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Great 'Flash Boys' Idea Doesn't Matter | ETF.com

Great 'Flash Boys' Idea Doesn't Matter

April 23, 2014

The white-knight trading platform of ‘Flash Boys’ is novel but unnecessary for most investors.

In the wake of Michael Lewis’ “Flash Boys,” there’s been a lot of attention paid to IEX, an alternative trading system launched in 2013. Lewis heralds IEX as a kind of white knight in the war against predatory traders.

But what exactly is a predatory trader? And more importantly, why should you care?

Imagine Bob wants to buy 1 million shares of XYZ. That’s a big enough order that it will take time. Bob’s not putting in a limit order and hoping for a fill. He’s going to “work” that trade to get the best possible price on average for each smaller chunk that gets executed.

The predatory part comes in when Bob cuts the first 10,000 shares into the market. In this case, one of the “predatory” high-frequency traders (HFT) somehow algorithmically decides there’s a lot more coming, and manages to execute piles of trades to buy up shares right now, thinking they can unload them to the next lot Bob puts in.

In the most nefarious theoretical example, the HFT trader can step in between the orders, “seeing” Bob’s 10,000 chunk as a live order while simultaneously “seeing” available shares. They get to eke out a profit by buying low and selling high.

IEX solves this problem in a few ways.

First, they only let brokers become subscribers, not just anyone with a shingle.

Second, they lag all information by 1/3,000th of a second, theoretically giving trades time to percolate and match up against “natural” order flow.

Third, they don’t let anyone co-locate, which means nobody gets a time advantage even after the 1/3,000th of a second lag.

Lastly, they don’t have the “rebate” system, which gives some investors cold hard cash simply for participating in the system as liquidity providers—a source of additional income for many HFT shops.

So let’s be clear: These steps will work. It’s a near certainty that “predatory” HFT shops don’t have their algorithms focused on IEX at all. Mission accomplished. I applaud clever financial engineering in the cause of fairer markets, and I wish them nothing but success.

Unfortunately, I’m not convinced this is really changing the nature of investing for anyone.

Why? A few reasons:

 

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