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IEX revolution will restore trust in Wall Street

A quiet cultural revolution has been set in motion on Wall Street. Not by Elizabeth Warren or Google, but by innovators determined to restore trust from within a system widely regarded as broken. First among these is Brad Katsuyama, the central figure in Michael Lewis's best-selling book "Flash Boys." Katsuyama's IEX awaits government approval of a new stock exchange that is set to upend a market that has become unmoored from its social purpose.

Once earning transparent commissions, stock exchanges now largely make their fees catering to high frequency traders (HFT). HFT firms buy special privileges from the exchanges, and some use these in dubious ways. For example, by combining superior trading with information on the trading intentions of less sophisticated investors like pension funds, some HFT firms profit by trading ahead of these investors. Such profits are a mechanistic exploitation of flaws in the system – flaws that appear to be both a regulatory accident and the product of an industry that has neglected client trust as an inviolable precept.

That financial firms have neglected the interests of their clients and society is not surprising to our generation – it is among the obvious takeaways of the financial crisis. Repeated scandals and fines following the crisis – from Libor rigging, to foreign-currency manipulation – have reinforced an already high level of distrust in financial markets.

Brad Katsuyama, president and CEO of IEX Group Inc.
Adam Jeffery | CNBC
Brad Katsuyama, president and CEO of IEX Group Inc.

In the wake of the crisis, political leaders sought to restore trust and resilience in finance through the Dodd-Frank Act. The extraordinary degree to which the act and its regulations have reworked the financial system can be seen in its 22,000+ page count – as long as 34 copies of Melville's Moby Dick.

Notwithstanding many good things the act accomplished, many have come to believe it did not fix the problem. Hillary Clinton, who last month proposed an expansive new financial regulatory agenda, has embraced the view that additional government intervention is central to addressing our lingering doubts about the financial industry. Her plan is premised on the belief that "there is still more to do" and is broadly consistent with the passionate rhetoric of Elizabeth Warren, an architect of aspects of the Act.

Our firm has spent the last six years responding to Dodd-Frank's derivatives market regulations and it is our firm conclusion that the core problem in finance cannot be regulated away. To be sure, new regulatory guiderails are an essential response to the crisis. But there are limits to the power of government action in fixing the system's most fundamental problem – the erosion of trust.

The Bank of England's Mark Carney has cogently articulated what he calls "the most fatal blow to public trust" – "the perception of a heads-I-win-tails-you-lose finance." He observes that "trust between the public and the financial system is needed to maintain the social license for finance to operate." Carney's effort to bring finance and various societal actors – policy makers, academics, religious leaders – together as part of an open forum is an admirable step in speaking to this larger issue plaguing finance.

But Carney also recognizes that policy makers have only limited ability to fix the core problem. Carney has noted that "virtue cannot be regulated." The Monetary Authority of Singapore's Ravi Menon echoed this point, asserting that "a mechanistic compliance with rules cannot be an adequate substitute for an internalized sense of responsibility and basic morality that a finance professional owes to his client or counterparty."

But if rules and their enforcers are incapable of closing the trust gap in finance, where are we left? The Fed's Bill Dudley points to leadership, saying, "…the problems originate from the culture of the firms, and this culture is largely shaped by the firms' leadership. This means that the solution needs to originate from within the firms, from their leaders."

But a leadership-centric approach to changing finance also has limitations. It is hard for firms who benefit from the status quo to upend it. Their temptation is to dress up the problem – to enact half measures that leave cellular enablers like compensation unaddressed. Even well-intentioned leaders must overcome stubborn obstacles to change. When leadership-driven reforms reduce rainmaker compensation or investor returns, executives will find their reforms challenged as high-mindedness that is not in keeping with shareholders duties.

This brings us back to IEX. Katsuyama's deep inside knowledge of the stock market could have enabled him to join those who paid for and exploited an unfair advantage. Instead, he determined to fix the problem by launching an exchange premised on trust and transparency, eliminating special advantages like trading rebates and special order types – an approach that aligns IEX's interests with end users like pension funds.

In IEX, we see a model of change that does not depend on new regulations, the determination of regulators, the virtue of employees, or the ability of executives to change culture. Instead, we see an innovator that is using inside knowledge to change the system from within, and forcing changes upon entrenched players. This is essential because outside innovators like Google who possess the financial and intellectual capacity to challenge Wall Street often view their best opportunities in realms that don't require them to master 22,000 page rulebooks.

Far from a clarion call to return to a world free of regulation, we recognize that government plays a critical role in promoting trust in markets. For IEX, it is the SEC that will determine whether to approve its application to become an exchange. To do so, the SEC will have to sort through a maze of complex issues raised by entrenched interests – a task IEX has sought to make easy by deconstructing accusations that its rules are "unfair, complex and opaque." The SEC must also change market structure to limit predatory trading strategies – a task to be informed by an advisory committee on which Katsuyama sits.

IEX is not merely a fix to inequities in the stock market – it is a symbol of another way of restoring trust in finance. For policy makers, this symbol is a call to acknowledge the limits of policy action in solving the most fundamental issues plaguing finance and to remove obstacles from those changing the system from within.

But even more urgently, it is a call for those of us working within financial markets to see ourselves as the best answer to the broken systems within which we operate. As a firm operating within the famously opaque derivatives market, it is a call we take seriously. It is not difficult to imagine IEX as a spark that lights a hundred firms like ours into a raging fire – a cultural revolution that restores society's trust in finance.

Commentary by Mike Bontrager and Luke Zubrod. Bontrager is the founder & CEO of Chatham Financial, a global risk management advisory and technology firm in the debt and derivatives markets. Zubrod leads the firm's public policy efforts. Chatham has no financial interest in IEX.