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3 years ago
Note of the translator: On Habré we published adaptation of the best-seller of Michael Lewis which tells about influence of high-frequency trading on a financial system in our blog. Now heroes of this book want to create "the exchange what it has to be".

Output from a shadow: As there are new exchanges

On September 16, 2015 the Commission on securities and the exchanges of the USA (SEC) declared that the IEX company is going to become public stock exchange which will carry the name Investors Exchange (The exchange of investors) [1]. IEX and its executive director Brad Katsuyama are known as heroes of the book of Michael Lewis "Fast boys" (Flash Boys): stubborn idealists who found fraud on securities market of the USA and decided to correct a situation. So they based the dark-pool. Now they want to make of it this exchange.

What is a dark-pool
Darc pool (dark pool) call liquidity or trade amount which is hidden from most of participants of the exchange market.

The considerable part of dark-pools forms transactions of large payroll companies and funds, information on which is not output to the general trading floors. Similar transactions, as a rule, pass through alternative finance networks (ECN) or directly between players of the market.

There are several types of dark-pools.

  • The independent companies created to offer to clients unique terms for exchange trade treat the first.
  • Broker dark-pools can be created by broker companies, inside dark pools auction goes between clients of one broker.
  • Darc pools of exchange platforms — sometimes dark pools are created also at the exchanges which want to give to some clients certain benefits thanks to anonymity and closeness of auction.

Why IEX wants to become the exchange? One of the reasons is that founders see in IEX not just business, but also the mission. Katsuyama, apparently, tries to improve functioning of the markets, and its command can make it only as the exchange, but not as a dark-pool. Especially, the phrase "dark-pool" guards a little. If you want to change how people conduct auction, do it by the light of day.

"We want to compete directly with the New York stock exchange", – the executive director of IEX Brad Katsuyama said in the interview. – "The best method to show a difference meanwhile what has to be this exchange and what it is now it is to be those whom we are".

Certainly, forming of the exchange makes sense and from purely commercial point of view [2]. The sizes of a dark-pool have a certain limit. The main benefit of public stock exchanges consists in pricing because the exchanges, exposing the prices at which everyone can perform trade, cope with this task better, than dark-pools. Theoretically the exchange can cover 100% of the market though it will hardly occur. For dark-pools it is senseless even in the theory: if all markets were shadow, nobody would know by what prices it is necessary to be guided during auction.

Besides, the exchange has one more advantage: it provides the so-called protected quotations. Bloomberg writes:

Becoming the exchange, the New York company IEX which is going to take itself the name "Exchange of Investors", will be able to get more profits. If the cost of securities at the exchange always is the most profitable, orders will be flown down on this exchange. Slaboreguliruyemy alternative trade systems [3] what under the law IEX at the moment also is have no such advantage. Even under such circumstances IEX was succeeded to attract about 1,4% of all volume of securities of the USA less than two years later after foundation of the company.

"At the moment people have a choice: they are not obliged to perform the operations through IEX, – Katsuyama claims. – Being the exchange, you are part of National market system (NMS). If you set the most beneficial prices, then orders will have to arrive to you. Thus, this choice passes into a certain obligation".

It is worth recognizing that this rule named with "the rule of protection of market orders" irritates many. Sometimes it is considered as a source of the current fragmentation of the market and lack of its transparency. Instead of selecting in what market it is better to trade, investors are forced to send the orders to the different small organizations, preferring as traders with fast computers and deep understanding of structure of the market. But rules are that that if you are the exchange and you expose the best price, then all have to direct the orders to you.

But there is a small problem because of one of the main features of IEX – a so-called "magic box" which reduces the transfer speed of orders to 350 microseconds [4]. The sense of the box containing in itself 38 miles of the fiber optic cable twisted in a bay consists in the following: high-frequency traders change the prices quicker, than investment companies; in the course of the change in price high-frequency traders have a benefit in speed, and they can conclude the bargain with slower players on the old, irrelevant price. It is considered that it is unfair, and IEX decided to put it an end and to please some investors [5].

All this, of course, is healthy, but when other exchanges are obliged to send warrants for the Exchange of investors, there is a little unusual situation.

Provide that you manage the exchange and you expose the quotation of bits of $10,00 / ask $10,02. Then provide that all other exchanges expose same bit and ask. Further, quotations begin the movement: those who exposed bit of $10,00 change the sentence for $9,99, and the players who exposed ask $10,02 change it for $10,01. Respectively, quotations of all other exchanges, except for IEX move: at least, during several hundred microseconds. On IEX the quotation of $10,00 / $10,02 is still exposed. Perhaps, it is still exposed because the bit on IEX and really still makes $10,00. Perhaps, the reason that the player changed the bit from $10,00 for $9,99, or even for $9,98, however this change still "to turn" around a box. You definitely do not know, but can assume that the bit of $10,00, most likely, will disappear through 350 microseconds.

And here to you the market request for sale comes. This order could be performed on bit of $9,99, however the best in the country beaten (National best bid) – the protected quotation – is the bit of $10,00 for IEX. Therefore even if it seems to you that the quotation exposed on IEX any more not is actual, anyway, you have to send the request for IEX [6]. After that it besides has to reel up many circles around a box because of which execution of this request is postponed and there is a risk that it will not be performed even on bit of $9,99 [7] at all.

Therefore quotations of IEX which are steadily exposed with a delay in 350 microseconds will be protected, also as well as quotations of other exchange platforms – their quotations are exposed with a variable delay. At all exchanges when processing orders there is some delay: nothing occurs instantly, and it is very difficult to perform synchronization quicker than one microsecond. If IEX makes certain operations quicker than other exchanges, then its quotations can be more actual. Thus, the intended delay of IEX can be less accidental delay, arising on other exchange platforms.

On the other hand, it is a little strange "to protect" quotations according to which it is impossible to trade instantly. If the delay of the order made not 350 microseconds, but 10 minutes, then in this situation it would be unfair to force investors to enter auction instead of agreeing to slightly less beneficial price, but to make the transaction right now. Also thought of this SEC. The rule of protection of market orders in regulation "National market system" is named (Regulation NMS) as a rule 611, obliging shopping centers "to stop dishonest trade according to the protected quotations". All its conditions are defined in the Rule 600. The sense is that the exchange cannot perform the request with the price below the best bit (or above the best ask) any exposed "automatic quotation" at other exchange. The quotation exposed at the exchange which "instantly and automatically" reacts to the arriving requests [8] is considered automatic. SEC during acceptance of regulation of NMS so spoke of this obligation:

The concept "instant" excludes development of the automatic systems and other technologies aimed at creation of a delay when drawing quotations.

After reading of this sentence you could think that IEX should have no protected quotations: the company just uses "the technologies aimed at creation of a delay when drawing the quotation". Of course, without context this sentence is senseless [9]. At other exchanges there are delays between acceptance and execution of requests too: laws of physics are that. These delays can be comparable with delays of IEX or is even longer than them, but they are unintentional. In this case SEC can have many reasons not to observe usual formalities: a delay not so big [10], investors seem happy, and SEC would be silly to refuse to the fighters for market justice trying to organize own exchange as exactly thanks to it the level of fair trade grows. The representative of IEX declared the following: "We are sure that all components of our model meet all normative requirements, and also a main objective of the Law on trade in securities – to formation of the effective, competitive, fair and natural market relations". All the same sounds somehow strange [11].

You can imagine the difficult and fragmented structure of the market: in spite of the fact that each of manifestations of complexity and fragmentation of the market can be justified by a number of reasonable and noble purposes, in total they do the market by more favorable place for the advanced high-frequency traders. The more knowledge you need to acquire, the you will be able to catch more benefits if you understand a subject quickly and thoughtfully. It is not necessary to take this generalized theory too seriously in everyone a separate case. Use effects of "a magic box" about which I told earlier, cause not so many problems and seem to all subject to deception and manipulations less. Sometimes your order will be performed a bit later or worse normal, because of "protection" of irrelevant quotations of IEX. However I hardly represent how the mean high-frequency trader can profit from this or do somebody harm [12]. Personally it is difficult to me to provide how to bypass this system. You smart, will think up. Perhaps, you will manage to think up as to bypass it [13].

Listings are one more curious reason of transformation of IEX into the exchange. In July of this year Brad Katsuyama in the letter addressed to the subscribers:

It is necessary to notice that IEX will begin to perform procedure of listing of securities not at once. Now we enter the standards according to the admission of securities which are already approved by the Commission [on securities and the exchanges] on other exchange platforms, into the primary documentation to start carrying out organizational and administrative actions and to give to the clients more opportunities when the exchange begins the work. We are glad to receipt of a large number of requests from the public companies interested in placement of the securities at our exchange. Because our attention is still more paid to creation of the market directed first of all to support of investors we are sure that we can also help issuers with improvement of their experience of interaction with the markets.

If you are the public company, then in order that your events were quoted at the exchange, you have to pay a certain amount of money for this privilege. The intercontinental exchange which owns the New York stock exchange last year earned 367 million dollars from payments for the admission on the Stock Exchange; Nasdaq OMX earned 238 million dollars. Exchange platforms quite actively fight for placement of someone else's stocks on them. Actually, it is not so important where shares of the company are quoted. Where you placed the shares, anyway, they will bargain also on other platforms. Of course, all exchanges have rules of opening and closing, a little different requirements to self-organization, different administrative functions, and also the unplanned failures in a network capable to prevent the company to come to IPO [14]. However the majority of the made decisions depends on perception and style of the exchange: striking examples – solidity of the New York stock exchange and high-tech character of the companies on Nasdaq.

What style of placement of securities at the Exchange of investors? Considering that on it it is impossible to expose the events so far, it is difficult to tell. But the fact that IEX "receives a large number of requests from the public companies", says that at the organization the positive brand forms (not without the aid of the book Flash Boys). It is possible to tell that feature of the exchange is assistance to investors. Many investors are disturbed by existence of manipulations in the market and threats from high-frequency traders. The admission of securities to trade at the Exchange of investors says to investors that they are not indifferent for the exchange.

Moreover, manipulations in the market and threats from high-frequency traders also concern both heads of the companies, and their concern much more seriously and causes more uncertainty. Heads of the public companies are, as a rule, far from discussions of structure of the market in comparison with managers of mutual funds. Their experience with the markets can be described not as "I lost 20 basis points during implementation of this operation", and it is rather as "That for the devil! For what reason my events unexpectedly dropped by 21% in only several minutes?" The structure of the market can bring the investment organizations into despondency, and can nonplus and intimidate heads of the companies. It is an excellent opportunity for development of the business if you know how it is possible to calm them.

Comments on perspectives to the new exchange IEX from the columnist of Bloomberg and the former investment banker Matt Levin are given below:

1. The official name of the organization specified in the request – Investors' Exchange LLC though Brad Katsuyama in the letter to the clients calls it Investors Exchange.

On page 164 of the book Flash Boys there is a footnote in which speaks as the company, the initial called Investors Exchange, came to the name IEX:

Despite desire to save the complete name, they found a small problem when were going to register Internet address of In order to avoid an awkward situation, they decided to take other name.

I do not know whether it managed to them to get rid of this awkwardness, but, anyway, the organization will be called Investors Exchange or Investors' Exchange.

2. Unpleasantly the fact that if IEX becomes the exchange, "the payment levied by it from participants of the market for providing summarized data on trade on all exchange platforms will be reduced". It is money too, and they, in fact, are levied for anything: IEX, as we know, criticized use of these summarized data.

3. IEX is a dark-pool, and yes, this concept guards a little.

4. Not all characteristics of a dark-pool of IEX will remain in Investors Exchange – in particular, Investors Exchange will lose "The broker's priority" – however the exchange will continue to use "a magic box". In the request it is told that "access to system is provided through the points of presence of the IEX exchange intended for creation of a delay in 350 microseconds when participants request access from points of presence of IEX to system".

5. The train of thought of Michael Lewis is stated in this fragment from its book Flash Boys:

Generally speaking, was considered that there are three types of activity which lead to large volume of too unfair trade. They called the first the electronic advancing transactions: traders saw that the investor tries to make something in one place, and were ahead of him in another (it happened when Katsuyama traded in RBC). They called the second type "ribeyt-arbitration". It was performed with use of legal "rollbacks", or ribeyt as they were called in the industry. The exchanges offered the clients ribeyta, however in practice these ribeyta did not add any liquidity. And, apparently, the most widespread type of activity they called the third "arbitration in the sluggish market". It arose in a situation when the high-frequency trader had an opportunity to learn about the change in price at one exchange and "broke" auction at other exchanges before these exchanges managed to react to it. It occurred round the clock day by day, and, most likely, this type of activity in a year made much more profit, than all other types combined.

Each of three aggressive strategy depended on speed. And the very first, crude idea to resist to them arose at Katsuyama: all tried to approach the exchanges as it is possible closer – so why not to try to distance "aggressors" from the exchange as it is possible further, to alienate itself from the others and not to allow them to come nearer? The idea was in placing engines of the exchange which compare warrants for purchase with warrants for sale, for considerable distance from those places in which traders were connected to the exchanges (which are called presence points), and then to demand from everyone who wanted to trade at the exchange, to be connected to it from a certain point of presence. If you place each participant of the market rather far from the exchange, then can level everything or, at least, the majority of benefits which speed can give.

It turned out that, having located participants of the market "it is rather far", it was possible to cause a delay in 350 microseconds if to locate a presence point at distance of 38 miles from the engine consolidating together warrants for purchase and sale. And 38 miles of a fiber optic cable can be placed in a small box.

6. It is obvious that nobody will be able to consider all parts: all this probabilistic characteristics which the algorithm can or consider or are not present.

7. For example, if the trader on IEX actually cancelled the bit of $10,00 and left the most profitable bit of $9,98 on IEX, then after passing of your request through "a magic box", the bit, best in the country, will return on the first exchange; therefore the request returns to the first exchange, and in the same time the quotation starts over again the movement so everywhere $9,98, etc. will be the best bit. The example is a little exaggerated, but an essence that players of the market complain of these delays to several share of millisecond.

8. In addition, look at determination of "the automatic quotation" in the Rule 600(b)(3). Sometimes under the word "exchange" I mean something bigger, but only when the sense of the statement does not change.

9. If this word seemingly not strongly distorts sense, then with the word there can "instantly" be some difficulties. What do I mean under the word "instantly"? If something occurs during 350 microseconds, then any sane person with confidence will tell you that it occurs instantly.

10. Compare the Rule 611(b)(8) which, in fact, justifies the exchanges for the fact that business on them is done despite presence of more beneficial price on other trading floor. It is possible provided that more beneficial price arose somewhere in the last second. The essence is that the exchange to be hard: you cannot learn what happens on other exchange platforms one second later after an event. But one second lasts by 2 857 times longer than 350 microseconds! If SEC wants that the exchanges could communicate with each other within one second, then it, for certain, will not be against if the exchanges are able to communicate with each other for 350 microseconds.

11. And if SEC really allows IEX to combine intended delays with the protected quotations whether it should not arrive in the same way and with other exchanges which will demand it?

12. The delay of the high-frequency trader who placed the warrant for IEX will be same, as well as yours so it will not be able to overtake you in any way. I believe that if this trader knows that you trade on IEX with a delay and that your order will be performed not at once, then, perhaps, it has a chance to overtake you on the way back to other exchange. However such option seems not optimum.

13. You can also tell SEC about how to bypass system – is sure that after application of IEX a number of loud statements will follow – but then you will not need to think out any more as to bypass it.

14. I remembered a curious story about technical failure of Nasdaq at an output of Facebook to IPO. But a story about an unsuccessful output on IPO of the BATS company is even more interesting. Since then BATS any more did not include in the register of any public company (including itself) though on it exchange investment funds are quoted.

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