Fear And Loathing At Nasdaq: Sell-Side Captive Exchanges' Desperation Exposed

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Nasdaq has warned the SEC that it might sue.

The SEC has attempted to define “immediate” for market purposes.

In the High Frequency Trading era, this is hazardous.

But the Nasdaq threat to sue the SEC reeks of fear.

Everybody's talking 'bout the new kid in town
Everybody's walkin' like the new kid in town.
There's a new kid in town.
-The Eagles

Over the past few months I have been following the squirming of the exchanges that are captives of the sell-side stock market dealers [exchanges such as BATS (BATS:BATS); The New York Stock Exchange, a subsidiary of Intercontinental Exchange Inc. (NYSE:ICE); and Nasdaq (NASDAQ:NDAQ); (hereafter, "the Stooges").

The Stooges include all the domestic exchanges except Investor's Exchange (PRIVATE: IEX). IEX is owned primarily by buy-side investment managers.

This post provides further evidence of the Stooges' awareness of the existential risk they face if the IEX application for exchange designation is approved by the SEC. The focus of this post is a Nasdaq threat to sue the SEC should the SEC approve the IEX "speed bump."

I have a sell on both ICE and Nadaq. No rush though. The stockholders of the exchange managers have reason for their complacency, and will not be wakened from their dream of endless positive alpha until the very last minute. It's been a good run all around.

The speed bump is succinctly defined in a Wall Street Journal article "Nasdaq Raises Lawsuit Threat over IEX Speed Bump Plan":

The speed bump is 38 miles of coiled fiber-optic cable, which adds 350 microseconds to the time it takes for orders to reach IEX's system.

The speed bump is the most significant innovation of IEX. It is designed to defeat the many shenanigans of High Frequency Traders (HFTs). HFTs generate revenues upon which the Stooges feast, at the expense of the rest of the stock markets' participants.

The speed bump is the primary bone of contention between the Stooges and IEX, although any IEX innovation is enough to raise the Stooges' ire. My recent post on this topic, " The State of Systemically Important Things: Dealer Bank And Exchange Wars," for example, chronicled the NYSE's inept response to another innovation, "the discretionary peg," also included in IEX' exchange application. The NYSE's craven attempt to steal IEX thunder by front-running the discretionary peg, asking the SEC to introduce the innovation, for which IEX has a patent pending, before IEX itself can introduce it.

This NYSE tactic is ugly in total, but perhaps most embarrassing is that NYSE, by submitting a carbon copy of IEX' innovation, neglected to notice the fact that the discretionary peg's function depends on the simultaneous arrival of market data updates from each other exchange to IEX. This in turn, depends on the distances between IEX and the other exchanges. Of course, said distances differ for NYSE. Thus the copied distances submitted by NYSE result in a request to the SEC which simply would fail to function!

The Stooges undoubtedly employ competent IT professionals. Perhaps they should run their SEC applications past these employees before submission.

The NASDAQ speed bump flip-flop

The latest reaction of a Stooge to the IEX speed bump is a comment letter filed on behalf of NASDAQ by its legal representatives, Gibson, Dunn, and Crutcher, to the SEC, (hereafter, The Letter) attacking the SEC's (perhaps ill-advised) proposed interpretation of the meaning, in the SEC regs, of the word "immediate."

The meaning of "immediate" is at the heart of understanding HFTs and their attempts to gain the upper hand in trade execution over the rest of us, who once thought immediate and a second were pretty close to identical in meaning.

Immediate, in the new SEC interpretation, is less than a millisecond. Anything faster constitutes "immediate." The IEX speed bump, at 350 microseconds, is immediate in the SEC proposed interpretation.

Nasdaq, in the Letter, does more than object to this definition of immediate. It threatens a lawsuit against the SEC, asserting that this interpretation is inconsistent with the existing SEC reg.

That is an attention-getter, for a pair of reasons:

  1. To a simple trader like myself, surrounded by bank regulators and futures regulators, the idea of suing one's regulator seems a major faux pas. I was once upbraided by my boss' boss for simply making fun of a regulator's employee in a letter to the American Banker. I'm a slow learner.
  2. The position of Nasdaq on the speed bump is reminiscent of the position of a LOTTO ball in the nightly TV drawings.

What does Nasdaq actually think about the speed bump? The exchange is clearly conflicted. It's first response to awareness of the IEX speed bump was to file for its own version of the speed bump with the SEC. Thinking better of this strategy, perhaps remembering the interests of the HFTs that pay Nasdaq's bills, Nasdaq quickly pulled the application - but CEO Bob Greifeld indicated the exchange might resubmit at a later date.

Through exchange sources, the press reports that all exchanges are preparing their own versions of the IEX speed bump. I am anxious to see how the Stooges' speed bumps will be reconciled with the interests of their HFT customers.

The law suit against the government is in competent hands. On the legal team that prepared the Letter was Eugene Scalia, who successfully represented MetLife (NYSE:MET) in their lawsuit claiming that the government had incorrectly identified MetLife to be a systematically important financial institution. His presence reinforces my suspicion that the SEC attempt to get out of the bind that its desire to approve of IEX' speed bump, on one hand; without getting into the matter of the many, many, games the Stooges are playing with time in assisting the HFTs, on the other; is doomed to fail. Mr. Scalia does not strike me as a loser.

The SEC could simply dismantle all the implicit subsidies the Stooges have created for the HFTs. Then IEX could either come up with other innovations that inspire less controversy, or disband, allowing Brad Katsuyama to go back to getting rich trading for Royal Bank of Canada (NYSE:RY). Somehow, I don't see this as a likely outcome.

I have proposed an alternative. Allow the existing exchanges to do whatever. Drop the SEC's National Market System. Let the exchanges generate a common pricing mechanism like the National Market System, should that be in their interest. Allow online customers to designate preferred exchanges. And create a government utility - a plain vanilla exchange that accepts a limited number of order types and subsidizes no trade type or trader type. An exchange for the retail investor. This would be a kind of analog to the banking system's protection for the retail depositor.

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.