Corporate Social Responsibility / Finance / Technology

New Stock Exchange on the Horizon Amidst High Frequency Trading Controversy

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Mark Mulkeen

The Investor’s Exchange (IEX) is planning to apply to become a fully registered stock exchange, and it may happen sooner than expected. IEX is currently registered as an alternative trading system (ATS), which is not regulated as highly as fully registered exchanges, such as the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations (NASDAQ). An ATS exchange is also known as a dark pool, and there are currently 45. Dark pools are allowed to choose who gets inside their exchanges, allow investors to be anonymous, and keep their rules secret. IEX, however, gives access to all brokers, lists investors, and is the only ATS which makes its rules public. IEX plans to become a fully registered stock exchange once it surpasses 5% U.S. stock volume, at which point it should become financially viable for it to take on the costs associated with additional regulation.

IEX is closer than previously expected to applying, due in large part, to the release of Michael Lewis’s new book, Flash Boys: A Wall Street Revolt. Since its release, IEX has doubled its shares per day to as high as 24 million, around a half percent of U.S. stock volume, and is bigger than 4 out of the 13 U.S. stock exchanges.     The book argues that the stock market has become rigged by what are called high-frequency traders. It also tells the story about IEX’s founder, Brad Richmond, who discovered issues for his electronic trading team at a Royal Bank of Canada’s (RBC) New York base were due to high-frequency trading. High-frequency traders pay large sums for private fiber-optic cables that connect them to stock price updates faster than public lines. The difference between high-frequency cables and public ones are mere milliseconds, but these traders have strong enough technology to act faster than those using public lines. These traders use their quicker info, along with algorithmic knowledge of customer interest in a certain stock, to buy a certain stock right before a customer, and then sell it to the customer at a higher price.

This practice has been accused of being a form of insider trading and front running, both illegal practices. High frequency trading, however, has remained legal up to this point. These transactions produce just cents of profit each, but add up over time to hundreds of millions in gains for these traders, and losses for those without the technology.

As a result, firms are willing to spend millions for these cables. Spread Networks recently built a high-speed fiber-optic cable network from the Chicago futures market to exchanges in New Jersey, a project that cost $300 million. They are leasing the network to firms for $10 million each.

Ben Katsuyama noticed at RBC he was being beat to trades by high frequency traders. As a result he found that orders he placed for clients only partially filled and the prices were increasing. This discovery led him to assemble a team to solve the problem. Part of the team was Ronan Ryan, a telecommunications worker, who helped implement high-speed fiber-optic cable networks for high frequency traders. Ryan and the team eventually figured out how to make trades without losing time to the higher-speed wires. Their solution to the problem lead Katsuyama to start up IEX.

This brings us to the ultimate significance of IEX. They built “speed bumps” that re-route the wiring of high frequency cables so that information from them arrives in the same time as all other cables, leveling the playing ground for investors. There is still much debate to be had over the legitimacy of high frequency trading, and high uncertainty about IEX’s future, but it is clear that a challenge has been made towards the traditional establishment of stock exchange trading in the U.S.

 

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60 Minutes. CBS. New York City, New York, 31 Mar. 2014. Television.

McCrank, John. “Exclusive: IEX Eyes Stock Exchange Status.” Reuters. Thomson Reuters, 05 Apr. 2014. Web. 07 Apr. 2014.

Pisani, Bob. “Michael Lewis, ‘Flash Boys,’ and ’60 Minutes'” CNBC.com. CNBC, 31 Mar. 2014. Web. 07 Apr. 2014.

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