06.21.2016

The IEX Exchange and Its Consequences for Investors

(This article first appeared on Tabb Forum)

The SEC has approved IEX, warts and all. The question now is: How will the approval of IEX impact US market structure?

Investors will rue this day. Spreads will widen, retail investors will be hurt, large buy-side firms will be disadvantaged, market structure complexity will increase, sophisticated trading firms will profit, and the quality of the US markets will deteriorate.

Over the past 200 years – and especially over the past 15 years of market structure automation – we have seen two major trends: First, markets have become more deterministic as they have become faster and data quality has improved; and second, spreads (displayed and effective) have tightened. This is completely logical – the faster and cleaner the market data, the tighter firms can quote and trade.

The same will be true in reverse. The slower and more problematic the data, the wider firms will need to price their trades, as speedbumps, by definition, obfuscate data, slow orders down and reduce the market’s determinism.

The IEX approval presents a number of challenges.

Currently, there are 12 exchanges (13 with IEX); seven of the current exchanges have less than 5% market share. These seven markets have the most to gain from copying IEX’s speedbump. That said, these won’t be exact cookie-cutter implementations of the IEX speedbump; we will see many variations on a theme.
If the SEC allows multiple speedbump markets, we can absolutely expect an increase in execution complexity. Some markets will be first in/first out; others will have delayed order types. And some will have IEX-like DPEG and crumbling quote-type functionality, while still others will just have various delays. If, like the movie “Something About Mary” says, eight-minute abs are fantastic, seven-minute abs must be better. We will be seeing a lot of “seven-minute abs” markets, and determining how to trade across these markets and order types will be challenging, to say the least.

Retail wholesalers not only offer immediate execution, they guarantee both the price and size of a retail broker’s clients’ orders. This means that even if the top-of-book size is only 100 shares, wholesalers will guarantee that same price for 1,000 shares. Speedbumps, however, make this retail guarantee problematic.

What Will This Mean for Trading and Investors?

One or more speedbumps and/or speedbump order types will decrease the determinism of the market, as there will be aggressive quotes that won’t be actionable (as they are traversing a bump) and displayed quotes that don’t actually exist. When displayed prices are not actionable or predictable and the data that is being broadcast – especially to market makers (the firms posting their trading intentions) – is not predictable, market makers must widen their quotes, because they cannot guarantee that they will be able to effectively trade out of (or hedge) a newly acquired position. This new market structure will have multiple implications.

Retail investors will be the real losers. As markets become less deterministic, and market makers and wholesalers widen their quotes, investors trading in smaller size will be hurt.

Navigating the market also will be more difficult for institutional brokers. That said, brokers have best ex obligations rather than order protection responsibilities. Brokers can avoid a market if they decide that their experience with that specific market is problematic. If multiple markets add speedbumps, and certain exchanges add speedbump order types, however, then avoiding exchanges becomes more difficult and determining the right routing procedures more complex.

Dark pegged exchange orders will increase as a percentage of the market – reducing transparency, price discovery and market efficiency. If speedbumps can more effectively protect dark pegged limit orders (as they should), we would assume that these types of orders will proliferate.

Sophisticated trading houses, and especially those leveraging their own money, will win – by definition, they have to. Folks with their own money at stake and who have short-term trading horizons have the greatest incentive to figure this out. And they will have to figure it out almost immediately, as the longer they don’t, the longer they will lose money.

Liquidity providers’ profits will come on the backs of investors’ returns.

To appropriately manage the increasing market complexity, brokers will need to reconfigure their routing strategies. This, however, will take months, if not years, during which time institutional investors will be hurt.

If exchange routing is based on the Order Protection Rule, and the speedbump market has a protected quote, then exchanges cannot avoid speedbump routing (even though brokers can). If exchanges are required to route to speedbump exchanges with phantom quotes, it would make exchange routing less effective.

To the extent that multiple speedbump markets proliferate, direct-feed data could become less important. However, if one expects that the largest markets would maintain their real-time structures, then the pricing of their data would continue to be valuable, and possibly even more so.

The importance of speed to investors will decline, which will mean that brokers’ investments in speed will not be as critical. Today, a significant amount of liquidity changes hands as the price moves. To capture this liquidity, brokers need to invest in low-latency routing, connectivity, and data. As speedbumps slow down the market, the importance of speed declines and with it, the imperative to invest in speed.

Conclusion

The acceptance of IEX as an exchange with a protected quote is a turning point for global market structure. In no other market have regulators allowed an exchange to adopt a sophisticated time-altering and manipulative mechanism to their national exchange infrastructure and forced firms and exchanges to trade off phantom quotes. This will open a floodgate of copycat and unique speedbump markets that will increasingly make it much more difficult to determine the best price, trade efficiently and achieve best execution. This will hurt the price discovery process, which will in turn hurt investors, issuers, and the efficiency and effectiveness of the US capital markets.

While the development of IEX was an attempt to turn the tables on sophisticated traders, the SEC in one fell swoop by approving IEX will effectively make the markets exponentially more complicated, line the pockets of sophisticated trading firms, and pick the pockets of investors both large and small (but especially small), while degrading the quality, effectiveness and competitiveness of the US capital markets.

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