While everyone is talking about high frequency trading and whether the stock market is rigged, Traders had it first. Michael Lewis, author of the forthcoming Flash Boys, tells 60 Minutes that he found Brad Katsuyama, a former HFT at the Royal Bank of Canada, who discovered the effects of high-speed trading. Last fall, Traders profiled Katsuyama and his crew at IEX.
Long frustrated by the sellside and its order-handling practices, the buyside is set to open up its own alternative trading system-and asking brokers to do business there.
The buyside is not going to take it. Anymore.
But is the already crowded and highly fragmented U.S. equity trading market, replete with 13 exchanges and 40 other trading venues, ready for another marketplace? The braintrust behind IEX, chief executive Brad Katsuyama, chief strategy officer Ronan Ryan, chief technology officer Robert Park and chief operating officer John Schwall all think so.
Ryan and Katsuyama said IEX will address institutional traders’ biggest concern regarding trading in broker-dealer operated dark pools: the inherent conflict of interest in order routing. The buyside has long argued that dark pool operators often route their orders to their own pools or desk first for execution, rather than send the orders to other pools. Brokers, the buyside says, are incentivized to complete orders in-house, as they can collect both sides of the commission. Also, there is concern the sellside is taking undue advantage of exchange rebates, choosing to post orders rather than trade against quotes immediately and pay a fee.
Also, institutional investors have publicly and privately lamented that extant venues, mostly public but in some cases private, are highly populated by high-frequency traders that only want to game their orders. These speedy traders are not concerned with providing liquidity or helping facilitate the block trades the buyside wants, rather they want to make money flipping small amounts of stocks. And they get paid mostly by rebates from the exchanges for providing liquidity.
IEX looks to end these issues, the execs said, by giving the buyside ownership of the venue and utilizing some features they want -no rebates for order flow, offering a limited number of order types and not colocating client servers with its own matching engine. And IEX will do this soon, Ronan Ryan, chief strategy officer at IEX Group told Traders.
IEX will start off as a dark pool in its initial two months, and will then file to operate as an ECN, displaying its best-priced quotations on the National Stock Exchange. IEX plans to become an exchange in the future. While operating as dark pool, IEX will be a fair-access, broker-neutral venue. All registered broker-dealers are welcome to become subscribers, Ryan said.
The concept of a buyside-only trading venue is not new-Liquidnet has run an institutional equities trading network for years. But the idea of the buyside actually owning a venue is. Liquidnet is privately owned. IEX did not disclose a full list of investors or member firms, but it did confirm that Capital Group Co., which runs American Funds (with $1.2 trillion in assets under management), and Brandes Investment Partners (with $25 billion in assets under management) are among its backers, as is Netscape founder Jim Clark.
And unlike Liquidnet, IEX doesn’t tout itself as a block trading venue. However, Katsuyama and Ryan expect an average execution size “greater than the industry average.”
The sellside is IEX’s customer. Ryan told Traders Magazine most of the bulge firms are already signed on to send orders to IEX and discussions with other brokers are ongoing. All orders sent to IEX must come from a broker-dealer, else it risks losing a buyside client’s order flow. There is no minimum order size required to trade at IEX, and it offers clients the ability to set minimum quantity parameters on their orders.
“Through the algo integration, the brokers will rest portions of the order with IEX,” Ryan said. “The broker can also access IEX liquidity when active.”
The Long Road
IEX Group was founded in March 2012. It has raised $26 million in three separate phases-$1.5mm in June 2012, $9.4mm in December 2012, and $15mm in May 2013, according to IEX officials. The proceeds came from the issuance of convertible preferred stock. The fundraising is now complete, and the firm is ready to open its order book. IEX is not yet registered with the Securities and Exchange Commission as an ATS, but is in the process of doing so.
IEX’s new headquarters is 7 World Trade Center in New York City. Its execs all have a deep understanding of the trading world from their days at RBC Capital Markets, where Katsuyama was global head of electronic sales and trading; Ryan, global head of electronic trading strategy; Park, head of global algorithmic trading; and Schwall, global head of product management.
The firm has 30 employees, 20 of whom are technologists with backgrounds ranging from technology firms to the sellside, exchanges and even high-frequency trading firms. Ryan describes himself as a technology infrastructure network engineer at heart. As the firm grows, his goal is to recruit more market-structure-oriented people, generate more ideas on how to trade in the current market environment and develop their ideas into trading methodologies.
Armed with a trading pedigree and deep knowledge of the markets, Katsuyama, a lifelong trader, knows what the buyside wants. It wants fast, anonymous execution, preferably in block size. Institutions do not want to be gamed by high-frequency traders and their technology, he added, so he is employing his own technoplogy to combat predatory strategies.
“We’re not anti-HFT. We focus on being pro-investor and pro-technology,” Katsuyama said. “Our view is to embrace technology to help our clients avoid predatory trading practices. That’s a viable trading solution everyone wants.”
To that end, Katsuyama and Ryan have been meeting with HFT firms and listening to their ideas as well.
“There’s always talk that HFTs are gaming the system and how there is a need to filter them out,” Katsuyama said. “But there are HFT strategies out there that are of benefit to the market. Some HFT firms have embraced us, while others have not.”
Selling the Sellside
And the sellside has been receptive to IEX’s philosophy, Ryan and Katsuyama said. Both execs have been meeting with and signing up firms to receive order flow when the wholly electronic continuous venue opens. They have been active in explaining to the sellside that IEX’s goal is empower the sellside, not disenfranchise it. The buyside, Ryan added, can only rest an order through the sellside.
“The more orders brokers send here, the better the chance they’ll get executed,” Katsuyama said. “We’re not like some venues where they take orders away from the full-service broker.”
Buyside firms must access IEX through their broker-dealers similar to the way they access exchanges today. If a buyside firm wishes to direct orders to IEX, it will have to work with its brokers to customize their algorithms and smart order routers to do so. Brokers, if they want order flow, will have to connect to IEX. Only orders from broker subscribers will be executed. Ryan said it is the buyside’s prerogative to direct flow to a particular venue, or request customization from brokers for order handling to use or avoid particular venues.
The buyside, Ryan said, is not telling brokers not to go to their own dark pools, but rather instructing them to rest a portion of an order in IEX, as well as in their dark pool. The brokers, he added, have been very cooperative in supporting their clients’ wishes in this regard.
“We are doing back-end algo integration with the brokers so that they are configured to interact with IEX both when passive and active,” he said.
All orders on IEX are firm, with no negotiation, and are not required to sit there for any minimum time period. Any trades that occur are printed to the trade reporting facility.
And that appeals to the sellside-staying in the order taking and execution business. So far, 50 brokers are in the process of subscribing to IEX, including Sanford C. Bernstein in New York. Jason Griffith, Sanford’s global head of trading, and Dave Liles, global head of electronic trading at the firm, said they’ve been involved with Katsuyama since his RBC tenure and have been active supporters of the IEX proposition since its inception.
“IEX’s philosophy works perfectly with our venue-agnostic order-routing strategy, not to mention a firm like ours that doesn’t have a dark pool,” Liles said. “Our mission isn’t to be a market center or liquidity aggregator-just to get best execution for our clients. The proposition of having a clean source of liquidity to tap got us, and our clients, excited. IEX fits perfectly into Bernstein’s liquidity aggregation strategy.”
Griffith added that upon hearing about IEX, Bernstein’s customers contacted the broker about using them. “Our buyside clients proactively reached out to us to hook up to IEX. Once we started getting the inbound calls saying they would be interested in IEX’s offering, that got everyone excited.”
Griffith added that Bernstein’s customers like the concept of a venue that provides additional natural liquidity and liked IEX team’s track record of work in market structure.
“We like Mr. Katsuyama’s story and what IEX is doing and why,” he said. “It fits in our agnostic order routing strategy to get our clients the best possible liquidity and price.”
IEX follows a price-priority model first, then by displayed order second. Then comes broker priority, which means a broker will always trade with itself first, which Katsuyama described as “free internalization.” He explained that brokers do not pay IEX to trade should an order be matched against another order from that same broker. This, he added, offers brokers incentive to trade in IEX.
IEX will charge 9 mils a share for every share that is traded on the platform, less than most other venues that trade upward of 30 mils. This is designed specifically to discourage those firms that trade simply for the rebate from trading on IEX.
Ryan said IEX will monitor activity on the ATS for compliance with its system guidelines, applicable industry rules, securities laws and subscriber behavior.
“We are not applying any type of subjective monitoring that we have seen on some venues,” he said. “We feel that this is better solved through objective and transparent measures such as our pricing, our order types and our architecture, which were designed to deter predatory behaviors in the market.”
Courting the Buyside
Another feature designed to help the buyside is that IEX won’t offer co-location with its matching engine server, in Weehawken, N.J. Brokers’ servers will be located in nearby Secaucus, N.J., roughly three miles or 350 microseconds away, introducing a buffer between when an order is sent to IEX and when IEX processes it. Clients that happen to have their servers at the facility will not be allowed to cross-connect.
This is in contrast to many venues and exchanges that allow clients to co-locate their servers alongside the venue’s to reduce latency and help buyers and sellers get the absolute fastest execution.
Ryan explained that IEX’s belief is that the ability to physically co-locate your strategy next to a trading venue, whether lit or dark, offers that party a distinct advantage over other participants in the industry.
“A competitive market will naturally attract participants with diverse objectives, so our goal at IEX is to provide relative fairness for the greatest number of participants,” he said. “By architecting a physical separation of 350 microseconds between our subscriber access point and our matching engine (where the trade occurs), IEX can operate as a continuous market while providing all of our subscribers with equal utility, as opposed to providing a small subset of members with a unique advantage.”
Aside from the fairness the 350-microsecond delay creates, IEX also looks to simplify trading for both the buyside and sellside. It will offer only a handful of order types that will universally appeal to all, according to Donald Bollerman, IEX’s head of market operations and former managing director at Nasdaq OMX.
“Our approach at IEX is to offer a simple yet concise set of order types that have clear utility to the broadest set of market participants,” Bollerman said. “We keep complexity down by focusing on bringing together buyers and sellers, rather than managing economics, aiding information discovery or relief of processing burden for those who care about ultra-low-latency. At this point in time, you can count the number of order types we have on one hand.”
Both the timing buffer and fewer order types appeal to the buyside. Institutions have long said HFTs and other firms with deep pockets have an unfair speed advantage thanks to their ability to afford co-location and super-fast computers. Fewer and simpler order types, they’ve told Traders Magazine, can only increase institutions’ efficiency and speed up the order selection process. All in all, IEX meets their needs.
Dan Royal, co-head of global trading at Denver-based Janus Capital Group, which manages $160 billion in equities, has known about IEX since its inception two years ago. He told Traders Magazine that Janus has been in discussions with IEX about its trading needs and concerns, as well as what the ATS wanted to do and how it planned on doing it. Upon seeing the end result, Royal is impressed.
“These guys are on to something,” he said, referring to the IEX team. “They have thoroughly dissected market structure, provided a solid educational effort and established a fair amount of credibility among the buyside. They recognize there’s an opportunity here.”
And Royal is a fan of IEX and its business/trading model. He said the existing ownership structure of many ATSs and exchanges introduces the potential for economic conflict in a broker’s routing practices. IEX, he said, helps eliminates much of this conflict and has credibility as a new and unique trading venue-one he would strongly support as a destination for his broker’s routing tables.
“People, including us, recognize this is different from other exchanges or markets and helps to level the playing field among market participants,” Royal said. “I’m supportive of them.”
