NYSE Attacks IEX Exchange Proposal, “Flash Boys” Hero Responds

When the book “Flash Boys" burst onto the financial scene in early 2014, it created a storm of controversy over “rigged markets” trading everything from Google, Apple and Facebook to General Electric, Ford and Proctor & Gamble. The resulting peek behind the curtain of high frequency trading (HFT) created a firestorm as the battle was characterized as “dirty.” A new shot was fired in that “dirty” battle Thursday, as a public comment from the stalwart New York Stock Exchange accused the up and coming hero of “Flash Boys” of not practicing what it preaches. In an exclusive statement to ValueWalk, the “hero” exchange responded.

One of the book’s primary charges that resonated with astute market participants was the lack of disclosure regarding trading rules. Order types were not fully disclosed and in general the appearance of two sets of rules, one for high frequency traders and another for the investing public, that raised knowing eyebrows. Transparency and allowing all market participants access to a level playing field were issues when author Michael Lewis released his book and remain so today, except the charges are being leveled at the book’s hero. After outlining the HFT problem in “Flash Boys,” Lewis introduced Brad Katsuyama and the IEX Exchange, who outlined a set of guiding principles based on fairness and equal access.  It is against this backdrop the New York Stock Exchange fired off a surprise comment letter Wednesday that publically challenged the IEX Exchange on, of all issues, transparency and fairness.

In a public comment letter on the IEX’s application to graduate from operating as a “dark pool” to becoming a full exchange and more actively competing with the NYSE on several levels, NYSE Vice President and Associate General Counsel Elizabeth King didn’t hold back punches. While commending IEX for the move into a tighter regulatory regime, King blindsided IEX by publicly attacking a disclosure deep behind how the exchange is operated. In humorous fashion, King claimed that IEX’s application was like an episode of the comedy “Seinfeld.”

“Like the “non-fat yogurt” shop on Seinfeld, which actually serves tastier, full-fat yogurt to increase its sales, IEX advertises that it is ‘A Fair, Simple, Transparent Market,’ whereas it proposes rules that would make IEX an unfair, complex, and opaque exchange,” King wrote, attacking IEX for exactly what was at the heart of the book “Flash Boys.”

The issue was so series that the NYSE believes the SEC should not consider the exchange without such disclosure. “IEX omitted critical operating procedure detail from its rules, which makes it impossible to fully ascertain how it proposes to operate as an exchange.”

IEX POP system, its “magic shoebox,” is the real issue.

Not only does the IEX not fully disclosing this method create problems, the NYSE comment letter points out that by slowing down the traffic coming into the exchange it might actually violate SEC rules.  The NYSE argues that IEX is creating an “unfair advantage” because it is slowing down orders.

“The Application provides scant details of IEX’s POP functionality, which IEX describes in its marketing materials as the hallmark of IEX’s model and how IEX differentiates itself from other trading venues,” NYSE writes. “What is clear, however, is that IEX has programmed an intentional delay into all orders entering its ATS systems and would continue this functionality if approved to operate as an exchange.”

The letter argues SEC Regulation NMS, which governs how automated exchanges operate, considers a certain amount of latency inherent with message transmission and trade operations, the SEC “made clear” that “any programmed delay equates to human discretion” and thus violates SEC rules.

At issue is the IEX Point of Presence (“POP”) system, which has been called the exchange’s “magic shoebox.” This is the mechanism that adds latency to delay orders by 350 microseconds, less time than it takes to blink, from reaching the matching engine. This delay is what is designed to create a “fairness” between high frequency traders and investors but is the issue many comment letters, including those from market participants Citadel and NASDAQ, have in opposing the IEX exchange application.

“Because all orders sent to IEX would be required to go through IEX’s POP, contrary to Regulation NMS, an IOC order would not immediately and automatically execute and any unexecuted portion would not be cancelled immediately and automatically,” the NYSE letter said. “Rather, the programmed intentional delay of 350 microseconds on order entry would mean that an IOC order would not receive an immediate execution and thus IEX’s quote would not meet the second prong of the definition of an automated quotation.”

Larry Tabb of the Tabb Group, a market structure consultancy, raised three concerns. The first, he said, was that the current IEX proposal allows certain IEX customers to access the exchange quicker than other exchanges. “When a customer uses the IEX router, they gain an advantage over those who don’t use the IEX router,” he said. This creates an “arbitrage opportunity.” The second is that latency creates issues trading across exchanges. To illustrate, Tabb provided the example of an institutional trader using both IEX and NYSE simultaneously. Based on the IEX guidelines submitted to the SEC, when an order is submitted to both IEX and NYSE exchanges at the same time, one exchange would display and execute the trade quicker than the other creating a host of fairness issues. Third, this such a delay at one exchange creates problems for all exchanges with SEC mandated order protection/interexchange routing. With delayed market data, is the price the exchange sees factual and are SEC guidelines required to protect pricing actually accurate?

350 Microseconds is no big deal as IEX responds

Supporters of HFT reform claim the IEX delay levels the playing field and should not damage market fairness.

“If you are affected by a 350 microsecond delay, you are a parasite,” tweeted Eric Scott Hunsader, president of Nanex, a software company that monitors HFT trading activity. “No one wants to save parasites.” On the other side of the argument are firms such as Citadel and the NASDAQ stock exchange, who claimed the result of the IEX POP system is that bids and offers will be delayed on other exchanges, negatively impacting exchange performance.

IEX responded that transparency is a core component of its business model and that it provided details on how the POP operates in their Form 1. “If some firms believe that more transparency is warranted beyond what is provided in Exhibit E and Exhibit F of our Form 1, documents which can also be found on our website, we are happy to provide more detail in our response letter to the SEC.”  An IEX spokesperson told ValueWalk to expect a response to the NYSE’s comment letter soon and that the SEC would have as much transparency as they desired in the future exchange’s operation.