IEX stands firm on "speed bump"

IEX has said that it will not move on the design of its signature “speed bump” that aims to combat some HFT techniques. The company is waiting to hear whether the SEC will grant it approval to become a fully-regulated exchange, a move that has split other market participants and triggered calls from lawmakers for market rules to be amended. Exchanges including NYSE and Nasdaq and funds including Citadel have written to the SEC objecting to approval being granted while a number of institutional asset managers have backed the platform's application.

An earlier version of this story incorrectly stated the length of time for IEX’s 350-microsecond “speed bump.” The story has been corrected.

Executives from IEX, the company that hopes to become Wall Street’s newest stock exchange, said Wednesday that they will not modify its signature “speed bump” meant to combat some high-frequency trading techniques while facing a fight for legitimacy.

“If there was an alternative that didn’t compromise our ability to protect investors, we’d be listening, but I don’t think any of those alternatives would actually satisfy the other side,” Chief Executive and founder Brad Katsuyama said.

IEX, the focus of Michael Lewis’s best-selling book “Flash Boys,” has applied with the U.S. Securities and Exchange Commission to become a regulated exchange, but is facing resistance from potential competitors such as the New York Stock Exchange and Nasdaq NDAQ, -11.32% . IEX’s “speed bump” is a 350-microsecond slowdown created through coiling 38 miles of cable in order to negate advantages gained through superfast connections to exchanges, which Lewis and IEX argue gives advantages to high-speed traders that harm other investors.

Katsuyama and Chief Strategy Officer Ronan Ryan visited Marketwatch’s San Francisco bureau Wednesday afternoon to discuss the current state of their application and the 67-employee, venture-funded company. The following transcript has been edited for clarity, brevity and to exclude off-the-record conversations.

MarketWatch: Give us some background and where you are now, since “Flash Boys”?

Brad Katsuyama: IEX was started in March 2012, and the first thing we really did was read the Exchange Act and Regulation NMS, the two primary regulations that governed exchanges. What you saw through and through was “investor protection,” “operating in the public’s interest,” “just and equitable principles of trading,” and what we knew was that we wanted to be a market-based solution, meaning we didn’t want to go and ask the regulators to change the rules to allow us to exist, we wanted to build something that existed within the rule set. And that’s what we did.

Fast-forward to today, we’ve gone from the 40th largest alternative trading system to the third, we’re larger than four of the 12 exchanges, and today we actually had our largest day ever, we did 466 million shares today. Our first day, we did 568,000 shares. So its grown nicely.

One of the things that we’ve done at IEX that is different is we’ve slowed our market down. What you’ve had are the exchanges, New York Stock Exchange and Nasdaq, selling high-speed traders the ability to get fast data — if you want information faster than someone else, you can pay them to get information faster than someone else. I think a lot of people have an issue with that. I practically don’t have an issue with that because there’s no way to ensure that everyone gets information at exactly the same time. ... The other thing they sell is collocation, the ability to take your servers and place them physically closer to the exchange’s servers. So that when the information comes out and he gets it, (the closer server) can trade thousands of times before the last person in line understands what’s happening. Fundamentally, that’s one of the biggest issues. A very large number of trades every single day are occurring between someone who actually knows the real price of a stock and someone who doesn’t.

So what we’ve done at IEX is we’ve slowed our market down by 350 millionths of a second. For context, it’s one-thousandth the speed of you blinking your eye. The most actively traded stock in the world is SPDR, the S&P 500 ETF , it trades once every 80,000 microseconds. So what does it matter if you’re buying now or 350 microseconds from now? It doesn’t matter, unless you’re trying to react to a real buyer, because as that buyer’s order is going across the market, you want to catch a signal that the buyer is there, and then race ahead of them. They’re basically electronically front-running them to different markets. ... That form of high-speed trading we think is predatory.

The other advantage of slowing our market down is to ensure that no one whose order is sitting on our market will trade at a stale price, because it’s IEX’s responsibility to price the trade. If the price of a stock goes from $10 to $9, and high-speed traders flood into IEX to try to sell stock at $10 because they know that the true price is $9 ... they have to go around the coils. As they go around the coils, it gives IEX time to say “Aha, the price is $9.”

Ronan Ryan: But currently, we’re an ATS, not an exchange, and the ATS is limiting.

Katsuyama: We have to reject orders in certain symbols if we’ve grown too big. So by regulation, there’s only so big that we can actually get. So we’re applying to become an exchange to lift that ceiling, and in that process, people are attacking us aggressively.

Texas Retirement Systems just filed a letter with the SEC on Friday supporting our comment, and they said we represent teachers and public employees in Texas, and IEX consistently has higher quality executions and has saved our constituents millions of dollars, and that’s through their own data analysis. And that’s just one fund out of thousands.

““If we skated through this process with no comment letters, we might have questioned ourselves. But they’re so vehemently against it that it’s giving us greater conviction.”” — IEX Chief Strategy Officer Ronan Ryan

MarketWatch: So what is the state of your application?

Katsuyama: On Sept. 21, the SEC published it for public comment. It was 45 days of comment, then 45 days to make a decision, on Dec. 21. So the last four exchanges that have been approved by the SEC have had a total of three public comment letters between them. Right now, we have 330-something, so its gotten kind of crazy. We have more comments than every exchange in the history of the United States combined. Nasdaq was second largest with 97.

So the SEC asked for more time. They said, “There’s so many comments, we need more time.” We granted them more time, and now basically they have to make a decision by March 21.

Ryan: In fairness to the SEC, they’re getting inundated with comment letters, so we granted them the extension.

Katsuyama: We know there is intense lobbying happening. The ones that are on public record are New York Stock Exchange, Nasdaq and BATS US:BATS , the existing exchanges; Citadel and Hudson River Trading, two high-speed trading firms; Modern Markets Initiative, a high-speed lobbying firm; the FIA Principal Traders Group, another lobbying association. It is really only, in isolation, exchanges and certain high-speed traders.

Virtu, a high-frequency trader, commented in support of IEX as a market maker, which is really interesting. What they’re saying is we make independent decisions to buy and sell stock based on a model and a number of factors, 350 microseconds doesn’t matter to us. Because they’re not reacting, they’re making their own decision on where to bid and what to offer. They asked us if it was the same speed bump for everyone and if it was deterministic, meaning it’s the same every single time. The answer to both was yes, and they said, “This is good for the market.” True to their word, and I’m sure they got a lot of heat from this from other high-speed traders, they submitted a letter to the SEC saying, “We think it’s innovative, we think it’s good for the market, and 350 microseconds does not affect our ability to provide liquidity and make markets.”

The No. 1 defense of high-speed trading is “provides liquidity and makes markets,” but all of a sudden you have the largest market-maker in the world saying it doesn’t matter, and a whole bunch of other firms saying it’s going to wreck the market. This is really crucial, because it shows not all high-speed trading firms are the same.

Of the 330 or so letters, I think 318 or something like that have been positive. But there’s a lot of money and manpower being spent trying to keep us from competing.

Ryan: If we skated through this process with no comment letters, we might have questioned ourselves. But they’re so vehemently against it that it’s giving us greater conviction. What’s really fantastic is that in the comment-letter process they’re outlining things that our delay doesn’t allow them to do. That’s the whole point! This is owned by the institutional investor because we went and told them specifically, “This delay will enable us to access other venues before other people can fade because they’re electronically front-running you.” And now literally in the comment letters, they’re like, “This does not allow us to fade our quotes on other venues.” It’s the gift that keeps giving!

Katsuyama: T. Rowe Price wrote a comment letter, took a section of an HFT comment letter and put it in there and said, “This is exactly why IEX exists, because you do this.”

MarketWatch: If the SEC comes back to you and says you need to modify or drop your “speed bump” in order to get the exchange approved, are you willing to do that?

Katsuyama: No. Internally, we came to the decision already that our No. 1 goal is protection of investors. That’s why we started the company, we believed that we could use technology to protect the interest of investors, many of whom are investors in IEX and our largest customers. So the answer is no, we’re not willing to create some kind of compromise that would prevent us from doing that.

If there was an alternative that didn’t compromise our ability to protect investors, we’d be listening, but I don’t think any of those alternatives would actually satisfy the other side. The other side is very sophisticated and they know exactly what they would like IEX to be doing, which is exactly what we do not want to be doing.

Ryan: For us to give up the speed bump and just to become another exchange, that’s not good for the market either. Why add just another?

Katsuyama: You have 12 exchanges that basically look the same. NYSE owns three, Nasdaq owns three, BATS owns four. And they’re all kind of the same.

MarketWatch: So what do you do if you’re denied?

Katsuyama: Right now, we’re profitable and still growing, so there are a number of different options for us, including re-filing.

MarketWatch: Say you get approved as-is, then other exchanges throw in a speed bump as well?

Katsuyama: The high-speed guys have thrown that out. The reality is nobody wants to pay (for collocation) to be on the other end of a speed bump. The whole point of paying is to be as close as possible. So when exchanges make more money selling technology and data than they do from trading, do they really want to create speed bumps? And is anyone going to pay to be on the other end of that? The answer to that is no.

If it was easy to do, they would have already done it. There’s an economic consequence that will ultimately prevent them from doing it legitimately.

Ryan: If they try to do anything — this is speculation — it would be with one of the tiny exchanges. New York Stock Exchange owns the old Amex. I wouldn’t be surprised to see them copy us on that market, but you’re not going to see any venue do it on their banner market. No chance. You’d be cutting off your nose to spite your face.

See also: The real challenge facing ‘Flash Boys’ hero is the IEX business model

MarketWatch: Do you feel you have a better chance of drumming up support out here in Silicon Valley?

Katsuyama: Yeah. I feel like IEX is more of a West Coast company, to be honest.

Ryan: Progressive technology, disruption.

Katsuyama: Our story definitely falls on more receptive ears out here, it feels like.

MarketWatch: Even though coiling a wire is a pretty low-tech solution.

Ryan: But when we talk to the people in Silicon Valley and tell them that today we did 1.73 billion messages, they cannot believe that the system that we run can handle so many messages.

Katsuyama: The lowest-tech thing we did is coil the cable.

Ryan: I explained to them our database architecture and how every single message is sequenced, which no exchange does. So we, as opposed to any other trading venue, can stitch back exactly what happened at any moment in time on our platform, and we store all of that data from our first trade. This is the newest trading venue from a technology standpoint, and it’s pretty impressive.

Katsuyama: And having a sequenced stream of every message allows us to perform huge amounts of data analytics, the audit function, the things that we provide back to the regulators. So when you look at things like the “flash crash.” The reason you never really got an answer was because there is no sequential order of events that occurred on that particular day. As a result, people have called for the Consolidated Audit Trail, the “CAT.” We do that every single day on our system.