The debate that engrossed observers of the equity markets over the application of the dark pool featured in Michael Lewis’s Flash Boys: A Wall Street Revolt, has faded. As well, the Investors Exchange LLC (“IEX”), application for approval as public exchange has died down for the time being. What may reignite the controversy is the filing of a suit threatened by other exchanges or high frequency traders, or both, challenging the SEC’s June 2016 decision to approve the application.
Central to the threatened lawsuit is the claim, advanced most forcefully by the exchanges and Citadel Investment Group, that IEX’s strategy violates Regulation NMS, and specifically Rule 600(b)(3). The problem, they say, is an innovation by IEX commonly referred to as a “speed bump,” which consists of 38 miles of coiled fiber-optic cable. The speed bump adds 350 microseconds (350 millionths of a second) to the time it takes orders to reach IEX’s system.
The purpose of the speed bump, of course, is to blunt the advantage of high frequency traders, who look for signals that other buyers and sellers are in the market and then insert themselves ahead of the slower orders so they can profit from short term trades. The strategy has come to be known euphemistically as latency arbitrage. This is how IEX characterizes its aims:
Our speed bump has two primary purposes. First, it protects client orders on IEX from being scalped at stale prices by certain high-speed traders who have purchased faster access to information from other exchanges, and know the prices to be stale. Second, it protects clients who use IEX’s Router from being beaten to other exchanges by high-speed traders who are looking to react to the clients’ orders by removing liquidity on those exchanges before the orders can be executed.
The exchanges profit from the volume high speed traders provide and the premiums the traders pay for faster access to information from other exchanges, which permits the traders to front run the order flow of other investors. The exchanges have not attempted to refute IEX’s claims in any meaningful way. Their opposition to IEX’s application before the SEC focused largely on legalities.
Rule 600 of Regulation NMS, which defines an “automatic quotation” as one that “immediately and automatically” responds in some fashion, whether by executing an order or cancelling it, is at the heart of the controversy. IEX’s opponents contend that the speed bump, by introducing a latency of 350 milliseconds, runs afoul of the rule because quotations are not “immediately” available.
On its face, the claim is not implausible. The original purpose of Regulation NMS was to modernize securities trading by replacing specialists on the floor of the exchange with computers that rapidly match orders so that investors get the best prices. In other words, the intent was to eliminate the inefficiencies of an antiquated system by encouraging speed. The rule had never been interpreted to permit delays, intentional or otherwise.
While the legal arguments of the exchanges opposing IEX have some surface appeal, they don’t hold up quite so well to closer inspection. For example, in seeking to explain the meaning of the term “immediately” in Rule 600(b)(3), Nasdaq relied on judicial holdings that the term “immediately” in a federal statute did not permit “deferral” or “postponement” of an action and that a rule requiring that emergency room care be made available immediately meant that it had to occur without loss of time. These precedents were not particularly helpful in answering the question whether Regulation NMS permits introduction of a barely perceptible delay in a trade. After all, 350 microseconds is about one thousandth of the time it takes to blink.
But the SEC was still required to essentially reinterpret Regulation NMS to justify approving IEX’s application in a way that deemphasized the importance of speed. Its chief basis for doing so though was a practical consideration, not a legal principle. The SEC found its justification in the fact that market participants today, for technological and geographic reasons, routinely experience delays in receiving updates to displayed quotations, many in excess of IEX’s 350 microsecond one-way delay.
The SEC thus determined that the requirement of immediacy in Rule 600(b)(c) precluded an exchange’s use of a device that would delay action with respect to a quote unless the delay was “de minimus” — that is, a delay so short as not to frustrate the aim of Regulation NMS to protect fair and efficient access to the exchange’s quotations. IEX’s 350 microsecond delay fell within the exception.
Federal courts give substantial deference to an agency’s interpretation of its own regulations when that language is open to question, unless some alternative reading is compelled by the language of a statute. The SEC’s interpretation of a less than crystal clear rule here seems reasonable enough and would probably survive judicial scrutiny.
Legalities aside, the argument of the exchanges is laced with irony, undoubtedly unintended. Imposing the speed bump, they say, not only violates Rule 600(b)(3), but undermines the integrity of the markets and thereby puts investors at risk. But the exchanges which make this claim have themselves introduced multi-tier markets, investing large sums in technology so they can profit from offering faster data access to a small cohort of traders who can both afford and benefit from superior access. They provide slower products, and inferior access, to those who cannot.
It is ironic as well that the exchanges would rely on Regulation NMS, a rule designed to insure fairness and market transparency, to protect both high frequency traders, whose tactics are widely viewed as unfair and not noticeably transparent, and the exchanges’ own franchise in catering to those traders.
This then is what the argument is really about, not whether it takes 350 microseconds to execute an order. IEX has now won the argument in the SEC and, perhaps more importantly, among the community of investors who believe themselves victimized by high speed traders.
In a recent interview, Nasdaq CEO Robert Greifeld claimed the SEC’s approval of IEX was an “abuse of process and a misuse of process” and insisted Nasdaq’s case was “very strong.” Sounds like Nasdaq is prepared to litigate the SEC’s approval of IEX. Right?
Instead, in an about face, Nasdaq signaled its intention to compete with IEX by seeking approval of what it called an “extended life” order type, which would allow investors to move ahead of other similarly priced orders if they agreed not to cancel their orders for approximately one second. Having exhausted all other possibilities, maybe Nasdaq has belatedly opted for what is really in the interest of it core clientele.
The SEC has for years been flirting with taking action to address directly the problems caused by high speed trading. By approving IEX as a public exchange, it has now done so indirectly.
One important reason for those problems is perhaps that the SEC’s approach — to deal with the legal and financial aspects of the debate — doesn’t work here. The central issues connected with high speed trading are not first and foremost legal or financial ones. They are matters of technology. The SEC needs to ask itself: Is it consistent with our securities laws and our notions of fair play to reserve the biggest profits for those with the fastest computers?