The Securities and Exchange Commission has decided to delay, for a second time, ruling on the application by IEX to register as a national securities exchange. This time it did so without seeking permission from the applicant, on the grounds that a decision requires clarification of its own order protection rule. Accordingly, the SEC has posted a notice of proposed interpretation and invited comment letters.
Specifically, the SEC is asking the public whether they should adopt a new standard for the term de minimis as it relates to response times of an exchange. This new standard would allow “the quotations of trading centers with very small response time delays, such as those proposed by IEX, to be treated as automated quotations,” thus paving the way for granting IEX the exchange status it seeks.
The need for a new interpretation of de minimis as it relates to automated quotations arises because the IEX design involves a “speed bump” measured at 350 microseconds (millionths of a second). This prevents traders from reacting to an order that is still in flight, having been partially filled but not fully processed. It therefore moves us closer to a true national market system, where orders are processed in the sequence in which they make first contact with market.
But does the SEC’s decision on this case really matter, except to those whose interests are directly at stake? I believe it does, because the rules governing transactions in asset markets affect the relative profitability of different trading strategies, and this in turn has consequences for share price accuracy and volatility, the allocation of capital across competing uses, the costs of financial intermediation, and the returns to ordinary investors.
There is a diverse set of participants in the secondary market for stocks, with significant differences in goals, investment horizons, and trading strategies. It is useful to group these into three broad categories: (a) long-term investors, who save during peak earning years and liquidate assets to finance consumption during retirement (b) information traders, who seek to profit from deviations between prices and their private estimates of fundamental values, and (c) high-frequency traders, who combine a market-making function with arbitrage and short-term speculation based on rapid responses to incoming market data.
There is clearly a lot of overlap between these categories. For instance, actively managed mutual funds and some hedge funds belong to the second category but often manage money for long-term investors, pension funds, or university endowments.
The traditional market making function involves the placement of passive orders that provide liquidity to the rest of the market. Such passive order placement is subject to adverse selection: if a posted offer to buy or sell is met by an information trader the market maker will suffer losses on average. In order for a market making strategy to be profitable, these losses have to be matched by gains elsewhere. Where do these gains come from?
In standard models of market-making, the bid-ask spread is determined by a balance between losses from transactions with information traders and gains from transactions against those with price-insensitive demands. But this is not the balance that exists in markets today. Instead, high-frequency traders combine passive liquidity provision with aggressive liquidity-taking strategies based on the near instantaneous receipt, processing, and reaction to market data. The posting of bids and offers is motivated less by profiting from the spread than by fishing for information, which can then be used to take and quickly reverse directional positions. The relative weights on passive liquidity provision and aggressive short-term speculation varies considerably across firms, but there is evidence that the most aggressive and profitable among these are able to effectively forecast price movements over very short horizons.
A transition to a truly national market system will affect the competitive balance between information traders and high-frequency traders. It is in the interests of the former to prevent information leakage so that they can build large positions with limited immediate price impact. It is in the interest of the latter to extract this information from market data and trade on it before it has been fully incorporated into prices. Other things equal, the ability to extract information from a partially filled order and trade ahead of it at other exchanges benefits high-frequency traders at the expense of information traders. A truly national market system would mitigate this advantage.
This means, of course, that high-frequency traders would be more vulnerable to adverse selection and would place a lower volume of passive orders to begin with. But the orders would be genuinely available, and not subject to widespread cancellation or poaching if one of them were to trade. Visible bid-ask spreads may widen but there would be no illusion of liquidity.
The shift in competitive balance between these trading strategies would have broader economic implications. The returns to investment in fundamental information would rise relative to the returns to investment in speed, which should result in greater share price accuracy. Furthermore, there is a real possibility that the aggregate costs of financial intermediation would decline, as expenditures on co-location, rapid data processing and transmission, equipment, energy, and programming talent are scaled back. This would be a desirable outcome from the perspective of long-term investors. As noted by Jack Bogle, the founder and retired CEO of Vanguard:
It is the iron law of the markets, the undefiable rules of arithmetic: Gross return in the market, less the costs of financial intermediation, equals the net return actually delivered to market participants.
Finally, extreme volatility events should arise less often. Algorithms making short-term price forecasts may predict well on average but they will sometimes mistake a random fluctuation for a large order imbalance. Such false positives can give rise to a hot potato effect, of the kind that is believed to have been in play during the flash crash. Of course, such events can occur even in the absence of market fragmentation, and cannot be prevented entirely, but a transition to a true national market system should reduce their amplitude and frequency.
For these reasons and more, approval of the IEX application would be a modest but meaningful step in the right direction.
Dr. Rajiv Sethi is Professor of Economics for Barnard College, Columbia University.
