Since IEX submitted an application last year to the SEC to become a public stock exchange, a big debate has erupted about a seemingly small time frame — 350 microseconds.
IEX's proposed exchange would implement an intentional delay of 350 microseconds to incoming and outgoing information, except for a few select order types.
The debate has led the SEC to issue an interpretive release, which in short asks: Do delays under 1,000 microseconds pose a problem for equity market structure? In the short term, the answer will affect IEX's application to become a recognized national exchange. Long term, the answer could redefine the foundation of equity market structure.
Here's our answer: Deliberately adding any amount of latency to the current market system would be a step backwards, especially when applied in an unequal way. Some types of investors do face real challenges, but intentional delays are not the answer.
National exchanges have experienced major technological innovations in the past 15 years. The rise of high-speed and automated markets have streamlined the dissemination of information and price discovery for equity investors. In removing human intervention at public exchanges, retail investors have seen their trading costs decline by at least 50 percent. Many market experts and retail advocates like Jack Bogle — founder of Vanguard and inventor of the first index mutual fund — have noted "Main Street is the great beneficiary" of this increasingly automated and transparent market.
To that end, Reg NMS was introduced in 2005 to oversee the evolving market structure and ensure the continuation of market automation and innovation. To further best practices for investors, Reg NMS enforced order protection status to best prices "represented by automated quotations that are immediately accessible." Essentially, public exchanges are required to provide the best available price for a security to an interested buyer or seller. To not give the best price would be an intentional obfuscation and added cost to investors. Specifically, Reg NMS states the definition of "immediate" as "the fastest response possible without any programmed delay."
This precise definition of "immediate" has come into question with the application of IEX to become a public exchange. Known in pop culture for its prominent feature as the protagonist in Michael Lewis' narrative "Flash Boys," IEX is seeking to become a public exchange that will implement an intentional — or programmed — 350 microsecond delay ("speedbump") for inbound and outbound information on specific trade orders. Under Rule 611 of Reg NMS, IEX would be entitled to receive all market orders when it is displaying the best price, even when that price is no longer available due to the total price reporting delay of 700 microseconds. This significantly increases the exposure of investors to such a delay. While there is no question that IEX is creating a programmed delay, the question the SEC is posing is if delays up to 1,000 microseconds are de minimis and not harmful to investors.
IEX's programmed delay also results in order discrimination as it is only applied selectively. While some order types are required to go over the speedbump, hidden-pegged orders, which automatically reprice to preset benchmarks (such as inside bid and ask quotes), are able to bypass the delay when repricing based on market movements. Such a structure adds dark liquidity to lit markets through its preferential treatment of an order type that lacks transparency. This will encourage the provision of more hidden, rather than transparent, liquidity.
As research has shown increased automation benefitting retail investors, there is also research quantifying the harmful effects of selectively applying a delay like IEX's proposed exchange. Columbia University Professor Charles Jones quantified 15 percent of trades would be impacted from a 350 microsecond delay, such as the one proposed by IEX. To the disadvantaged order type, the cost would come to 1.67 cents per share, totaling more than $400 million in wealth transfers in the public marketplace each year. Fifteen percent of trades affected is hardly de minimis.
IEX's proposed implementation of a selective delay as a public exchange would be a bad development for investors. While we understand the intended purpose is to protect institutional investors, this SEC-sanctioned form of latency arbitrage will only entice other public exchanges to implement their own delays as a way to shore up business. The positive developments of market efficiency and innovation that have transpired over the years would devolve into a race to the bottom, as more delays would only create more opportunities for exploitation and rent-seeking. The whole foundation of Reg NMS as a source of protection and promotion of market innovation for the benefit of investors would come into question.
Institutional investors do face challenges in today's market structure and there needs to be thorough and fact-based discussion on possible solutions. But the SEC expanding the definition of "immediate" and approving IEX's exchange application as is are neither solutions nor innovations to these challenges.
Commentary by Avanidhar Subrahmanyam, and Holly A. Bell. Subrahmanyam is a professor and the Goldyne and Irwin Hearsh Chair in Money and Banking at the Anderson School of Management at UCLA. He focuses on research related to market structures and behavioral finance. Bell is an associate professor at the University of Alaska Anchorage, with a research focus on financial market structure and regulation. Follow her on Twitter @hollybell8.
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