• Both sides mobilize executives to try to sway Congress and SEC
  • Flap hinges on whether a speedbump helps, or hurts, investors

Brad Katsuyama and his Investors’ Exchange were lionized in the best-selling book “Flash Boys” as protecting mom-and-pop investors from predatory high-frequency traders.

Now nearly two years later, his firm, IEX Group Inc., is counting on that renown to help smooth its path to become a public stock exchange. The designation would bring a stamp of approval from the U.S. Securities and Exchange Commission for Katsuyama’s idea of briefly pausing orders to take away the edge possessed by traders with superfast computers. The SEC’s endorsement would also enhance IEX’s business by boosting the number of trades it handles.

Brad Katsuyama
Brad Katsuyama
Photographer: Andrew Harrer/Bloomberg

Standing in the way are some of those same speed traders, who have an opportunity -- via the regulatory process -- to chasten IEX and its earnest leader. Leading the charge is the hedge fund Citadel LLC, whose billionaire founder Ken Griffin was furious over the negative light that the Michael Lewis book cast on his firm, according to two people who have spoken with him.

Aligning themselves with IEX competitors like the New York Stock Exchange and Nasdaq Inc., senior Citadel executives have trekked to Capitol Hill to lobby congressional staff and written several critical letters to the SEC arguing that the approval would harm, rather than protect, most investors. While IEX says the complaints are fear-mongering, the opposition has prompted the SEC to delay its decision and forced Katsuyama’s firm to mount a counter-lobbying effort.

‘Country Club’

“Despite IEX’s attempts to make trading nicer, it is never going to be a country club sport,” said R. Cromwell Coulson, the chief executive officer of OTC Markets Group Inc., who like many in the industry has been watching the battle with keen interest. “Citadel plays hard to win.”

Ken Griffin
Ken Griffin
Photographer: Jonathan Alcorn/Bloomberg

The clash, however, is more than just a financial titan versus a Wall Street upstart. It raises thorny policy questions that the SEC under Chair Mary Jo White has been slow to answer, including if U.S. stock markets are tilted in favor of the speediest traders and whether the proliferation of trading venues has spurred a spate of high-profile exchange breakdowns.

The issues raised by IEX’s application could cause the SEC to re-visit a controversial 2005 regulation credited with spawning the surge in electronic trading and eroding the dominance of the NYSE and Nasdaq. The policy’s major plank requires that investors get the best available price when they buy or sell shares. IEX’s opponents argue that its strategy of delaying orders will result in stale prices, putting it in conflict with the bedrock rule.

“If they want to be an exchange and play in the big leagues, they should have to play by the same big league rules as everyone else,” John Nagel, Citadel’s senior deputy general counsel, said in an interview. He declined to comment on the firm’s meetings with congressional staff and SEC officials.

Thorough Review

Even supporters of IEX have noted that the exchange application provides a good hook to review whether some regulations are outdated. Goldman Sachs Group Inc., the first major broker to urge the SEC to approve IEX’s request, told the agency in a Jan. 12 letter that it should now look broadly at “market structure rules to ensure that they are keeping pace with amongst other things, changes in trading technology and innovation.”

As recounted in Lewis’s 2014 book, Katsuyama and some of his colleagues set up IEX after concluding that stock markets were rigged in favor of speed traders.

Unlike other exchanges, IEX doesn’t sell ultra-fast access to its order book or offer financial incentives to entice traders onto its platform. To underscore its pro-investor stance, the firm has refused to accept funding from brokers.

IEX’s most famous innovation sends trades through its “magic shoebox,” which contains a coiled fiber-optic cable that pauses incoming orders by 350 millionths of a second. IEX says the slight delay, which it calls a speedbump, removes the risk that other traders can exploit fast computers to jump ahead of slower-moving investors.

‘No Gimmick’

The company says it isn’t surprised by Citadel’s reaction, which IEX believes shows the threat it poses to the status quo. IEX is hopeful that SEC commissioners will sign off on its exchange request by the next deadline of March 21.

“When ‘Flash Boys’ came out, everyone just said IEX is a marketing gimmick,” Katsuyama said in an interview. “Now all of a sudden it’s a full out battle. If this was a marketing gimmick no one would have cared that we were going to become an exchange.”

Chicago-based Citadel, which also operates a market-making business, has invested heavily in high-frequency trading and is a massive presence in the U.S. stock market, often accounting for more than 14 percent of daily transactions. The firm regularly comments on SEC issues.

Griffin views IEX as an existential threat to modern markets, which he believes have made trading easier and cheaper for all investors, said the people who asked not to be named because their discussions with him were private. 

Obsolete Prices

The firm said it’s worried that if one exchange is allowed to slow trading, others would follow suit with their own speedbumps, leading to multiple venues showing obsolete price quotes. It would be impossible for brokers to get the best price for their clients and changes may even provide new opportunities for gaming the system, Citadel says.

Griffin also didn’t like that “Flash Boys” portrayed Citadel as secretive and he took issue with the book’s negative depiction of firms that pay brokers to execute their customers’ stock trades, a widespread practice that is profitable for Citadel and other companies, the people said.

For IEX, the elevation to exchange status would boost the number of trades on its platform because brokers would be required under SEC rules to send orders there when it showed the best price for a stock. IEX presently operates as a dark pool, a private venue that relies on brokers and traders to send it business. It now handles about 1.7 percent of daily volume for U.S. stocks.

The SEC’s approval also would mean official acceptance of a different type of exchange -- a move that potentially threatens entrenched competitors. NYSE and Nasdaq have filed letters with the SEC that don’t outright oppose IEX, but take aim at its unique features such as the speedbump. In a Nov. 12 letter to the SEC, NYSE accused IEX of marketing itself as pro-investor but in reality trying to get a government sanctioned leg up.

Misleading Advertising

“Like the ‘non-fat yogurt’ shop on Seinfeld which actually serves tastier, full-fat yogurt to increase its sales, IEX advertises that it is a ‘fair, simple, transparent market,’ whereas it proposes rules that would make IEX an unfair, complex and opaque exchange,” NYSE wrote.

Spokesmen for NYSE and Nasdaq declined to comment.

On Capitol Hill, tensions between IEX and Citadel have intensified with accusations of name calling and spreading misinformation, according to people who have met with the companies. Both sides maintain they only sent lobbyists to counter the other’s aggressive tactics.

Citadel has told congressional aides not to be fooled by the “Flash Boys” halo effect and IEX’s false narrative that the market is rigged, according to people familiar with the matter. The firm has brought Jamil Nazarali, head of execution services, and Chief Legal Officer Adam Cooper to Washington to meet with the staffs of at least four senators, including Senate Banking Committee Chairman Richard Shelby of Alabama and the top Democrat, Ohio’s Sherrod Brown, according to people who attended.

Sketching Pictures

Katsuyama and John Ramsay, a former SEC official who is now IEX’s chief market policy officer, have also lobbied House and Senate staff. In meetings, Katsuyama used a notepad to sketch pictures that simplified the complex aspects of his firm’s market, down to the cables they coil to slow down speed traders, said people who attended. The firm’s executives dismissed Citadel as a beneficiary of the status quo, the people said.

In December, IEX also appealed to mutual funds and large investors, asking them to weigh in on its behalf with the SEC.

“This fight isn’t about a speed bump,” Katsuyama wrote in an e-mail to the potential supporters. “This is a fight about money -- who makes it and from whom.”

The lobbying is a reminder that the SEC’s decision is being closely watched. Because of the interest, the agency sent one of its senior market regulators, David Shillman, to Capitol Hill to provide briefings, according to House and Senate staff members.

Tough Decision

The SEC has been deluged with several hundred comment letters about IEX’s application; typically, new stock exchanges attract a handful at most. Whichever way the agency decides, White could face blowback from Congress, the finance industry and even fellow commissioners. Her spokeswoman, Gina Talamona, declined to comment.

With two vacancies on the five-member SEC, White may be the swing vote. Democratic Commissioner Kara Stein, who has questioned whether some speed traders can front run other investors, will probably support IEX. Republican Commissioner Michael Piwowar has questioned whether the exchange should be approved without first changing the broader rules passed in 2005, known as Regulation NMS, according to two people familiar with the matter. Stein and Piwowar declined to comment through aides.

While the deadline for the SEC to act on the application is looming, the agency could seek more time, dragging the process out for months. IEX, which has been discussing the details of its operation with the regulator’s staff, plans to update its application in light of the criticism, said people briefed on the deliberations. The SEC could also push the company to adjust IEX’s most controversial features.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE