Way out of the shadows: How new exchanges arise

Translator’s note: In our blog on the hub, we published the adaptation of the best-selling book by Michael Lewis, which talks about the impact of high-frequency trading on the financial system. Now the heroes of this book want to create a "stock exchange as it should be." September 16, 2015, the US Securities and Exchange Commission (SEC) announced that IEX is going to become a public stock exchange, which will be called Investors Exchange (Investor Exchange) [1]. IEX and its CEO Brad Katsuyama are known as the heroes of Michael Lewis' Flash Boys



): stubborn idealists who discovered fraud in the US securities market and decided to rectify the situation. So they founded their dark pool. Now they want to make a real exchange out of it.


Why does IEX want to become a stock exchange? One of the reasons is that the founders see in IEX not just a business, but also their mission. Katsuyama seems to be trying to improve the functioning of the markets, and his team can only do this as a stock exchange, not as a dark pool. Moreover, the phrase "dark pool" is a little alarming. If you want to change the way people bid, do it in the light of day .

“We want to compete directly with the New York Stock Exchange,” said IEX Executive Director Brad Katsuyama. “The best way to demonstrate the difference between what a real exchange should be and what it is now is to be who we are.”

Of course, the formation of the exchange makes sense from a purely commercial point of view [2]. Dark pool sizes have a certain limit. The main advantage of public stock exchanges is their pricing, because exchanges, setting prices at which everyone can trade, do this task better than dark pools. Theoretically, the exchange can cover 100% of the market, although this is unlikely to happen. For dark pools, this is pointless even in theory: if all markets were shadow, no one would know what prices should be guided during trading.

In addition, the exchange has another advantage: it provides the so-called secure quotes. Bloomberg writes :

By becoming a stock exchange, the New York-based company IEX, which is going to take the name "Exchange of investors", will be able to get more profit. If the value of securities on the exchange is always the most profitable, orders will be flocked to this particular exchange. Weakly regulated alternative trading systems [3], which, according to the law, is the IEX at the moment, do not have such an advantage. Even under such circumstances, IEX managed to attract about 1.4% of the total US securities less than two years after the founding of the company.

“At the moment, people have a choice: they are not required to conduct their operations through the IEX,” says Katsuyama. - Being a stock exchange, you are part of the National Market System (NMS). If you set the most favorable prices, then orders will have to come to you. Thus, this choice becomes a commitment. ”

It is worth recognizing that this rule, called the "rule for protecting market orders," annoys many. Sometimes he is consideredsource of current market fragmentation and lack of transparency. Instead of choosing which market is best for trading, investors are forced to send their orders to various small organizations, giving preference to traders with fast computers and a deep understanding of the market structure. But the rules are such that if you are an exchange and set the best price, then everyone should send their orders to you.

But here a small problem arises because of one of the main features of IEX - the so-called “ magic box ”, which reduces the transfer speed of orders to 350 microseconds [4]. The Meaning of a Box that Holds 38 Miles of Fiber Optic Cable, consists in the following: high-frequency traders change their prices faster than investment companies; in the process of changing prices, high-frequency traders gain an advantage in speed, and they can conclude a deal with slower players at the old, irrelevant price. It is believed that this is unfair, and IEX decided to put an end to this and to please some investors [5].

This is all great, of course, but when other exchanges are required to send orders to the Investors' Exchange, a slightly unusual situation arises.

Imagine that you manage a stock exchange and quote a bid of $ 10.00 / ask $ 10.02. Then imagine that all the other exchanges exhibit the same bid and ask. Further, quotes begin their movement: those who put out a bid of $ 10.00 change their offer to $ 9.99, and players who set a ask of $ 10.02 change it to $ 10.01. Accordingly, quotes of all other exchanges move, with the exception of IEX: at least for several hundred microseconds. The IEX is still quoting $ 10.00 / $ 10.02. Perhaps it is still on display because the IEX bid is actually still $ 10.00. Perhaps the reason is that the player changed his bid from $ 10.00 to $ 9.99, or even $ 9.98, but this change is still “spinning” around the box. You don’t know for sure, but you can assume that the $ 10.00 bid will most likely disappear after 350 microseconds.

And then a market application for sale comes to you. This order could be executed with a bid of $ 9.99, but the best bid in the country (National best bid) - a protected quote - is a bid of $ 10.00 on IEX. Therefore, even if it seems to you that the quotation exhibited at IEX is no longer relevant, one way or another, you should send an application for IEX [6]. After that, she again has to wrap a lot of circles around the box, because of which the execution of this application is delayed and there is a risk that it will not be executed at all even with a bid of $ 9.99 [7].

Therefore, IEX quotes, which are invariably set with a delay of 350 microseconds, will be protected, as well as the quotes of other exchanges - their quotes are set with a variable delay. There is a delay in order processing on all exchanges: nothing happens instantly, and it is very difficult to synchronize faster than one microsecond. If IEX performs certain operations faster than other exchanges, then its quotes may be more relevant. Thus, the deliberate delay of the IEX may be less than the random delay that occurs on other exchanges.

On the other hand, it’s a little strange to “protect” quotes that you can’t trade instantly. If the delay in the order was not 350 microseconds, but 10 minutes, then in this situation it would be unfair to force investors to enter the auction instead of agreeing to a slightly less favorable price, but to complete the transaction right now. This is what the SEC thought about. The Rule for the Protection of Market Orders in the Regulation "National Market System" (Regulation NMS) is referred to as Rule 611 , which obliges shopping centers to "stop unfair trading at protected quotes." All of its conditions are defined in Rule 600.. The point is that the exchange cannot execute an order with a price lower than the best bid (or higher than the best ask) of any “automatic quote” placed on another exchange. An automatic quote is an exchange quoted on the exchange, which “instantly and automatically” responds to incoming orders [8]. The SEC, during the adoption of the NMS regulation, commented on this commitment:

The concept of "instant" excludes the development of automatic systems and other technologies aimed at creating delays in setting quotes.

After reading this sentence, you might think that IEX should not have protected quotes: the company is just using “technologies aimed at creating a delay in setting quotes”. Of course, without context, this sentence is meaningless [9]. Other exchanges also experience delays between accepting and executing applications: these are the laws of physics. These delays may be comparable to or even longer than IEX delays, but they are unintentional. In this case, the SEC can have many reasons for not following the usual formalities: the delay is not so long [10], investors seem satisfied, and it would be foolish for the SEC to refuse market justice fighters trying to organize their own exchange, since it is thanks to this that the level of honesty is growing trade. The IEX representative said: “We are confident that "that all components of our model satisfy all regulatory requirements, as well as the main goal of the Securities Trading Law - the establishment of effective, competitive, fair and regular market relations." It still sounds somehow strange [11].

You can imagine the complex and fragmented structure of the market: despite the fact that each of the manifestations of the complexity and fragmentation of the market can be justified by a number of reasonable and noble goals, together they make the market a more favorable place for advanced high-frequency traders. The more knowledge you need to acquire, the more benefits you can get if you understand the topic quickly and thoughtfully. This generalized theory should not be taken too seriously in each individual case. The consequences of using the “magic box”, which I talked about earlier, cause not so many problems and less and less seem prone to deception and manipulation. Sometimes your order will be executed a little later or worse than usual, due to the "protection" of irrelevant IEX quotes. However, I can hardly imagine how a vile high-frequency trader can profit from this or harm someone [12]. It’s hard for me personally to imagine how to get around this system. You’re smart, you’ll come up with it yourself. Maybe you can figure out how to get around it [13].

Another curious reason for turning IEX into an exchange is listings. In July of this year, Brad Katsuyama in a letter addressed to his subscribers:

It should be noted that IEX will not immediately begin listing securities. Now we are introducing standards for the admission of securities, already approved by the Commission [on securities and exchanges] on other exchange platforms, in our initial documentation in order to begin organizational and administrative measures and provide our clients with more opportunities when the exchange starts its work. We are pleased to receive a large number of applications from public companies interested in placing their securities on our exchange. Due to the fact that so far our focus is more on creating a market aimed primarily at supporting investors, we are confident that we can also help issuers improve their experience in interacting with markets.

If you are a public company, in order for your shares to be listed on the stock exchange, you must pay a certain amount of money for this privilege. The Intercontinental Exchange, which owns the New York Stock Exchange, earned $ 367 million last year in admission payments to the Securities Exchange; Nasdaq OMX earned $ 238 million . Exchange platforms are quite actively fighting for the placement of foreign shares on them. In fact, it is not so important where the company's shares are quoted. Wherever you place your stocks, one way or another, they will be tradedand at other sites. Of course, all exchanges have their own rules for opening and closing, slightly different requirements for self-organization, various administrative functions, as well as unplanned network failures that can prevent a company from entering an IPO [14]. However, most of the decisions made depend on the perception and style of the exchange: vivid examples are the solidity of the New York Stock Exchange and the high-tech nature of the companies on Nasdaq.

What is the style of placing securities on the Stock Exchange of investors? Given that it is not yet possible to put up their shares on it, it's hard to say. But the fact that IEX “receives a large number of applications from public companies” suggests that the organization is forming a positive brand (not without the help of the Flash Boys book). We can say that the peculiarity of the exchange is to assist investors. Many investors are worried about the presence of market manipulations and threats from high-frequency traders. The admission of securities to trading on the Exchange of investors tells investors that they are not indifferent to the exchange.

Moreover, market manipulations and threats from high-frequency traders also concern company executives, and their concern is much more serious and causes more uncertainty. Heads of public companies are generally far from discussing market structure compared to mutual fund managers. Their market experience can be described not as “I lost 20 basis points during this operation,” but rather as “What the hell! “Why on earth did my stock drop 21% for no reason in just a few minutes?” The market structure can discourage investment organizations, or it can confuse and intimidate company executives. This is a great opportunity to grow your business if you know how to calm them down.

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Below are comments on the prospects for the new IEX exchange from Bloomberg columnist and former investment banker Matt Levin:

1. The official name of the organization indicated in the application is Investors' Exchange LLC, although Brad Katsuyama in his letter to his clients calls it Investors Exchange.

There is a footnote on page 164 of the Flash Boys book that explains how the company, originally named Investors Exchange, came to be named IEX:

Despite wanting to keep the full name, they discovered a small problem when they were about to register an investorsexchange.com Internet address. In order to avoid an awkward situation, they decided to take a different name.

I don’t know if they managed to get rid of this awkwardness, but, one way or another, the organization will be called Investors Exchange or Investors' Exchange.

2. Unpleasantthat if IEX becomes an exchange, "the fee charged by it to market participants for the provision of consolidated data on trading on all exchange platforms will be reduced." This is also money, and they, in fact, are charged for nothing: IEX, as you know, criticized the use of these summary data.

3. IEX is a dark pool, and yes, this concept is somewhat alarming.

4. Not all IEX dark pool characteristics will be preserved in Investors Exchange - in particular, Investors Exchange will lose “ Broker Priority ” - however, the exchange will continue to use the “magic box”. In the applicationIt is said that "access to the system is through the points of presence of the IEX exchange, designed to create a delay of 350 microseconds when participants request access from the points of presence of IEX to the system."

5. The Michael Lewis line of thought is outlined in this passage from his Flash Boys book:

Generally speaking, it was believed that there are three types of activity that lead to a large volume of overly unfair trade. The first they called electronic leading transactions: traders saw that the investor was trying to do something in one place, and ahead of it in another (this happened when Katsuyama traded in RBC). They called the second type “rebate arbitration”. It was carried out using legal “kickbacks,” or rebates, as they were called in the industry. Exchanges offered rebates to their customers, but in reality, these rebates did not add any liquidity. The third and, apparently, the most common type of activity they called "arbitrage in the sluggish market." It arose in a situation where a high-frequency trader got the opportunity to learn about price changes on one exchange and “disrupted” trading on other exchanges before how these exchanges managed to react to this. This happened around the clock, day after day, and, in all likelihood, this type of activity for the year brought much more profit than all other types combined.

Each of the three aggressive strategies depended on speed. And the very first, raw idea to confront them came precisely from Katsuyama: everyone tried to get to the exchanges as close as possible - so why not try to distance the "aggressors" from the exchange as far as possible, to distance yourself from the rest and not let them get closer? The idea was to place the exchange engines, which compare buy orders with sell orders, at a considerable distance from the places where traders connected to exchanges (called points of presence), and then demand from everyone who wanted to trade on exchange, connect to it from a certain point of presence. If you place each market participant far enough from the exchange, then you can level all or at least most of the advantages that speed can give.

It turned out that by placing the market participants “quite far away”, a delay of 350 microseconds could be caused if the point of presence was located 38 miles from the engine, which brings together buy and sell orders. And 38 miles of fiber optic cable can be put in a small box.

6. Obviously, no one will be able to take into account all the details: all these are probabilistic characteristics that the algorithm can either take into account or not.

7. For example, if a trader on IEX actually canceled his bid of $ 10.00 and left the most profitable bid on IEX of $ 9.98, then after passing your application through the “magic box”, the best bid in the country will return to the first exchange; therefore, the application returns to the first exchange, and at the same time, the quote starts its movement again, so everywhere the best bid will be $ 9.98, etc. The example is somewhat exaggerated, but the point is that it is precisely these delays in a few fractions of a millisecond that market players complain.

8. Among other things, take a look at the definition of “automatic quotation” in Rule 600 (b) (3) . Sometimes by the word "exchange" I mean something more, but only when the meaning of the statement does not change.

9. If this word does not seem to distort the meaning much, then with the word “instantly” some difficulties may arise. What do I mean by the word "instantly"? If something happens within 350 microseconds, then any sane person will confidently tell you that this happens instantly.

10. Compare Rule 611 (b) (8), which, in essence, justifies exchanges for trading on them, despite the fact that there is a better price on another trading platform. This is possible provided that a better price has occurred somewhere in the last second. The bottom line is that being an exchange is not easy: you cannot find out what is happening on other exchanges one second after what happened. But one second lasts 2,857 times longer than 350 microseconds! If the SEC wants exchanges to be able to communicate with each other within one second, then it probably will not mind if exchanges can communicate with each other in 350 microseconds.

11. And if the SEC really allows the IEX to combine intentional delays with protected quotes, should it not do the same with other exchanges that require it?

12. The delay of the high-frequency trader who placed the order on IEX will be the same as yours, so he will not be able to overtake you. I believe that if this trader knows that you trade with IEX with a delay, and that your order is not executed immediately, then perhaps he has a chance to overtake you on the way back to another exchange. However, this option seems far from optimal.

13. You can also tell the SEC how to get around the system - I’m sure that after making the IEX application a number of high-profile statements will follow - but then you will no longer need to figure out how to get around it.

14. I recalled a curious story about the technical failure of Nasdaq when Facebook was launched on IPO. But even more interesting is the story of a failed exitat the BATS IPO. Since then, BATS has no longer included in its register a single public company (including itself), although exchange investment funds are quoted on it .