Markets

Michael P. Regan is a Bloomberg Gadfly columnist covering equities and financial services. He has covered stocks for Bloomberg News as a columnist and editor since 2007. He previously worked for the Associated Press.

There are three main reasons behind Nasdaq's $1.1 billion purchase of the International Securities Exchange, but only one of them is likely to cause widespread gossip and speculation among the market-structure debate club that's been meeting nonstop since "Flash Boys" was published. It also points to a broader problem in the stock-trading world.

First, the purchase will help Nasdaq firmly leapfrog over CBOE Holdings as the biggest owner of U.S. options exchanges by volume. Second, it will also allow Nasdaq to double its stake in the Options Clearing Corp. clearinghouse to 40 percent.  

Flying High
Shares of Nasdaq Inc. continue to march higher despite -- or maybe because of -- the overall volatility in the market.
Source: Bloomberg

The third reason, however, is where all the intrigue lies. The deal gives Nasdaq licenses to run more stock exchanges, right when IEX Group -- the company profiled in "Flash Boys" as the antidote to suspected high-frequency trading predators -- is waiting for the Securities and Exchange Commission to rule on its application as an exchange. According to an interview with Annie Massa, Nasdaq Chief Executive Officer Robert Greifeld made it clear that he'd consider asking the SEC for permission to also run an exchange with a "speed bump" to delay buy and sell orders by a tiny fraction of a second, one of IEX's main selling points.

Nasdaq, justifiably, will have some sour grapes if the SEC approves IEX as an official exchange with its "magic shoebox," which coils long lengths of computer cables to slow down the speed at which orders reach its matching engine. As Nasdaq stated in its comment letter on IEX's application, the company's PSX exchange applied in 2012 to do something similar using programmed delays instead of cables. However, the exchange withdrew the application after discussions with SEC staff made it clear they probably wouldn't receive approval because delayed orders would not be considered  "protected quotations" that are guaranteed to be filled if they are the best bid or offer on any exchange. 

However, a lot has happened since that application in 2012. Michael Lewis' "Flash Boys" drew national scrutiny to the fairness of the electronic stock market, which is scattered over 12 official exchanges and dozens of dark pools. IEX and its "magic shoebox" were championed as the best way to thwart the automated high-speed traders who prowl over the various venues looking for profitable trading opportunities that exist for only fractions of a second.

Investors have clearly embraced the IEX model, making it one of the biggest dark pools by volume, even though most of the others are operated by big brokerages: 

Deep End of Dark Pool
IEX has grown into one of the top three alternative-trading venues in the U.S.
Source: Bloomberg Intelligence, FINRA

Many investors and traders think that IEX helps level an unfair playing field and that it should be allowed to upgrade its status from dark pool to exchange, which is advantageous for several reasons: Its quotes would be protected; it would have certain legal shields as a self-regulatory organization; and it would be able to eventually earn extra revenue by listing companies and exchange-traded funds.  

The SEC is expected to rule on IEX's fate on March 21 unless the issues raised in comment letters are serious enough to cause a delay. IEX already made a last-minute concession by redesigning its router, which sends unfilled orders to other trading venues, so that it's subject to the same speed bump that applies to incoming orders. That may have helped improve its chances of approval.  

But as Nasdaq's Greifeld has shown, approving IEX could open the floodgates for more companies that want to operate exchanges with speed bumps. Approving them would mean making an already complex market much more complicated, which is generally thought to be a bad idea considering the many technology problems that have made headlines in recent years.

Ultimately, the worries about the convoluted structure of the stock market go beyond whether IEX receives approval to become an exchange. What's needed is a top-down review of Reg NMS, the complex set of rules that had the good intention of opening stock trading to competition but ended up creating a 50-headed beast. Yet, as SEC Chair Mary Jo White pointed out on Wednesday, this is an election year and sweeping changes to rules simply are not gonna happen.  

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Michael P. Regan in New York at mregan12@bloomberg.net

To contact the editor responsible for this story:
Daniel Niemi at dniemi1@bloomberg.net