IEX And LTSE: Exchange Elitism

Includes: CBOE, NDAQ
by: Kurt Dew

Do buy-side and Silicon Valley startup firms benefit from exchanges that focus on them alone?

IEX and Long-Term Stock Exchange believe the answer is “Yes”.

But exchanges can’t succeed through exclusion. Exchanges must meet the needs of all.

And this is impossible under the SEC umbrella.

Elite projection is the belief, among relatively fortunate and influential people, that what those people find convenient or attractive is good for the society as a whole,”

according to public transit consultant Jarrett Walker.

Elite projection has come and gone in stock exchanges since common stock trading is said to have begun at the Amsterdam Bourse in 1602.

Today, elitism is again a factor in exchange-trading. IEX and a prospective exchange, Long-Term Stock Exchange (LTSE), seek to protect their elite constituencies, buy-side traders and Silicon Valley tech elites, from the high-frequency trading (HFT) hoi polloi. Both efforts will ultimately prove self-defeating.

These two exchanges seek to innovate within the current norms established by the SEC. Their approach, as with any approach that limits itself to the boundaries established by the SEC’s National Market System (NMS), misunderstands the extremes to which lasting important financial innovation must be taken to be something other than a fad. In his excellent characterization of the essentially iconoclastic nature of significant innovation, Paul Lavin emphasizes that important innovation never fits within the confines of existing regulation.

Perhaps the madness of experts is best represented by the tendency to rely ever more on the regulatory state. Excessive regulation and its unintended consequences defines the existential danger of normativeness. It suppresses essential disruptive entrepreneurialism. Bad regulation really could be the lead horseman of the apocalypse.”

The essence of current market elitism

IEX and Long-Term Stock Exchange (LTSE) have banded together, according to an IEX press release, reports Matt Levine of Bloomberg. LTSE seeks to cater to the Silicon Valley elite complaints about “Wall Street mentality.” This exchange elitism is nothing new. It was at work when Elizabeth I blessed the membership of the Royal Stock Exchange in London circa 1571. Brokers were unwelcomed at the Royal Exchange; the claim then – that brokers were too rude. At least today’s exchange elite exclude with greater specificity.

The IEX/LTSE team is simply the reactionary phase of a timeless cycle in the process of transaction gatekeeping – gatekeepers seeking to limit where, when, and how a transaction is legit. The forces of reaction and normalization are constantly at war with the sine qua non of transactions – volume. But this is a war the reactionary always loses.

How do these exchanges plan to protect their elite?

IEX is a new stock exchange with new, yet reactionary, trading technology and old listing standards: that is, listing standards like those of the old-line exchanges [New York Stock Exchange (NYSE), Nasdaq (NDAQ), or BATS, now a subsidiary of CBOE Global Markets (CBOE)]. IEX’ SEC approval last year was controversial, since IEX reduces the execution speed of an order, forcing transaction data feeds from brokers and other exchanges to go through miles of fiber optic cable, thereby slowing the high-frequency trading (HFT) race from one exchange to another.

The focus at IEX is upon protection of one kind of trader – those good boys and girls that do not collocate and do not avail themselves of the opportunity to use order information from the collocated computers of broker-dealers (primarily the buy-side); from another kind of trader – those rascals, the HFTs, that do collocate (that pay old-line exchanges to locate their proprietary computers near the exchange clearing engine, giving them a quicker look at the exchange data feed.)

In other words, IEX allows the HFT hoi polloi onto the playing field, but without their baseball gloves.

By teaming with IEX, LTSE seeks to accelerate its plan to attract listings from firms seeking to reap the supposed rewards of taking good corporate behavior to a higher level. It is the view of some Silicon Valley startups – LTSE’s constituency – that the values of their far-sighted startup projects are too often burdened by the cynical expectations of Wall Street, with Wall Street’s purported “we-want-it-all-now” greed; importuning the Silicon Valley startups to show immediate results; at the expense of more valuable longer-term profits. These startups seek to attract an investment constituency that “gets it”; Silicon Valley is all about the long run.

Elon Musk expresses the Silicon Valley view of the SEC/old-line stock market mindset, quoted in an article by Shanthi Rexaline.

Public company stocks, particularly if big step changes in technology are involved, go through extreme volatility, both for reasons of internal execution and for reasons that have nothing to do with anything except the economy. This causes people to be distracted by the manic-depressive nature of the stock instead of creating great products. They're constantly trying to make up false rumors and amplify any negative rumors. It's a really big incentive to lie and attack my integrity. It's really awful.”

Musk suggests he might be better served taking Tesla [his firm] private. LTSE seeks to be an exchange that gives Silicon Valley inhabitants the virtues of a public market, such as small investor access and inclusion in indexes referenced by ETFs, without the disadvantages Musk enumerates.

The essential futility of LTSE

But there is a critical difference between exclusionary exchanges and other elite clubs. Exchanges exist to attract traders; not to repel them. A buy order at a given price does not depend on the trader’s attitude for its beneficial effect.

There are two primary reasons to choose a primary listing venue. Publicity; and volume at the market close, discussed here. Of the two reasons, only one generates volume, and hence income for the exchange – volume at the market close.

The essential functions of the market close are: first, there are no HFT games – no opportunities to use the feeds on one exchange to alter resting orders at another; second, a trader can place an order that settles at the high-volume closing price hours in advance; third, all orders filled at the close are filled at the same price; and fourth, the closing price is the price reported on accounting statements and in daily valuation of market-priced books.

But IEX and LTSE, by limiting behavior, exclude traders

And that exclusion will lead to IEX’s and LTSE’s ultimate marginalization. LTSE cannot compete with NYSE’s closing volume. But LTSE does not produce revenue by providing publicity for listing companies. I cannot visualize a future for LTSE. But I can imagine a successful future for IEX.

IEX’s speed bump is a negative feature at the close. And the close is when an exchange butters its bread. The realities of exchange competition are muddied by the detritus of intra-day orders. A smart buy-side trader places her important orders at the close; the magic moment when the sell- and buy-side, like predator and prey at an oasis, are attracted by their common fundamental need, volume.

The bankruptcy of the IEX and LTSE strategies lies in their exclusionary tactics. Like the Royal Exchange before them, their exclusion of some traders ultimately will drive the included out into the street where the hoi polloi fill the ultimately defining need of the lonesome included, the volume provided by HFTs. Exchange revenues are not generated by self-congratulatory press releases, but by trading volume.

IEX’s objectives are consistent with success. But their tactics are reactionary

IEX can reconcile the needs of the broker-dealers, and their HFT-based tactics, with the needs of the buy-side. But not within the SEC’s NMS framework. Yet to be viable, IEX must meet the needs of both buy-side and sell-side traders. On this wider path, IEX may not only survive; but dominate.

The problem that stifles IEX is their acceptance of SEC regulation. The fundamental objective of the SEC – the protection and proliferation of the exchanges themselves - prevents IEX's success. It is this SEC objective that has produced the clamoring needy horde of exchanges, dark pools, and other dealing platforms that arbitrage retail orders – all feeding on the inefficiencies spawned by the SIP.

To bring the needed genuine revolution in trading technology to financial markets, we need a futures-like, security-like beast that will force regulators to turn their attention from their current perverse objective, the protection of exchanges. Such a new market beast would drive regulators to compete for survival; forcing regulators back to their necessary function – investor protection from real bandits, such as those that infect the cryptocurrency space. If IEX creates this new market beast, it will thrive.

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.