IEX, Ideology, and the Role of an Exchange
IEX, Ideology, and the Role of an Exchange

			IEX has raised significant capital, possibly at a valuation well into the hundreds of millions. IEX plans to become a full exchange and continue capturing market share, but I wonder if it might have a unique long-term vision that excites investors. In this post, I will speculate about what that vision might look like. To be absolutely clear, this post is highly speculative, and does not constitute trading or investment advice.
CEO Brad Katsuyama testified that “IEX was founded on the premise of institutionalizing fairness in the market.” Soothing words, and possibly words that tell us something substantive about IEX’s values.
IEX recently introduced the D-Peg, an order type that uses market data to make a prediction about where the price is heading, and transact only at times that are predicted to benefit the user. The D-Peg is a blending of price prediction, traditionally the role of traders, with the matching process itself. Combined with the 350us structural delay built into IEX, it’s easy to see how even crude prediction signals could become incredibly powerful. As cofounder Dan Aisen puts it:
[W]e don’t need to be the single fastest at picking up the signal– as long as we can identify that the market is transitioning within 350 microseconds of the very fastest trader, we can protect our resting discretionary peg orders. It turns out that 350 microseconds is an enormous head start
I imagine that even something as basic as an order book ratio (e.g. [AskQuantity – BidQuantity] / [AskQuantity + BidQuantity]), known 350us in advance, has tremendous economic value.
This philosophy is interesting to think about, and I can see how it might appeal to certain audiences. If the exchange has a better idea of the market price than its customers, it makes a sort of sense for it to use that information to ensure trades can only occur at that price. But, I think the idea is ultimately a misguided one.
Here are some problems with it:
1) The exchange, in an effort to increasingly prevent adverse selection, may want to make their prediction more sophisticated. If a skewed order book results in ‘bad fills,’ then the same can be said for trades occurring after price moves on correlated instruments. If the price of PBR has just dropped by 1%, then buy orders for PBR.A are surely in danger of being “picked off.” Should the exchange try to prevent that? IEX may well have decided that they’ll always allow this kind of adverse selection. But keep in mind that trading signals do not work forever, especially when they are heavily used — so IEX will likely need to continually revise their prediction methods.

2) As the prediction methods get more complex, they are more liable to be wrong. In the example above, maybe an event occurs that affects the values of the two share classes in different ways. The exchange could erroneously prevent traders clever enough to understand that from executing, impeding price discovery.


3) Sophisticated traders like the PBR/PBR.A specialists could opt out of these order types. but how would they make an informed decision? Right now, we just know that the D-Peg uses a “proprietary assessment of relative quoting activity.” Could that “proprietary assessment” change over time? If so, are those changes announced? Matt Hurd has lamented the D-Peg’s undisclosed nature, and thinks it contradicts IEX’s mission of transparency. [1]


4) An exchange cannot increase the profitability of one group of traders without harming another. Now, maybe the only group harmed here are unsympathetic high-frequency traders who don’t deserve their profits. I’m skeptical of that. Who might some of those evil traders “picking off” quotes on IEX be? The motivation for Thor, and a critical part of the Flash Boys story, is the fading of liquidity when a trader submits large marketable orders. Some of the traders that the D-Peg will stymie may be people like the young Brad Katsuyama, investors or brokers who send liquidity-seeking orders simultaneously to many different exchanges. Say the NBBO for BAC is 10.00/10.01, and an investor wants to sell a large holding, so she sends sell orders to multiple exchanges, including IEX. One of those orders hits Nasdaq right when another gets to IEX, but IEX waits 350us, and, seeing the Nasdaq bid disappear, perhaps decides not to execute any resting D-Peg interest with the incoming order. Had the investor timed her sell orders differently (in a similar spirit to Thor, sending the IEX-bound order early), she’d have gotten a better fill rate. [2]

Another possibly harmed group could be non-D-Peg resting orders on IEX. One fascinating aspect of the IEX speedbump is that they can use it not only to prevent resting orders from executing at inopportune moments, but also to help traders remove liquidity at opportune moments! I was surprised to see that some order types can automatically trade against others upon a change in IEX’s view of the NBBO, through a process called “Book Recheck“. The mechanics of IEX seem complicated, so I could be wrong, but it looks to me like orders eligible to “recheck” the book may initiate a trade at a price determined by the realtime (*not* delayed) NBBO. [3] In contrast, cancel requests for the passive sides of these trades would be subject to the IEX speedbump. Here is a concerning, hypothetical example:
A) The NBBO for a stock is 10.00/10.01
B) A trader has submitted an ordinary (non-peg) limit buy order at 10.00 resting on IEX
C) The NBB at 10.00 is completely executed, making the new NBBO 9.99/10.01
D) The trader, seeing that 10.00 is no longer a favorable price for her purposes, tries to cancel her buy order
E) Her order cancellation goes through the 350us speedbump
F) In the meantime, IEX sees that the new NBBO midpoint is 10.00, and decides that a D-Peg sell order (or midpoint peg) is now eligible to recheck the book.
G) The D-Peg order is matched with the bid at 10.00.

The combination of algorithmic order types and selective use of the speedbump resulted in one trader getting an especially good fill, and another trader getting an especially bad fill. I guess if you’re not careful designing your exchange which supposedly prevents traders from picking each other off, you might do some picking-off yourself. [4]


5) Trading that occurs during price movements tends to be more informed, and preventing it could make markets less efficient. This would only be an issue if IEX captured significant market share, but it does sound like permitting trading only during periods of market stasis is part of IEX’s long-term vision. Referring to the D-Peg, Chief Strategy Officer Ronan Ryan says that “[a] core insight behind our market philosophy is that price changes are valuable opportunities, especially for those strategies fast enough to detect signals from price changes.” And also: “The economic benefit is that investors aren’t paying (or selling at) a worse price to a predatory strategy that is aware of quote changes before they are.”

It sounds like the idea is to stop an informed order from trading with an uninformed order, with the exchange deciding which is which. Naturally, the exchange is not an oracle and will misclassify some orders. But, if IEX becomes the dominant marketplace, and its classification is sufficiently good, informed orders will rarely get filled. You might think that wouldn’t happen, because IEX is only targeting ‘short-term’ alpha, but I’d venture a guess that a sizable chunk of order flow with long-term alpha will also have some short-term alpha inseparably folded into it. With information-bearing order flow being blocked, at a certain point, the exchange will be in the position of deciding when the imbalance between supply and demand warrants a price change. I happen to think that generally markets work better when people can freely trade with one another at prices of their choosing [5], and that a vision like this won’t get IEX into the same league as the major exchanges. But, market participants will be the judges of whether this model is a viable one.



6) Even if the exchange is pretty good at determining the market clearing price and balancing supply and demand. It’s not clear they can do so more cheaply than algorithmic traders and human market participants. Right now, IEX is charging 9 cents per 100 shares traded, significantly greater than estimates of typical HFT profit margins. [6]



7) IEX, by delaying executions, is effectively using market data from 350us in the future, piggy-backing on price discovery from other markets. As Aisen suggests, the speedbump is probably accounting for the vast majority of their prediction algorithm’s edge. [7] This is different from complaints about dark pools’ use of visible order information for price discovery. Dark pools can only use order information from the present, and have to report trades to the public tape “as soon as practicable“. The speedbump might well allow IEX to cheaply discover pricing information from lit market data, potentially starting a new era of speedbumps, with each exchange wanting to have a longer delay than their competitors have. Regulators may want to carefully think through possible end results of this form of competition.

8) We don’t understand how this sort of market structure would hold up under stress. HFTs thoroughly simulate their algorithms, does IEX do the same? In a flash crash situation, IEX might stop D-Peg matching for an extended period, preventing those clients from getting filled at prices they may love, and isolating much-needed liquidity from the rest of the market. Additionally, if IEX is too effective at blocking informed order flow, some traders could panic when they repeatedly try and fail to get executed, damaging market stability.

Most of these issues aren’t especially important to overall market health as long as IEX’s market share stays below a few percent. And I think their market model is a perfectly fine one for a dark pool, although a little more disclosure wouldn’t hurt. The question is whether their target audience of fundamental traders will want to participate in this sort of market. I suspect ultimately that they won’t, though IEX might reach critical mass before participants really have time for reasoned debate.
We may have a glimpse of what “institutionalized fairness in the market” really means. To some, it may mean the relief of relying on a trustworthy institution to equitably determine the timing and pricing of their trades. To others, it may sound like a private company determining the market price via secret, non-competitive algorithms — unaccountably picking winners and losers. Institutional arbiters are part of civilized society, but ideally they’re transparent, receptive to criticism, and reformable when not working. Before we hand over the keys to IEX, we had better make sure that they meet these standards.

[1]Hurd’s complaint seems fair enough, but I’ll mention that competing exchanges aren’t always perfectly transparent either. For instance, Nasdaq Nordic’s documentation seemed to have some noteworthy details about reserve orders that weren’t available on Nasdaq’s US site.

[2] Brad Katsuyama said that “fading liquidity” is one of IEX’s “concerns regarding negative effects of structural inefficiencies” in his testimony to the US Senate:
[D]ue to the construct of the market system certain strategies are able to get out of the way of buy or sell interest as they are accessing the market in aggregate, which calls into question the fairness of the inefficiencies which allow or enable such behavior, and the potential distortion of price discovery and of supply and demand.

[3] Execution Tag “LastLiquidityInd” has a value for “Removed Liquidity on Recheck.” And the Form ATS says:
Upon a change to the Order Book, the NBBO, or as part of the processing of inbound messages, the System may test orders on one or both sides of its market against the contra side of the Order Book to determine if new executions can occur as a consequence of the change in the IEX Book or prevailing market conditions[.] Orders resting on the Order Book at the IEX determined Midpoint, may be eligible to trade against orders in the updated Order Book, which were ineligible, or did not satisfy the order’s conditions, when they were originally booked.
Does that mean the recheck uses the same non-delayed NBBO that IEX uses in the rest of their logic? I don’t know, but more disclosure from IEX seems like a good idea.

[4] Our hypothetical trader who had her buy order “scalped” may also have heard statements from IEX such as “You can not scalp trades, you can not scalp orders that are on IEX.”

[5] Within some reasonable limits of course. Limit-Up-Limit-Down price constraints seem to be appreciated by most participants, though even those aren’t completely free from criticism. Reg. NMS Order Protection also has some passionate opinions on both sides. There is always going to be some tension between letting traders determine prices unencumbered, and protecting them from ‘erroneous’ or ‘unfair’ transactions.

[6] Rosenblatt Securities, which has conducted surveys of HFTs, recently estimated that HFT profit margins in US Equities are around 5 cents per 100 shares. Tabb Group similarly sees shrinking profit margins.

[7] The D-Peg aside, even the simplest formula like the NBBO midpoint will have massive alpha with a 350us “head start.”
					