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:
- Despite all the histrionics, the numbers suggest that the vast majority of investors—certainly ETF investors—really shouldn’t care. IEX’s own marketing information explains that the only investors who really need to worry about “predatory” investors are large institutions, not smaller investors. If you’re not working an enormous order, it’s just not going to affect you very much. The vast majority of noninstitutional trades never even enter the market anyway. If you place your 1,000-share market order with Schwab, overwhelmingly you’re likely to be crossed internally at UBS, Schwab’s main counterparty. Your execution will be right in line with the national best bid and offer (NBBO) system at the moment, but you’re just not going to hit the HFT pool.
- People don’t want a “clean” price, they want the best price. One of the great criticisms of flash trading is that it sneaks inside the NBBO system; that is, that HFT traders can trade inside the NBBO, snatching up a juicy price on a “sell” order in the system before it matches to a natural trader who might want the same lot of shares. IEX will also talk to NBBO, in addition to trying to match order flow internally, but by definition, the best price you’ll ever get off the system is NBBO, since the whole IEX system is being designed to support and improve the “bestness” of NBBO. And since the order flow coming through IEX will be “slow,” it won’t participate in any price improvement—however slight—that an HFT counterparty might bring to their individual trade.
- It’s all about liquidity, especially for ETF investors. Currently, IEX is processing around 20 million shares a day. That’s out of 2 billion to 3 billion shares that change hands across all of the other various trading venues. ETFs work because authorized participants can execute seamless arbitrage between big baskets of stocks and big chunks of ETFs with absolute certainty. When APs hit the “Arb” button on their desk, those orders are almost always going to hit the markets with the most liquidity for execution. And evidence suggests that system is working fantastically well. That’s why a fund like the iShares Russell 2000 (IWM | A-84) can hold a squirrely basket of 2,014 stocks and still trade less than a basis point wide, smack on fair value, all day, every day. How exactly are you supposed to do better than that?
- Any investor (as opposed to trader) should already be using limit orders. That means you’ve set in your mind that you want to buy IWM, but only when its price crosses under, say $114. With very, very few exceptions, when the price trades under $114, you’ll get a fill, for $114. Whether that fill comes from a bevy of HFT shops selling you shares, or from a grandmother in Iowa, does nothing to change your investor experience.
Go forth and do good, IEX. I’m just not sure you’ll be seeing my little orders anytime soon.
At the time this article was written, the author held no position in the security mentioned. Contact Dave Nadig at [email protected].