise, must pass through the POP, so there is no competitive disparity in terms of access to IEX’s trading system. There is no rationale for requiring that IEXS should incur a delay in routing out to other markets, since it will not have a competitive advantage in accessing those markets.

Citadel, FIA, and NYSE all made claims that IEX’s structure would favor and provide advantage for dark orders over public lit orders. IEX responds to this point as well:

First, we again stress that all orders, displayed or not, will be subject to the POP before the order is received by the System so there is no discrimination in terms of how orders can enter the trading

system, displayed or non‐displayed. Further, displayed orders will always trade with priority ahead of non‐displayed orders at the same price as part of IEX’s book priority.

IEX addresses some Citadel comments generally about market structure:

Citadel seems to assume that any measure of protection for one group of investors can only be gained to the detriment of others. In fact, by reducing incentives for certain speed‐based strategies, IEX expects to provide a better experience for institutional and retail investors, brokers, and market makers, and to strengthen investor confidence generally. Market integrity is not a zero‐sum game.

Citadel and FIA both compare IEX’s POP delay to the often criticized “last look” functionality in the currency markets (think BATS and NASDAQ Flash Orders circa 2009). IEX points out that Last Look in currency markets allows high speed traders to renege on a displayed quote. IEX’s pegged D-peg order, which protects against a stale fill in a crumbling quote, is not a lit quote; the comparison is not accurate.

Finally, BATS asked the SEC in its letter to communicate new standards to the entire market about what types of latency are permissible by an exchange, with respect to accessing quotations. IEX believes the SEC should not try to legislate a speed for the markets. Doing so would create unintended consequences:

IEX does not seek a regulatory mandate that would impose any aspect of our model on others and believes that the Commission can better facilitate market progress and constructive competition by considering each exchange proposal or innovation on its own merits and allowing market participants to make their own choices to suit their respective needs within the existing regulatory framework.

This note today is quite a bit to take in. I know that as I re-read it, I need to do it in stages and doses. Perhaps this note is one to file, and read during a lull in your trading day; we hope you find it a useful reference.