SEC Should Stand Up for Investors
The following is an interview with Brad Katsuyama, co-founder and CEO of IEX. It originally appeared on Forbes.
The alternative trading system IEX continues to gain market share and has been referred to as the fastest growing securities market in U.S. history. In order to scale its ability to protect more investors, IEX needs approval from the Securities and Exchange Commission to operate as a stock exchange. But the company is facing a surprising level of opposition, with some even calling the company “un-American.” Brad Katsuyama, IEX’s CEO and co-founder explains:
Jared Meyer: Why was IEX started and how is it different from the existing stock exchanges?
IEX: IEX was started because many of our employees, including me, worked at banks, exchanges, or high-frequency trading (HFT) firms and we all saw, from our different vantage points, how the stock market had become an uneven playing field for regular investors. Stock exchanges were selling data and technology advantages to a small group of HFT firms. These advantages earn the exchanges hundreds of millions of dollars in fees, and give certain purchasers of these advantages the ability to scalp regular investors. Exchanges went from being places that focused on matching buyers and sellers to platforms that create and sell high-frequency trading products. IEX is a market response that eliminates the speed advantages and looks out for the interests of long-term investors.
IEX’s top priority is investor protection—which makes us very different from the other exchanges. We created a “speed bump” of 350 millionths of a second, which has caused a great deal of concern for people who sell speed (the major exchanges) or need speed to make money (select HFT firms). This is why we face opposition. While large segments of the marketplace, including investors both large and small, support IEX, the major exchanges and some high-frequency traders are trying to block us, saying that we should not have the right to compete with the incumbent exchanges.
JM: Is the extent of HFT the problem with the current model? I always thought that it made markets more efficient and responsive.
IEX: HFT is too vaguely defined to give a yes or no response—because it can be beneficial or harmful. The beneficial aspects come from firms that post bids and offers, provide liquidity, and contribute to more efficient markets. Firms such as Sun Trading and Virtu (which wrote a comment letter in support of IEX) do not care about a 350 microsecond speed bump. However, there are also HFT firms who believe that 350 microseconds is critical to what they do, as they look to pick up trading signals so that they can race ahead and pick off trades from regular investors.
One of the benefits of IEX being a market-based solution is that we designed a platform that didn’t have to decide which HFT was beneficial or harmful—we invited all HFT firms to participate. But given the speed bump, many predatory aspects of HFT are deterred and minimized on IEX.
JM: Some people, including former SEC commissioner Paul Atkins, argue that Congress should revise antiquated securities laws before the SEC approves IEX. What do you think of this idea?
IEX: First, lobbying to change the rules before letting a new entrant compete is a common way to delay new competition. It’s a very old tactic. What you see now are some people asking the SEC to revise Regulation National Market System (Reg NMS), which has been heavily debated for the past ten years and will most likely take many more years to update. IEX’s opponents want us to sit on ice for that amount of time, which is a pretty clever way to stifle innovation and competition. We think IEX fits within the current rules and we firmly believe we should have a chance to compete.
Second, regulation cannot solve this problem alone. It is difficult, if not impossible, to effectively regulate rapidly-changing technology. I am sure that many aspects of Reg NMS made sense when they were adopted. For example, under the rules a broker can bypass quotes on an exchange that doesn’t respond immediately, where immediate is defined as one second or less. But one second in today’s marketplace is an eternity, so in ten years that particular exception has become obsolete. Market-driven innovation will be far better at adapting to technological changes than regulation can, as long as new entrants are given that opportunity.
JM: To continue to operate, does IEX need Congress to pass any new laws or the SEC to make any more rules? Or does the company only need the SEC’s approval?
IEX: We are not asking for new laws or rules. Our position all along has been that our model fits within the existing regulatory structure, yet it has the potential to rectify many market structure issues that have emerged.
The irony is that IEX was designed to serve the same principles that exchange regulations were put in place to uphold. IEX is helping to return integrity to the public markets. We do this by prioritizing the investor: we protect them from latency arbitrage on IEX as well as on other exchanges when trading through our router. In fact, the router’s ability to protect investors imposes costs on predatory HFT by forcing them to honor their bids and offers across the market, not just on IEX—which is why some HFT are so upset.
JM: If IEX is beneficial for long-term investors, why is the company’s petition for exchange registration receiving so much pushback?
IEX: We have received more public comment letters than all stock exchange applications before us combined, but despite the noise being made by exchanges and some HFT firms, 95 percent of the commenters are supportive of IEX becoming an exchange. We have support from a broad range of market participants, including citizens, academics, retail investors, global pension funds, asset managers, hedge funds, electronic market makers, and even some large banks. When you consider who the stock market was built for, it feels very good to have such broad support.
The push back against IEX’s business model comes from a narrow range of interests, mostly the existing stock exchanges and select HFT firms. These exchanges earn a lot of money by selling speed, and access to that speed is crucial to some HFT firms’ business models. You can imagine how upset they are by a new entrant that is slowing things down, just a bit, to level the playing field. If the dynamics of competition shift to prioritize something other than speed, such as investor protection, then the value of speed decreases, but the market becomes a lot fairer for investors.
JM: So some HFT traders and the large existing exchanges are profiting off the current system and they want to defend their lucrative business models?
IEX: That’s right. Today the exchanges make more money by selling access to faster data and their technology than from trading. NYSE, NASDAQ, and BATS fragment the market by owning and operating ten of the twelve U.S. exchanges. If a company actually cares about bringing buyers and sellers together, why would it operate multiple exchanges? The reason is that they have fostered an environment that is ripe for HFT firms to get in the middle and interfere with orders from long-term investors. Also, each exchange charges for market data, connectivity, colocation, etc. The current model is great for exchanges, but a horrible deal for brokers and an “invisible tax” on real investors.
The debate over IEX has become so heated because established interests will do whatever it takes to protect their monopoly on speed. They are outspending us on lobbying and trying to use the regulatory process to block real progress on behalf of investors.
JM: Even if it benefits long-term investors, isn’t IEX’s business model technically illegal? The coiling process does purposely delay trading, and this is prohibited by Reg NMS.
IEX: The irony is that we got the idea for our coil from the existing exchanges. Currently, exchanges sell co-location services which allow members (including HFT) to place their servers in the same data centers as the exchanges’ technology. The closer to the exchange you are, the faster you receive information and the faster you trade. But certain firms that have servers in the far corners of the data centers complained that their cables were longer than their competitors’. The exchanges’ answer: give all members who pay for co-location the same length of cable and coil the cables of the closer members. This process has been permitted by the SEC for years with no discussion of it violating any rule. IEX simply does the same thing, which is coil cable to create equality. We just coiled more cable, and not just for people who pay us to co-locate—but for all IEX participants.
Also, our opposition has cherry-picked language from the regulation while conveniently ignoring the principles of Reg NMS, which are to uphold the interests of long-term investors. Reg NMS states clearly that when the interests of long-term investors conflict with those of short-term trading interests, it is the interests of long-term investors that must be prioritized. That is the exact point of our exchange and technology design, and we believe that IEX complies more with the regulation than do existing exchanges.
JM: When will we know if IEX gains SEC approval?
IEX: March 21 is the date when we expect an SEC decision.
JM: It is unfortunate that a regulation that was put in place to protect long-term investors is being used to block the growth of a system that aids long-term investors. There is an opportunity for consumers, and IEX’s model can change Wall Street’s paradigm . Protecting existing high-frequency traders and exchanges is no reason for government to stand in the way of innovation.
Jared Meyer is a fellow at the Manhattan Institute for Policy Research. Follow him on Twitter here.
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