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Karl Antle
Karl Antle
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IEX & the Re-Mutualization of Market Infrastructure

Whether success or failure, devil or savior, IEX exists because enough members of the buy-side community wanted it to.

In light of our most recent post on misaligned motives in capital markets, I’ve been doing more thinking about Michael Lewis’s new book, Flash Boys, and the hero of that story, IEX.  

In this context, I am less fascinated by the actions of high frequency traders than by the motives of the team who founded the new exchange. Many of those involved could have made more money on the sell side or by operating a more classic dark pool or exchange. So why did they launch this endeavor?

For the good of the market.

In Flash Boys, major buy-side institutions are under attack, with the very infrastructure designed to support them instead serving them up on a silver platter to a sea of financial piranhas. Whether or not this is true, it got me thinking about the original structure for exchanges and infrastructure.

For as long as public markets had existed, they’d been supported by exchanges and infrastructure that were created as a mutuals and funded by all participants for the good of facilitating transactions more efficiently. But in the late 1990s, our capitalist tendencies persuaded us that the mutual structure wasn’t pulling its weight in driving new products, technology, and price efficiencies. The diagnosis: an acute lack of profit incentive.

So one by one, major exchanges and infrastructure providers demutualized and became publically-traded, for-profit entities themselves, complete with the resulting corporate governance requirements and conflicts of interest. What we didn’t realize was that under this new, profit-seeking M.O., exchanges were designed and incentivized to seek out the largest revenue sources available -- and in recent years, that’s meant high frequency traders.

Suddenly, the new infrastructure and those that founded it no longer had aligned interests, encouraging the buy-side to seek out new options and opening the door for new “fair market” marketplaces like IEX. Whether success or failure, devil or savior, IEX exists because enough members of the buy-side community wanted it to.

This poses interesting questions about the past and future of our capital markets. Were we too hasty to overlook the consequences of rampant demutualization in favor of what we thought was a more profitable capitalist structure? Do we return to mutualized infrastructure or introduce another wave of new regulation?

Or, do we apply the traditional venture process to financial technology: a demand exists, a solution is created, a company is launched, and we all watch as a largely uncertain future plays out.

The reason we created VSL was because we believe that data, technology, and transparency are the answer -- and that this is the beginning of a wave of buy-side investment in technology and startups in recognition of the impact technology is having even in the most fundamental aspects of investment management.

Karl Antle is a Partner at ValueStream Labs. A highly adaptable technology enthusiast, Karl has global experience in Business Development, Corporate Finance, Strategy, and Operations specializing in technology enabled Financial Services businesses. Karl was a Principal in ... View Full Bio
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User Rank: Author
5/28/2014 | 12:53:10 PM
IEX is not an Exchange, yet.

You are absolutely right about demutualisation.  When an exchange is driven by profit as their top priority, they lose sight of the ultimate goal; to have the most robust, healthy functioning market possible.  

A few days ago the topic came up at the annual CME shareholders meeting.  The CME introduced equal length fiber connections from their matching engine to customer servers long before IEX started doing it with exchanges.   The CME has been able to stay focused on fair markets more so than equities exchanges in New York, possibly because exchange members have a stronger influence on the election of board members and CME executives, and their less pressured by shareholders.  After seeing the amount of money made by other exchanges, the CME is going to start charging higher market data fees.  The argument was made that this will hurt the small traders. "It's like killing a fly with a sledge hammer."-R.H Balin

CME members used to buy memberships because access to the floor was for all intents and purposes, access to the market.  Now, as trading has moved to computer screens, access to the markets is achieved by purchasing data feeds from the exchanges.  The debate is; should exchange members get access to the data feeds at lower prices?  

I called IEX to find out more information about them the day after the book came out.  They are not an exchange although the 60 Minutes piece and every other TV interview portrayed them as such.  Currently, they are a registered "automated trading system" (ATS) and a registered broker dealer.  What that means is that they're basically a hub (think of a router except bigger) connecting to other exchanges in equal distances.  Their goal (as it was explained to me) is to become an exchange, because they'll "make much more money when they can charge data fees like the other exchanges."

We don't need another exchange.  What we need is fewer exchanges with incentives aligned with stronger markets not profit, like you said, but also for the other exchanges to route orders (as mandated by Reg NMS) with equal distances between them.  IEX didn't come up with the concept, and they shouldn't be the only exchange with that capability.  Every equity exchange should be required to do that.

Although we may never have a completely fair marketplace, the goal should always be to have the most robust market, and we need to do everything we can to keep it as fair as possible in order to achieve it.  Information should flow freely and fairly. 

Great Article!

Justin Bouchard
User Rank: Author
5/29/2014 | 2:10:17 PM
Re: IEX is not an Exchange, yet.
IEX is an ATS (dark pool) but it aspires to become an exchange. The term exchange has been used loosely in many of the articles and in the 60 minutes program. Perhaps this speaks to the perception that exchanges and ATSs are similar, or confusion over what are the differences in the media.

Your point about how CME has worked hard to provide a level playing field within its data center by providing equal length cables between its matching engine and each customer's service is important. I believe that NYSE has done the same thing in Mahwah, NJ, where it provides equal length cable as well.

I think IEX goes a step further.  It's matching engine is located in a different data center than its front door where orders enter. It places its access point three miles away from its matching engine. In addition, it delays each order by 350 microseconds passing it through 38 miles of coiled cable. This has discouraged some fast trading firms from participating. But it is making the buy side feel more comfortable. Recent statistics show an increase in small and large block trades.
User Rank: Author
5/29/2014 | 2:28:57 PM
Re: IEX is not an Exchange, yet.

You make a good point.  The CME matching engine is also removed from colocation hosting facility.  Many people think that it is in Aurora, but it's not.  Customer servers are hosted in Aurora, but the matching engine is many miles away.  They keep the location secret for security reasons, but it is a similar concept.  

I'm curious if 350 microsecond delay really has an impact.  In many cases, delays (usually caused by inferior technology) just result in sitting duck orders that can't be pulled as quickly, or some other disadvantage.  They may have overthought the solution and inadvertently created another problem.
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