The 350-microsecond trading question

(updated with correction)

The addition of IEX Group as the 13th U.S.-registered stock exchange could have an impact on how asset owners and other institutional investors trade large blocks of stock.

But what the exact impact on block trading will be when dark pool operator IEX — which employs a 350-microsecond delay or speed bump for all trades — begins operating a lit exchange in September depends on whom you ask.

IEX's entry into the fully transparent exchange field “will reduce a lot of the noise around arbitrage and aggregate real liquidity and get a better fill done,” which will benefit block trading, said Joseph Saluzzi, partner, co-founder and co-head of equity trading at Themis Trading LLC, Chatham, N.J. “If IEX is disruptive, so be it. Everyone wants less noise, more liquidity — if it works, going lit throws a monkey wrench in the high-speed game.”

Countered David Weisberger, managing director and head of the trading and quantitative services product group at Markit Ltd., New York: “IEX will continue to be a good dark pool and may even get better, but if the impact of the decision is increased market complexity by enabling more order types and variations of speed bumps from other exchanges, it could hurt asset owners. This is due to the fact that proprietary trading firms always benefit when markets undergo structural changes, since they are quicker to exploit the inefficiencies created by complexity, than the firms that trade on behalf of asset owners.”

IEX gained fame as the subject of the 2014 Michael Lewis book “Flash Boys,” which focused on the negative impact of high-frequency trading on the U.S. equity markets. The book argued that how IEX's speed bump to delay such trading would make trading fairer for all equity investors by barring high-frequency traders from using predatory techniques to read the market in advance of trades.

The use of a speed bump was prominent in IEX's proposal seeking Securities and Exchange Commission approval to operate a registered stock exchange, which IEX received on June 17. Other registered U.S. exchanges do not use speed bumps.

The fact that IEX already operates a dark pool should help it grow once the lit exchange is up and running, said Richard Johnson, vice president, market structure and technology, at Greenwich Associates, Stamford, Conn. “There's an audience already trading with IEX,” Mr. Johnson said. “What will change is they will have protected quotes. We expect their 1.6% market share to increase, possibly as high as 6%.”

The SEC's process of for reviewing IEX's application included more than 500 comment letters. Some of its biggest supporters were pension funds like the $188.8 billion California State Teachers' Retirement System, West Sacramento; $128.2 billion Texas Teacher Retirement System, Austin; Norges Bank Investment Management, which manages Norway's 7 trillion Norwegian kroner ($827.5 billion) Government Pension Fund Global, Oslo; and the €183.3 billion ($203.4 billion) Dutch pension fund manager PGGM, Zeist, Netherlands.

Leading the opposition to IEX were hedge fund giant Citadel LLC; Nasdaq Inc.; Intercontinental Exchange LLC, owner of the New York Stock Exchange; and BATS Global Markets Inc.

Texas Teachers' comment letter, co-signed by T. Britton Harris IV, chief investment officer, typified the reasons pension funds favored SEC approval. Texas Teachers cited its experience with trading on IEX's dark pool, saying it led to “larger and higher quality executions compared to most other venues. Second, we believe that there is a pressing need for the introduction of a national securities exchange that is solely focused on the efficient transfer of capital between buyers and sellers.”

However, Markit's Mr. Weisberger said the endorsements by Texas Teachers and others “are somewhat misleading. While I have little doubt that trades done, in the dark, on IEX benefited by 33 basis points of superior performance compared to trades that executed on traditional stock exchanges, it is unclear why,” Mr. Weisberger said. “It could be simply that the lack of information leakage from trading in a dark pool was the main driver considering the market impact of trading on displayed exchanges. It is extremely unlikely that displayed trading on IEX would provide that benefit.”

Mr. Weisberger said institutional investors should have three takeaways from the IEX approval:

nIt's tantamount to an SEC endorsement of the use of dark pools, which is “huge for asset owners” that use dark pools for block trading;

nIt could lead to more exchanges using speed bumps with displayed, pegged orders that “would create the illusion of liquidity” in market structure, “meaning that liquidity seekers will suffer”; and

nThe speed bump “does nothing to protect lit orders that are sent to IEX, and lit orders are the only kind of orders that promote price discovery. ... Simply put, with displayed orders, IEX's delay does not allow repricing, nor does it change the order at which orders are processed,” Mr. Weisberger said. “This means that a displayed limit order can still be accessed by a high-frequency trader after all the other exchanges have moved their quotes, if that trader gets their order to IEX before the posted order gets canceled.”

While Mr. Weisberger said market liquidity would be hurt if other registered exchanges received SEC approval for their own speed bumps, Themis Trading's Mr. Saluzzi said such proliferation is unlikely. “If others try, their speed bumps will have to affect everyone — market makers, investors, whoever,” as is the case with IEX's speed bump, Mr. Saluzzi said. “I don't think NYSE, Nasdaq will do that. They've spent years making their markets faster and faster; now they're going to slow them down? That would ruin their business model.”

IEX's journey to SEC approval had some similarities to the road taken by a Canadian stock exchange operator, Aequitas Innovations Inc., Toronto. Aequitas has been incorporating a speed bump for select market participants since its NEO Exchange opened in March 2015 — though unlike IEX, Aequitas did not previously operate a dark pool. “It's interesting to observe the discussions on IEX,” said Jos Schmitt, CEO of Aequitas. NEO's speed bump only applies to orders coming from high-frequency traders specifically when they want to take liquidity, Mr. Schmitt said. “It's a different model, a different approach (than IEX), but the same fundamental objective: to create a market that's fairer and more equitable,” he said.

Since it opened, 50% of trades on Aequitas' NEO Exchange are made between parties other than high-frequency traders, Mr. Schmitt said. Another 25% are non-HFT investors trading with market makers.

Ronan Ryan, president of IEX, said there will be less need for fragmented block trades on IEX's exchange. “If (traders) have to fish all over the place with blocks, you're closing the market,” Mr. Ryan said. “If you trade on IEX, a buyer will find you.”

However, Mr. Schmitt doesn't think institutional investors will change how they trade blocks of stocks as a result of IEX's entry as a lit exchange. “You won't see people put in large blocks of trades wherever,” Mr. Schmitt said.

“Dark pools can bring benefit, and straight execution is another mechanism. Institutions today always break up their orders and use all various tools available to them,” he added.

Greenwich's Mr. Johnson said whether IEX's entry will mean less block-trade fragmentation is anybody's guess for now. “That's too hard to answer,” Mr. Johnson said. “It's not necessarily a question of flipping a switch. When IEX becomes a lit market, then we'll see if there's a benefit.” n