A Nasdaq speed upgrade is threatening IEX


The time it takes for trades executed at US exchanges such as IEX to be published on Nasdaq’s consolidated feed of stock prices will shrink drastically following an overhaul that takes effect on Monday – to less than 20 microseconds, down from 480 now.

As a result, a high-speed trading firm could learn of trades done on IEX and quickly act on that knowledge at other exchanges where prices are just millionths of a second out of date, market experts say. That sort of front-running is exactly what IEX was set up to prevent.

“The fact that this shortcut is out there does negate to a certain extent IEX’s whole model,” said Richard Johnson, vice president for market structure and technology at Greenwich Associates.

IEX – whose founders, including chief executive Brad Katsuyama, gained fame as the protagonists of Michael Lewis’s book Flash Boys – set itself up as a place where investors could buy without disclosing their intentions to high-frequency traders who might use that information against them. It did so by setting up 350-microsecond delays on information coming in and out of IEX. The idea was that by the time a fast trader learned of a transaction executed on IEX, it would be too late to act on it.

But there is another pipe of information out of IEX. Regulations require the exchange and its peers to report trades to “securities information processors” run by the Nasdaq and New York Stock Exchange without delay. The SIPs consolidate quote and trade data for stocks listed on those two exchanges.

That source of information wasn’t a problem for IEX when trades took 480 microseconds to be posted by the SIP. But it could be once Nasdaq’s upgraded, faster SIP goes live Monday at 4am. EDT.

IEX says Nasdaq’s faster speeds have been running in test mode for more than a month and haven’t affected its usefulness.

Investors’ orders “will continue to benefit from our outbound speed bump,” said Eric Stockland, IEX’s chief strategy officer. The change at Nasdaq’s SIP “does nothing to change this.”

IEX said it has studied the implications of the SIP upgrade and concluded that it is highly unlikely for any high-speed strategies to emerge that would exploit information going out on the public feed before emerging from the outgoing speed bump.

IEX points to its method for handling “routable” orders to explain why the SIP shortcut doesn’t enable predatory strategies. A routable order is one that can be broken up and sent to multiple exchanges.

IEX sends such broken-up orders to other exchanges without waiting for the speed bump. Only the portion of the trade sent to IEX is subject to a delay. So by the time part of such an order is executed on IEX, the other parts would have been executed on the other exchanges and there would nothing left for a predatory trader to front-run, according to IEX.

Ironically, the threat to IEX stems from efforts to correct a speed deficit at the SIPs that many complained had tilted the markets in favour of high-speed traders. Critics accused the exchanges of neglecting the public-facing SIPs while setting up faster, private access for traders who can afford to pay higher fees.

The different speeds at which trade data are published gave high-frequency traders an opening to exploit fleeting price differences in shares of the same company across different markets, critics say.

“Investors will benefit from lower latency in a highly valuable, inexpensive public feed,” Jeff Davis, Nasdaq’s deputy general counsel, said of the upgrade. Latency refers to delays in a computer network.

The upgrade to the data feed “is making the market a little bit more fair,” said Patrick Flannery, chief executive of MayStreet, a financial markets software firm.

Speed-driven trading strategies are an unexpected consequence of the way stock trading has evolved in the US. Regardless of where they are listed, shares can be traded on any number of exchanges, with price and transaction data shared among all of them. Trades are supposed to be executed at whichever exchange offers the best price. That means big orders can be broken up among many exchanges. And since those exchanges aren’t all in the same place, there are time lags in how quickly updated information arrives at each.

Specialists in electronic trading say the heyday for capturing tiny profits at the expense of slower investors was six or seven years ago. Back then, banks and brokers sometimes relied on the SIPs to stay abreast of the market. Today, Wall Street has gotten savvier about the need to get market data from direct feeds and to locate their trading systems’ servers as close as possible to the exchanges’ data centres.

While most market participants have reacted by trying to become faster, IEX decided to slow things down. A speed bump on incoming orders gives the exchange time to scour the prices quoted on other platforms to ensure it is executing at the best price. The second, outgoing bump imposes a delay before market participants learn about the trade from IEX.

The new, faster SIP could offer a way around that second bump.

“Very rarely has data been available through the SIP faster than it has these proprietary feeds,” MayStreet’s Flannery said. “There is definitely some possibility that it will be gamed.”

IEX has raised at least $ 75 million from investors including Bain Capital Ventures, MassMutual Ventures, Sapphire Ventures, Spark Capital and TDF Ventures.

Write to Alexander Osipovich at alexander.osipovich@dowjones.com

This article was published by The Wall Street Journal

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