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The 'Flash Boys' Exchange Is Growing Up

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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On Wednesday, the Securities and Exchange Commission disclosed that IEX has applied to become a public stock exchange, to be called the Investors' Exchange.  IEX, and its chief executive officer, Brad Katsuyama, are of course the heroes of Michael Lewis's "Flash Boys," rebellious idealists who discovered that the U.S. stock market was rigged and decided to do something about it. What they did was start a dark pool. Now they're trying to turn it into an exchange.

Why would IEX want to become an exchange? One obvious reason is that IEX is not just a business but also a mission: Katsuyama seems to genuinely want to reform the markets, and the way you do that is as an exchange, not a dark pool. "Dark pool" just sounds bad. If you are trying to change how people trade, you want to do it in daylight:

"We want to compete directly with NYSE," Katsuyama, the chief executive officer of IEX, said in an interview. "The best way to show the difference between what we think an exchange should be doing and what they currently are is to be one ourselves."

There are also business reasons to be an exchange, of course.  There's sort of a natural limit on the size of a dark pool: A key benefit of public stock markets is price discovery, and exchanges -- which display quotes with which anyone can trade -- tend to be better at that than dark pools. If you are an exchange, you can aspire to 100 percent market share, though you probably won't get there. But for a dark pool that doesn't even make theoretical sense: If 100 percent of the market was dark, no one would know what prices to trade at. 

But there's another market-share advantage to being an exchange, which is that being an exchange gets you protected quotes. From Bloomberg News:

Becoming an exchange -- which the company plans to call the Investors Exchange -- could help New York-based IEX win more business. When an exchange has the best price for a stock at any given moment, orders must be routed its way. Lightly regulated alternative platforms, which is what IEX legally is today, don’t enjoy that same advantage. Even with that headwind, IEX has won about 1.4 percent of U.S. equities trading less than two years after launching.

"Right now, IEX is a choice that people may or may not make," Katsuyama said. "As an exchange, you’re part of the National Market System. It becomes an obligation if you’re the best price to send the order. It goes from optional to mandatory."

I should say that this rule, the "order protection rule," annoys a lot of people. It is sometimes blamed for the market's current fragmentation and opacity. Instead of everyone choosing what market(s) they want to trade in, investors are forced to route their orders to a bunch of smaller venues, giving an advantage to traders with fast computers and a deep understanding of market architecture. But it's the rule: If you're an exchange, and you display the best price, everyone else has to route to you.

But this interacts a bit weirdly with one of IEX's main selling points, its "magic shoebox" that slows down orders by 350 microseconds. The idea of the shoebox -- a box filled with 38 miles of coiled fiber-optic cable -- is that high-frequency traders are quicker to update their prices than slower institutional investors, and when prices change the high-frequency traders can change their prices rapidly and trade with slower traders at the old, stale price. This is, arguably, bad, and IEX decided to stop it, and some investors are happy about it, and that's all great.  

But when other exchanges are required to send orders to Investors Exchange, it gets odd. Let's say you're an exchange and you have a quote of $10.00 bid / $10.02 offered. And let's say the other exchanges have the same best bid and offer. Then your quote moves -- the people bidding $10.00 change their bid to $9.99, and the people offering $10.02 change their offer to $10.01. And the other exchanges' quotes move too. Except IEX's: At least for a few hundred microseconds, IEX is still displaying $10.00 / $10.02. That might be because there really is still a bid at $10.00 on IEX. Or it might be because the person bidding $10.00 on IEX has changed his order to bid $9.99, or even $9.98, but the modification is still swirling through the shoebox. You can't really know, though you might make an educated guess that the $10.00 bid will probably disappear within 350 microseconds. 

And then you get a market sell order. That order would execute against your $9.99 bid, except that the national best bid -- the protected quote -- is IEX's $10.00. So -- even if you think that IEX's displayed quote is probably stale -- you have to send the sell order to IEX, where it too has to swirl through the shoebox, delaying its execution and running the risk that it won't even be able to execute at $9.99.  

So IEX's quotes, which are effectively 350 microseconds in the past, would be protected along with other exchanges' quotes, which are ... well, they're not exactly in the present. They're some variable amount of time in the past. Every exchange has some delay in processing orders; nothing happens instantaneously, and it's hard to synchronize anything to the microsecond. If IEX is faster at other operations than other exchanges are, then its quotes may be more current than theirs. Its intentional delay might be shorter than their accidental delay.

On the other hand it does feel a little weird to protect quotes that you can't instantly trade against. If a market delayed orders by 10 minutes, instead of 350 microseconds, it would be sort of unfair to force investors to trade there rather than take an apparently inferior but immediately available price elsewhere. And this is something that the SEC has actually thought about. The order protection rule is Rule 611 of Regulation NMS, which requires a trading center "to prevent trade-throughs on that trading center of protected quotations." Those terms are defined in Rule 600; the meaning for our purpose is that an exchange can't execute a trade at a price lower than the best bid (or higher than the best offer) of any displayed "automated quotation" on another exchange. An "automated quotation" is one displayed on an exchange that "immediately and automatically" responds to incoming orders.  And the SEC, in adopting Regulation NMS, had this to say about that requirement:

The term "immediate" precludes any coding of automated systems or other type of intentional device that would delay the action taken with respect to a quotation.

If you just read that sentence you would think that IEX can't have protected quotations: It uses an "intentional device that would delay the action taken with respect to a quotation." Of course there's no reason just to read that sentence without context. Other exchanges also have delays between receipt and execution of orders; that is just how physics works. And those delays might be comparable to, or even longer than, IEX's. But they're not intentional. There's plenty of reason for the SEC not to stand on ceremony on this point: The delay isn't that long, investors seem happy with it, and it would be awkward for the SEC not to let the poster boys for market fairness become an exchange because of the thing that makes their exchange fair. An IEX spokesman says, "We are confident that all aspects of our model meet all regulatory requirements and further the goals of the Securities Exchange Act to promote efficient, competitive, fair, and orderly markets." Still the words are awkward.

You can have a general theory of market structure that it is complicated and fragmented, and that while each particular instance of complexity and fragmentation may be justified by sensible and high-minded reasons, the accretion of them makes the market more favorable to sophisticated high-speed traders. The more stuff there is to figure out, the more advantage you can get from being good and fast at figuring out stuff. One shouldn't take this general theory too seriously in any individual case. The magic-shoebox effect I described above doesn't seem particularly troubling, and more to the point it doesn't seem gameable: You might sometimes get slightly delayed, and get a slightly worse execution, because a stale IEX quote is protected, but it's hard for me to see how any nefarious high-frequency trader could use that fact to its advantage and your detriment. For me, though. It's hard for me to figure out a way to game it. You all are smart, tell me how to game it. The prize is maybe you get to game it.

There's one other interesting reason for IEX's exchangeification, which is listings. From Brad Katsuyama's letter to subscribers in July:

It is important to note that IEX will not be operational as a listing exchange at launch. We are including listing standards, which have already been approved by the Commission for other exchanges, in our initial filing in order to begin certain administrative/regulatory processes and to provide optionality after our launch. We are honored to be receiving significant inbound inquiries from public companies regarding our intention around listings and while our focus so far has been to build a market that better serves the investor, we strongly believe we can help issuers improve their experience with the markets as well.

If you are a public company, you want your stock to be "listed" on an exchange, and you pay the exchange for the privilege. Intercontinental Exchange, which owns the New York Stock Exchange, made $367 million in listing fees last year; Nasdaq OMX made $238 million. The exchanges compete pretty hard for listings, but honestly it doesn't matter that much where a company lists. Wherever you list, your stock will still be traded elsewhere. There's some stuff -- different opening and closing mechanics, slightly different governance requirements, various administrative functions, the occasional computer glitch messing up a high-profile IPO -- but a lot of the decision comes down to perception and symbolism. There's a mature heft to New York Stock Exchange companies, a techy buzz to Nasdaq companies.

What is the symbolism of listing on the Investors Exchange? Well, you can't list on the Investors Exchange, so it's hard to say. But the fact that IEX is "receiving significant inbound inquiries from public companies" tells you that a positive brand is already developing. ("Flash Boys" obviously doesn't hurt.) It's a symbolism of being, you know, for investors. A lot of investors worry that the market is rigged and that high-frequency traders are a menace. Listing on the Investors Exchange says to those investors: We care. More to the point, though, a lot of corporate executives worry that the market is rigged and that high-frequency traders are a menace. And their worries are both vaguer and deeper. Public company executives tend to be a lot further removed from market structure discussions than mutual fund managers are; their experience of market structure is less "I had 20 basis points of slippage executing this trade" and more "holy moly why did my stock go down 21 percent in a few minutes on no news?" Market structure can be frustrating for institutional investors, but it can be baffling and terrifying for corporate executives. That's a big business opportunity for anyone who can soothe their terror. 

  1. The formal name on the application is "Investors' Exchange LLC," but Brad Katsuyama's letter to customers says "Investors Exchange."

    A footnote-in-footnote: Here's the footnote from page 164 of "Flash Boys" describing how IEX, originally called "Investors Exchange," came to be called IEX:

    In the interests of clarity, they'd hoped to preserve the full name, but they discovered a problem doing so when they set out to create an Internet address: To avoid that confusion, they created another.

    I don't know if that confusion has been resolved, but in any case they're going with Investors Exchange. Or Investors' Exchange.

  2. One kind of boring one is that if it becomes an exchange, IEX "will also receive a cut of the fees charged to market participants for a consolidated feed of trading data from all exchanges." That is real money, though not anything particularly interesting; indeed IEX has rather famously criticized the use of those consolidated feeds.

  3. That's "dark pool," but of course that sounds bad.

  4. While not every aspect of the IEX dark pool will carry over to the Investors Exchange -- in particular the latter will get rid of Broker Priority -- the shoebox will. The application says that "All access to the System is provided from a Point of Presence (an 'IEX POP') of the Exchange, which is designed to provide Access Participants with 350 microseconds of latency from such IEX POP to the System."

  5. Michael Lewis describes the reasoning in this excerpt from "Flash Boys":

    Broadly speaking, it appeared as if there were three activities that led to a vast amount of grotesquely unfair trading. The first they called electronic front-running — seeing an investor trying to do something in one place and racing ahead of him to the next (what had happened to Katsuyama when he traded at RBC). The second they called rebate arbitrage — using the new complexity to game the seizing of whatever legal kickbacks, called rebates within the industry, the exchange offered without actually providing the liquidity that the rebate was presumably meant to entice. The third, and probably by far the most widespread, they called slow-market arbitrage. This occurred when a high-frequency trader was able to see the price of a stock change on one exchange and pick off orders sitting on other exchanges before those exchanges were able to react. This happened all day, every day, and very likely generated more billions of dollars a year than the other strategies combined.

    All three predatory strategies depended on speed. It was Katsuyama who had the crude first idea to counter them: Everyone was fighting to get in as close to the exchange as possible — why not push them as far away as possible? Put ourselves at a distance, but don’t let anyone else be there. The idea was to locate their exchange’s matching engine at some meaningful distance from the place traders connected to the exchange (called the point of presence) and to require anyone who wanted to trade to connect to the exchange at that point of presence. If you placed every participant in the market far enough away from the exchange, you could eliminate most, and maybe all, of the advantages created by speed. 

    It turns out that "far enough" was a 350-microsecond delay, which could be achieved by locating the point of presence 38 miles from the matching engine. And you can put 38 miles of wire in a box.

  6. Obviously no human has any time to think about any of these things; they are just probabilistic questions for algorithms to ponder, or ignore.

  7. E.g., if the trader on IEX actually cancelled his $10.00 bid and left the best IEX bid at $9.98, when your order gets through the shoebox the national best bid will be back on the first exchange, so the order goes back to the first exchange, but in the intervening time the quote moves again so that the best bid anywhere is $9.98, etc. This is all a bit hyperbolic but the point is that these sub-millisecond delays are what people complain about in market structure.

  8. See in particular the definition of "automated quotation" in Rule 600(b)(3). I am sometimes using the word "exchange" here where I strictly mean something broader, though not in any ways that matter for our purposes.

  9. Which I suppose does not have the force of law, though the "immediately" does. What does "immediately" mean though? If something happens in 350 microseconds, for any reasonable human purpose it is fair to say that it happens "immediately."

  10. Compare Rule 611(b)(8), which basically gives exchanges an excuse for trading through a better quote elsewhere if the better quote only showed up elsewhere within the last second. The idea is, you know, it's hard to be an exchange, you can't be expected to know what's going on on other exchanges within a second of when it happens. But a second is 2,857 times as long as 350 microseconds! If the SEC just wants exchanges to be current with each other to within a second, surely it should be okay with exchanges that are current within 350 microseconds.

  11. And if the SEC does let IEX combine speed bumps and protected quotes, doesn't it have to do the same for any other exchange that asks?

  12. Like, the high-frequency trader is delayed on IEX the same as you are, so he can't race ahead of you anywhere. I suppose if he knows that you're going to be delayed going to IEX and not get filled then perhaps there's a chance to fade ahead of you coming back to the other exchange, but that doesn't seem too compelling.

  13. Or tell the SEC how to game it -- there will be a public comment period on IEX's application, which I bet will be fun -- but then the prize will be that you won't get to game it.

  14. I linked to the very amusing Nasdaq/Facebook glitch, but even more glorious is the time that BATS messed up its own initial public offering. Since then, BATS hasn't listed any other public companies (or itself), though it does list exchange-traded funds.

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

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Matt Levine at

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