Let The Stock Market Wars Begin

by: Kurt Dew


We are about to see some dramatic stock exchange competition.

IEX has applied to give us, for the first time, an alternative to the existing stock exchange clones.

The competition will get ugly.

So first get the markets some protection.

Then let the wars begin.

Show me how you do that trick.

The one that makes me scream."

  • The Cure

With each passing day, the desperation of the securities exchange management firms and their dealer customers becomes more apparent. The new exchange, IEX (Private) is now odds-on to gain regulatory approval of its application to become a stock exchange, and poses an existential threat to the New York Stock Exchange, owned by ICE (NYSE:ICE), and the newly listed BATS (:BATSBATS).

In my last article I advocated creation of a sort of backup exchange and an added degree of flexibility for retail traders placing orders. The primary purpose was to remove the SEC and CFTC, the United Nations Observers of the Exchange Wars, from the battlefield. Let the war begin. Winner take all.

The backup exchange would be an electronic non-profit marketplace, a sort of trading Post Office, where retail traders could be assured of their orders being executed without the effects of the many for-profit exchange adjustments existing to meet the needs of particular customers.

The added degree of flexibility would be the ability to use discretion in placing orders on particular exchanges online. If because of reputation or experience, some retail customer chooses to show preference for one or more exchanges over others, that customer should be permitted to exercise her choice without cost.

There are two purposes for these changes.

  1. Reliable markets for retail traders. Reduce the possibility that the primordial ooze of new trading rules, new order types, new exchange subsidies of order types, and new exchange subsidies of certain types of high volume participants - and the unintended consequences of the interaction of all the above - leads to disasters that affect reliable function of the whole system for the public. This backup exchange would only accept a few traditional order types and would include none of the innovations and other shenanigans the for-profit exchanges have begun to introduce.
  2. Innovative entrepreneurial markets for all. Encourage the SEC and the CFTC to reduce the heavy-handed regulation they have exhibited in approval of new initiatives of the newly entrepreneurial exchanges in recent years. If the regulators can be sure that there is a single exchange that functions without the many complicated twists and turns the new exchanges are bringing to the trading environment, they can be sure a retail order won't be involuntarily hijacked as the exchanges fall all over each other trying to increase volume by creating advantages for an attractive customer or group of customers.

My larger objective is to untangle the web of conflict that has been created by an SEC/CFTC regulatory apparatus overwhelmed with the complex alternatives that competitive exchanges are presenting users of their markets. If the regulators can place their faith in a boring fail-safe backstop exchange, they no longer have a reason to restrain competition among the other exchanges.

And the whining of the dealers like Citadel can fall on deaf ears, as competition from a new exchange, IEX, that favors the buy side, enters the fray.

HFT-dominated exchange innovations. My first article provided a laundry list of features for-profit exchanges have introduced for the benefit of targeted customers:

  1. Co-location: the offering of customer computer location on-site, reducing the time it takes to for co-located customers to "see" market prices in comparison to the other customers in the market.
  2. Purchase of order flow from retail and wholesale brokers.
  3. Discriminatory fees. Liquidity "providers" are subsidized, liquidity "users" must pay.
  4. A host of new order types, designed to help high frequency traders (HFT) customers to gain various advantages over others, have been introduced.

Most of these features meet needs of HFT traders, but not all. The exchange payments for retail trades from the electronic brokers such as E*TRADE Financial (NASDAQ:ETFC) and TD Ameritrade (NASDAQ:AMTD) may reduce the commissions retail customers pay for their trades.

Interestingly, these various changes in the rules were largely approved with little fanfare, until a book, Flash Boys, by Michael Lewis was written. Lewis characterized all of the existing stock exchanges as "rigged," and contrasted them with a new exchange, led by Brad Katsuyama, named IEX, which he argued was not rigged, the hero in a struggle to restore fairness to exchange-traded equity markets.

Mary Jo White, Chair of the SEC, has objected to the charge that the markets are rigged. Her argument is persuasive. There is no evidence that the exchanges do anything that is not within SEC rules, or hidden from public scrutiny, at present.

That does not mean, as I explained in the last article, that a simple retail order gets the best possible fill. All the machinations of the exchanges to benefit one customer at another's expense must have unintended effects - and among those effects have been demonstrable losses in system reliability as with the Flash Crash.

It is also true that the customers with maximum leverage on exchange policy-makers, the large volume money managers and wholesale dealers, must give considerable thought and spend money to optimize their use of the IT behind trading. This effort is necessary to avoid losing money to other wholesale traders. Institutional investors use high speed computer algorithms to defeat the attempts of dealers to improve their prices, and the reverse.

Money Management's Revenge. I believe more light and less heat will be shed on the current struggle for market dominance between the exchanges that now represent the real protagonists - on one side, the broker-dealers of the sell side and HFT specialists; and on the other side, the large institutional traders, fund managers, insurance companies, and the like - if IEX, the would-be exchange that specializes in meeting the needs of the under-represented money management firms, did not bear the weight of the halo that Michael Lewis placed on its head in Flash Boys.

If the old-line exchanges such as BATS, and NYSE, did not have to defend special IT-enabled pseudo-innovations such as co-location, perhaps IEX would not need to defend its innovations.

IEX innovations:

Speed bump. IEX is famous for the "speed bump," a coiled cable internal to the order execution system at IEX that is intended to prevent HFT traders from "front-running" large institutional orders. The other exchanges and the various HFT practitioners sent in comment letters opposing the speed bump, and therefore IEX' designation as an exchange by the SEC. But it appears that the SEC has informally caved to the firestorm of rebuke to the HFT opposition and plans to permit the speed bump.

D-Peg. A discretionary pegged order type introduced by IEX in its application for exchange designation. This order type rests at the national best offer (NBO, if a buy) awaiting an opposing order to trade at the midpoint of the bid-offer spread. Its innovative characteristic is that it is "smart." It will not bite on the mid-point offer if it receives a signal from a second IEX idea, the "crumbling quote detector."

Crumbling quote detector. It would be a mistake - for a buyer, resting at the primary bid, trying to buy at the midpoint of the bid-ask spread - if, at the instant of the trade, those bids fell away, leaving a lower mid-point and a loss for the buyer at the old midpoint.

Enter the IEX "crumbling quote detector." IEX' execution engine does more than watch the bids and offers from the SEC feed (SIP). It looks at the quotes from the other exchanges at light speed with its own cables. If the various other exchange quotes begin to vanish, the IEX crumbling quote detector warns the d-peg order that the bid is "crumbling," which automatically cancels the d-peg order.

Pretty clever, seems to me. But it must be said, experimental. Yet another innovation that might strike fear into the heart of the SEC/CFTC regulators concerned about unintended consequences of allowing exchanges to think when placing customer orders.

Reaction of NYSE, BATS, and Nasdaq (NASDAQ:NDAQ). How are the other exchanges reacting to these IEX innovations? Badly. Very, very badly.

First the speed bump. BATS, NYSE, and Nasdaq are all developing their own speed bumps, in case the speed bump attracts business to IEX. Not pretty. Guess it's not about fairness.

The NYSE reaction to IEX' D-peg and Crumbling quote detector is particularly ugly. First, NYSE applied for the self-same new order to the SEC, embarrassing themselves twice in the application.

Once, by admitting to the SEC that NYSE's purpose was to imitate the IEX innovation and to front-run the IEX by using it before IEX received exchange designation that IEX could use it themselves only afterward. Second, NYSE did not bother to understand the IEX innovation before they copied it and sent it off to the SEC.

Which made the NYSE submission nonsense, since the order would not work at all as submitted by NYSE. Why not? IEX has a numerical formula for finding the simultaneous quotes of the other exchanges in its application. It uses the time it takes light to travel a fiber optics cable from each other exchange to IEX, which is located in Weehawken, NJ. Light takes a different amount of time to travel to Mahwah, NJ, where NYSE keeps its computers.

So because NYSE simply copied the IEX formulas, NYSE would not see the simultaneous prices, and the crumbling quotes would never be identified.

That ability to choose which exchange to execute my trades is looking better and better.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.