Investor-friendly exchange goes live in August

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by Daniel Broxup, attorney
Mika, Meyers, Beckett and Jones

Reprinted by permission

A new “investor friendly” stock exchange has been approved by the SEC. The Investors Exchange (IEX) will begin exchange activity on August 19, 2016 as one of only thirteen SEC-registered stock exchanges. Up until now, IEX has been operating as a type of Alternative Trading System (ATS) known as a “dark pool.”  Dark pools carry out a similar function to stock exchanges: matching customers’ buy and sell orders to facilitate trading.  However, unlike stock exchanges, dark pools conceal their pre-trade order flow, and bid and ask prices, from the general public.

The approval of IEX’s exchange status caps a meteoric rise for a company that was founded less than four years ago. The founders, led by a former Wall Street trader named Brad Katsuyama, set out to create an exchange that would protect “average Joe” investors from the predatory trading practices of High Frequency Traders (HFTs). One of those trading practices is “electronic front running,” which is accomplished by exploiting miniscule differences in the time that it takes for fragmented market orders to arrive at different trading terminals.

The HFTs utilize algorithms and superior trading speed to detect the order at its first destination (stock exchange or ATS) and then immediately “front run” the order to other trading terminals. This practice imposes completely unnecessary “intermediary” costs on average investors. IEX has implemented a number of measures to try to stamp out electronic front running and other HFT practices that exploit HFTs’ speed advantage.

By taking on the HFTs, IEX has also taken aim at the big Wall Street banks responsible for facilitating HFT abuses. The relationship between HFTs and the banks was laid bare by Michael Lewis in his book, “Flash Boys.” In his  book, Lewis describes a practice known as “dark pool arbitrage.” The banks set up this arbitrage opportunity for HFTs by parking their customers’ orders in their own dark pools, and pricing the orders aggressively, instead of sending the orders out into the market to obtain “best execution.” As soon as the HFTs are alerted to the situation, they proceed to purchase shares of  the subject stock at the lowest available price and then turn around and sell the  shares in the dark pool at a marked-up price. This arrangement between the HFTs and the banks is mutually beneficial. The HFTs earn profits on the spread between their purchase and sale prices. The banks benefit in a number of different ways, including savings realized by not having to pay commissions to other trading venues, fees gained through trading in their dark pools, and increased order flow to their dark pools.