"You know the nearer your destination, the more you're slip slidin' away."- Simon and Garfunkel
I supported the SEC approval of IEX's exchange designation with all my might and main in the spring of last year. IEX's rival exchanges "encouraged" a cast of academic thugs to produce "end of days" forecasts of the disastrous effects of IEX's existence. But, at the time, one opponent of IEX was a man I cannot dismiss. Kenneth Griffin.
Kenneth Griffin, head of Citadel, has frequently shown himself to be an advocate of open, transparent markets. On the two recent occasions within my limited knowledge, he battled the usual opponents of open markets, the dealer banks.
- He attempted to launch an electronic trading venue for Credit Default Swaps (CDS) in cooperation with CME Group (NASDAQ:CME).
- More recently, he attacked the burgeoning exchange fees of the three serial offenders, exchange management firms Intercontinental Exchange (ICE) - through its stock exchange subsidiary, New York Stock Exchange Group; Nasdaq, Inc. (NASDAQ:NDAQ), and BATS, recently acquired by CBOE Holdings (NASDAQ:CBOE)
CDS trading. In the fight to get electronic CDS trading off the ground, the Citadel-CME combine was thwarted by a Byzantine conspiracy of dealer banks; dealer-controlled services - laughingly called "information providers," Markit and Depository Trust Clearing Corporation (DTCC) (read about them here) - and what must be called the "dealer-friendly" exchange management firm, ICE.
The buy-side brought a suit against this wolf pack, as evidence of a conspiracy surfaced, alleging restraint of trade. The suit was ultimately settled with a $1.8 billion payment from the defendants. But, of course, the CDS market went not to Citadel-CME, but to the more conveniently opaque offering of ICE.
Exchange fees. The horrific growth in exchange fees flung in the faces of the broker-dealers and traders that are the exchange's purported "customers" while these same customers simultaneously suffer a dramatic decline in their revenues is analyzed by Larry Tabb of Bloomberg here.
The Main Event. Citadel Confronts IEX.
Citadel's bitter opposition to IEX's exchange designation took me by surprise. The Citadel attack was not out of fear from IEX's competition. Certainly, tiny IEX is no threat to mighty Citadel. Citadel handles up to 14% of market transactions in an average day in contrast to IEX's roughly 2% of the exchange portion of the market.
Griffin was reportedly angered by the characterization of Citadel in Michael Lewis's book, "Flash Boys," as "secretive." Deservedly so. Citadel is a prolific commenter on SEC rules and regulations. Griffin himself writes regularly for publication in the financial news on topics important to the industry. More to the point, I know more about the specific ways in which Citadel uses HFT simply from the public record reports of Citadel itself than I know about any other HFT firm from any source. The accusation that Citadel is secretive is just inaccurate and unfair.
IEX probably needed "Flash Boys" to bring the SEC's tendency to avoid rocking its own very vulnerable boat - the National Market System (NMS) - into the open air. Without the book's publicity, it is easy to imagine that the SEC's standard "death by delay" approach to a threat to the anti-competitive market system would have wound on for years. But Michael Lewis is into selling books. Sometimes he steps on the facts a little to reach his goal. Hence the vilification of Citadel.
However, I believe Griffin's base objection is about the health of the market, not personal pique. As Citadel puts it:
"If one exchange is allowed to slow trading, others would follow suit with their own speed bumps, leading to multiple venues showing obsolete price quotes. It would be impossible for brokers to get the best price for their clients and changes may even provide new opportunities for gaming the system."
The Citadel argument is subtle because it hinges on the words that dare not pass the lips of any of the combatants in the war of the IEX speed bump. The problem is the SEC. It's SEC's NMS-induced "War of the Clones" that is spawning a host of parasite exchanges, feeding on the blood of the trading customer.
The War of the Clones
Question: How many exchanges does it take to process the average customer trade? Answer: Wrong question. To execute a transaction, every substantive broker-dealer must pay 12 exchanges for proprietary data feeds - all but two of these fee-gobbling exchanges exist solely to collect these fees.
But none of those exchanges are used to fill the order. The average order goes to the broker-dealers themselves who either act as counterparties to the customer or fill the order through a broker-operated "dark pool."
The dealers pay the fees nonetheless since the broker-dealers must demonstrate that the customer's fill is at the "best price" at the time - an expression without any literal interpretation in the brave new world of electronic, computer-based trading - but with a very specific legal interpretation.
The broker's fill must meet or improve upon the current price on the infamous Securities Information Processor (SIP), the SEC's molasses-slow version of the current reality of prices. If you don't buy all the clones' hyper-fast proprietary fees for comparison to the SIP, how are you going to make a living beating the SIP for customer orders?
Is this Griffin's concern?
This is where the ugly implications that Griffin may have perceived to follow from the existence of the IEX exchange raise their heads. If IEX provides a separate set of prices substantially different from those of the existing exchanges, that has a nasty indirect effect. It will require the broker-dealers to obtain yet another set of feeds.
Not because IEX charges for a fast version of its feed. The SEC denied it permission to create one, even though IEX had no plans to charge for its feed. But because, as Citadel predicted, yet another wolf pack of clones is forming. NYSE has just applied to clone IEX. But, of course, all these new clones created by the usual exchange management suspects will have a prominent distinction. They will charge for faster versions of their prices. These new fees will have the broker-dealers going to the ridiculously contorted extreme of paying more exchange fees - this time for faster, slower prices?
We have a new nominee for SEC commissioner from the Trump administration, Jay Clayton. Maybe he will do something about this insane situation.
The clone problem is not IEX's doing. It is not Citadel's doing. But it seems quite likely that the clone problem more than obliterates any benefit to the efficiency of the market as a whole that the IEX speed bump provides.
And worse, any innovation, no matter how efficient, no matter how it improves the quality of prices to the trading customers of exchanges, will immediately be buried in the ensuing blizzard of clone exchanges and their heap of new fees. The SEC has doomed the stock market to a gradual collapse under the weight of the ill-conceived National Market System.
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.