In an interview with Business Insider, IEX CEO, Brad Katsuyama, continues to claim that their delay “stops client orders from being scalped.” Unfortunately, this sweeping claim, while possessing an element of truth, is actually false with respect to the most contentious point of the IEX exchange debate. That debate hinges on the treatment within the National Market System (NMS) of IEX’s firm, displayed orders, but Mr. Katsuyama’s claim only applies to IEX’s non-displayed (dark) orders.
To explain this important distinction, if an order is firm, IEX is forced to execute it, even if that order is being “scalped” by HFT firms that believe the order is alone at the price… This is because the IEX delay does not change the sequence of events in their matching engine and therefore HF firms are not slowed down any more than other participants. In short, with displayed orders it is only relative speed that matters.
This is very important. At the core of the IEX exchange debate is whether their DISPLAYED quotes become “protected” under the National Market System (NMS). The crux of the argument against that claim is simple:
Allowing an intentional delay would enable the exact scenario depicted by Michael Lewis in “Flash Boys” — quotes “disappearing” when orders are entered.. Here is how:
Consider a situation where one exchange has a firm order to sell 2000 shares of a stock at $20.10 on an exchange without a delay and three other exchanges have pegged orders to sell a total of 8000 shares at the same price, and all of them have implemented a delay. Whether on a screen or from the perspective of an order router, it would look like there are 10,000 shares available. Let’s contrast today’s world and a hypothetical world where IEX’s delay is approved:
Today – a smart order router that sends 4 orders simultaneously will likely be filled on all 10,000 shares.
Post approval of the IEX delay, the smart order router will get filled on the 2000 share order accessing the firm quote, BUT the other 8000 shares could all move out of the way during the delay, when those exchanges “see” the firm order get filled….
So, what is the offsetting benefit for IEX’s displayed quotes to be protected to counter the chaos such a ruling would unleash?
NOTHING
Yes, I said nothing. IEX’s dark pool, could continue to provide the benefit of protecting those orders without protection under Reg NMS. They could become an exchange without their lit quotes being protected OR they could retool the delay to apply only to DARK orders, where the delay actually provides a benefit.
It is truly unfortunate that this debate continues to be positioned as a referendum on HFT, when it should not be. One suggestion: the SEC could separate the exchange application from the question of determining the status of IEX’s displayed orders under Regulation NMS. While I don’t have a strong view on the exchange application generally, the answer to the “protected quote” question should be: “No.” Deeming an intentional delay acceptable would set a precedent which would decrease incentives for providing the firm orders that are critical to price discovery.
