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June 13, 2016

The SEC at a Technological Crossroads

By Lev Bagramian,  Better Markets Senior Securities Policy Advisor

The Securities and Exchange Commission (SEC) is on the verge of making a pivotal decision that could mark the beginning of a new era in which private sector solutions help close serious regulatory gaps in our equity trading markets.  Or, it could signal more of the same chronic SEC inertia, paralysis and inaction that has allowed those markets to deteriorate so badly in the first place.

Our markets today are fragmented, opaque, and dominated by high frequency trading (HFT) firms that use speed, preferential data access and advanced technologies to gain unfair advantages and reap enormous profits.  Not all of it, but too much of this is predatory and systemically destabilizing.  Traditional retail and institutional investors pay the price for this broken system.      

Investors Exchange, LLC (IEX) is trying to solve these problems by offering a trading venue that is simpler and fairer to all market participants.  It has applied to the SEC to become a new securities exchange in the national market system, like the New York Stock Exchange or NASDAQ.  The application has received enthusiastic support from many market participants, including institutional investors, market experts, reform advocates, academics and even too-big-to-fail dealer banks like Goldman Sachs and JP Morgan Chase.  But a small, well-funded group of very powerful incumbent HFT firms and several established exchanges strongly oppose it, seeking to protect business lines and profits.

The IEX platform promises to be good for investors and good for the markets.  It will create a trading environment that discourages and disrupts predatory HFT practices and better serves the needs of investors interested in the long term fundamentals of equity trading—which is key to capital formation.  The SEC is required to act on IEX’s application by June 18, 2016, and it should approve the application without any further delay or postponements.

The principal innovation in the IEX platform, and the one that has drawn so much attention in the world of market structure reform, is their proposed “speed bump,” a technology feature that subjects all traders to the same data access speed limit.  This, coupled with IEX’s smart routing technology, will help address one of the most serious challenges confronting our securities markets today: the unfairness that arises when exchanges sell preferential access to trading data and order routing.

Today, high frequency traders use technology to interfere with buy and sell orders.  When they learn, through their high-speed data ports or due to their physical proximity to the exchange’s servers, of a partially-filled trade of a security, they can cancel or modify the price of their existing bid or offers of the same security.  They do this before a customer’s order has had a chance to be fully filled, a manipulative technique called “scalping” or “electronic front-running.”  This speed advantage and ability to get ahead of a trade is enough to virtually guarantee huge trading profits over time, and it comes at the expense of traditional retail and institutional investors.  Rules under SEC’s Regulation NMS (a package of recent rules on national securities markets) contemplate that when the interests of long-term investors conflict with those of short-term trading interests, it is the interests of long-term investors that must be prioritized.  The speed bump and the smart router promise to level the playing field.  IEX won’t allow traders to circumvent it because it won’t sell preferential data access to anyone and its smart router is designed to disrupt and counter HFT traders’ electronic front-running.

The IEX platform incorporates other less talked-about features that will help create a much-improved trading environment.  Many exchanges today attract profitable trading volume by offering incentives to traders, known as rebates or maker-taker fees.  This creates conflicts of interest that can induce brokers, for example, to select trading venues based on who pays the best rebate, not on who offers the best execution for the client.  IEX won’t offer any rebates.  This will not only help eliminate conflicts of interest, it will also discourage predatory HFT trading on IEX, since those traders are often drawn to venues that pay rebates.

Yet another problem on many exchanges today is the complex and confusing proliferation of order types and the fee structures that go with them.  For example, according to a recent study, the four major exchanges (NYSE, NASDAQ, BATS and Chicago Exchange) have over 830 pricing levels for participants to choose from (or be confused by).  These practices ultimately undermine the best interests of investors.  Investors are ill-served by brokers who do not have a clear understanding of the true cost of trading.  The constant fee adjustments also increase the probability of errors and systemic breakdowns. 

And this complexity even hampers the ability of brokers to comply with the “best execution” requirement, as the complex array of order types and prices make it more difficult for brokers to identify the best venue for their clients’ trades.  IEX, in contrast, will only offer five order types, along with a flat fee structure.  This will help make the marketplace simpler and more transparent.  And like the elimination of rebates, it may discourage the participation of HFT firms, which are also drawn to exchanges with complex order options.  Rounding out some of the IEX innovations, their platform will be subject to a strong anti-manipulation rule and other measures designed to make trading more fair and transparent. 

Allowing this innovative new approach to take hold in the marketplace is especially important because the SEC has failed repeatedly to tackle market structure problems directly.  For example, confronted with obvious flaws in the structure and operation of our markets, one of the SEC’s primary responses was to form an advisory committee stacked with incumbent industry executives and advocates seeking to preserve the status quo, the Equity Market Structure Advisory Committee (EMSAC).  In April, the Committee met to discuss a possible pilot program that would merely experiment with the elimination of maker-taker rebates.  Unfortunately, industry representatives on the EMSAC, including current exchange executives, defended the rebate system so vigorously that a stalemate resulted.  Paralysis was the predictable (and industry created) outcome and no actual proposal for a pilot program emerged. 

Ultimately, the innovations IEX is proposing remain to be tested, and their beneficial impact on investors is yet to be assessed.  It should be approved and then very closely monitored. 

Going forward, IEX must maintain its investor-friendly features.  And it should build on them with additional protections that help ensure the integrity of their marketplace.  For example, they should establish a “three strikes” policy of permanently barring market participants who have been found in violation of securities laws three times.  And they should, when listing initial public offerings (IPOs), impose heightened corporate governance and investor-friendly listing standards on the new companies. 

But it is now the SEC that must summon the political will to resist the industry opposition to the IEX application, and give it a chance.  The SEC is at a crossroad: it will either promote the public interest by allowing a private-sector generated innovation and beneficial new trading model to enter the marketplace, or they will again capitulate and subordinate the public interest to a powerful industry.  It is past time for the SEC to act and do the right thing.



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