Views on improving the integrity of global capital markets
22 September 2014

HFT and IEX’s “Fair-Access” Platform: One Step Forward, Two Steps Back?

Posted In: Market Structure, US SEC

In the first blog post of our two-part series on high-frequency trading (HFT), I looked at one way in which IEX is attempting to make markets more investor-friendly. In this post, I look at a controversial policy at IEX that is potentially negative for investors.

Having achieved the PR coup of featuring prominently in the book Flash Boys, IEX is moving forward with its attempt at becoming a major player in the exchange world. While the need for yet another trading venue may not appear obvious, IEX’s mission of providing a market where predatory HFT algorithms are neutralized may prove valuable to investors. Indeed, Goldman Sachs has proclaimed its support for the project, even if it ultimately comes at the expense of its own platform, Sigma X.

While IEX is currently a dark pool, it has aspirations to become an exchange like NASDAQ or BATS, and recently raised $75 million to that end. At the time of writing, it is the seventh-largest trading venue in the United States with approximately 1% market share. IEX President and CEO Brad Katsuyama has even outlasted his CNBC sparring partner William O’Brien, who left the BATS exchange after it agreed to settle with the SEC over allegations that O’Brien’s Direct Edge platform gave unfair advantages to HFTs prior to its merger with BATS in 2013.

However, as part of its application to become an exchange, IEX is attempting to obtain the SEC’s support for a policy that may be detrimental to investors. In particular, concerns center on IEX’s proposed use of the controversial practice of broker preferencing (aka on-market internalization). Broker preferencing allows brokers to jump strict price-time priority and execute for free when they have orders on both sides of the trade at the same price or better. The financial media has suggested that the use of broker preferencing is a business tactic necessary for IEX to attract substantial order flow in a saturated and competitive exchange market.

Currently, broker preferencing is a feature of Canadian markets but is not allowed in the US. It was a topic studied by the SEC at the request of the US Congress in 1996. That report found no significant negative effects due to broker priority; however, the analysis in that study likely needs updating given the changes in market structure since that time. The concerns around broker preferencing are that it provides no obvious improvements in market quality for investors (as opposed to brokers) and risks several negative consequences. First, if an investor order can be stepped ahead of by a broker having both sides of a trade, a resting order would be denied a fill that it would otherwise receive under strict price-time priority. This may reduce the incentive to post public quotes. Second, broker preferencing is desirable for larger brokers because it allows them to avoid exchange-trading fees. However, broker concentration is likely to increase as only the trades of the largest brokers could have some certainty of execution. Therefore, smaller brokers would likely struggle to stay in business.

IEX’s response is that it is attempting to reduce market fragmentation and cites the Canadian market as an example where none of the major banks have their own dark pool because they can internalize on-market. In addressing the criticism that they are encouraging broker concentration, IEX states that in such a fragmented market they are simply providing an alternative priority policy and that the market can decide whether it will succeed. Further, they claim that only 2% to 3% of volume is internalized in this way so it is not a critical issue in any case.

On principle, we at CFA Institute think it is important to preserve nondiscriminatory execution, in order to protect market integrity and provide fair treatment for all types of investors. If there are positive consequences from moving off-market internalization onto public markets, then these should be studied more carefully than has been the case to date. IEX’s negotiations with the SEC on this matter are ongoing, although it is believed that the SEC refused such requests for broker priority from NASDAQ and NYSE in the past.

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About the Author(s)
Sviatoslav Rosov, PhD, CFA

Sviatoslav Rosov, PhD, CFA, is Director, Capital Markets Policy EMEA at CFA Institute. He is responsible for developing research projects, policy papers, articles, and regulatory consultations that advance CFA Institute policy positions, focusing on market structure and wider financial market integrity issues.

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