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IEX’s Katsuyama: Market Structure Problems Are Everyone’s Responsibility

Don't single out HFT for the market's problems. Anyone who has worked in the industry during the past two decades has been complicit in corrupting the markets.

Although there is a lot of talk about what regulations are needed to improve the current US equities markets, some believe that regulatory change may not be the answer. If regulation isn’t the fix, then what is?

“I think people need to take a different approach to improving the industry. Let your opinions be known, let the information be known, and help educate investors,” said Brad Katsuyama, CEO of IEX in an exclusive interview with Wall Street & Technology.

Brad Katsuyama, Founder & CEO, IEX
Brad Katsuyama, Founder & CEO, IEX

“Regulation may not be the solution to what is happening now,” said Katsuyama, who believes education and forced transparency would cause behavioral shifts and provide investors with more information to make better decisions.

IEX, the alternative trading venue featured in the Michael Lewis book Flash Boys, has been gaining order flow and market share while slowing down orders to level the playing field between high-speed traders and investors.

The dark pool has garnered the attention of buy-side institutions by bucking the trend against complex order types (it has only four), banning rebates, not allowing co-location next to its matching engine, and consuming faster data feeds to price stocks.

Since its launch on Oct. 25, 2013, IEX has been gradually increasing its volume from a little over 1 million shares per day in October and 5 million per day in December. On May 20, IEX’s average daily volume was 54 million double-counted shares or 27 million shares single-counted, according to statistics on its website.

On May 6, the venue captured a record high 0.631% share of equity trading volume. So far in May, IEX's average daily volume of 31.6 million single-counted represents a 67% increase from the venue's average volume of 19 million shares executed in March.

Gradually increasing volume
As a sign of its traction on the buy side, IEX executed more blocks than many of the continuous trading dark pools ranked in Tabb's March 2014 "Equities Liquidity Matrix" report.

According to Jay Fraser, IEX’s head of business development, 20% of IEX’s volume in May to date has been executed in at least demi-blocks ($100K to 200K notional) or blocks ($200K and above), and 27.5 % when measured by shares.

IEX’s 20% share of volume executed in either blocks (measured as prints higher than $200K) or demi-blocks (measured as prints between $100K-to-$200K) is higher than other continuous trading dark pools ranked by Tabb's report, including Goldman Sachs Sigma X (2%; excludes demi-blocks), Deutsche Bank Super X (6%) Barclay’s LX (6%), ConvergEx Group Vortex (6%), LavaFlow (10%), Knight Match by KCG (12%), GetMatched by KCG (12%), ConvergEx Group’s Millennium (14%) and Instinet CBX (17%).

In an email, Fraser stated, “Investors and brokers rest on IEX because it’s safe and productive.” Fill rates for 100,000-plus share orders that rest for over an hour are 28%, while they are less than 1% for immediate or cancel (IOCs), he wrote. Fraser said that fill rates increase two to three times as clients transition from 5,000 to 10,000 share orders to more than 100,000 share orders.

“We view these as proof points that all of the protective measures we’ve built into our market and technology design (including a 350-microsecond buffer, the True Price matching engine architecture, lack of rebates, only 4 order types, etc.) are delivering a higher-quality experience for our customers,” wrote Fraser.

The dark pool was formed by Katsuyama, a former Royal Bank of Canada trader, and Ronan Ryan, who was hired by RBC for his expertise in mapping the latencies between various exchange datacenters and building the fastest routes for HFT strategies. Both Katsuyama and Ryan are considered the main stars of Flash Boys, which has reinvigorated a debate over fairness of the electronic market structure.

Avoid over-regulation
While the book has created a media frenzy over the role of high-frequency traders along with bold claims that the stock market is rigged, Katsuyama said he is not sure if high-frequency traders are to blame for some of the current market flaws.

Despite calls for repealing Regulation NMS, the legislation implemented in 2007 that mandated the need to route to the venue with the best price, additional regulation is not necessarily the answer, said Katsuyama in IEX’s lower Manhattan office.

“You don’t want to unnecessarily over-regulate the market,” he told us, pointing out that IEX exists within the current regulatory market structure to solve the problem. “We didn’t need rule changes; we didn’t ask for changes. We just decided to think differently and build something different.

“So before you question the rules in the game, I would question the players in the game first,” he said, pointing out that many firms have known of these issues for years.

“Anybody could have done what we have done. They could have done it in 2009 or 2010. It’s 2014 and we’re talking about this” only now. Katsuyama insists that part of the problem is the incentive structure, which pays rebates to HFTs and brokers that add liquidity or take liquidity. “Reg NMS might have fueled some of the incentives that are an issue. But people could have sorted this out a long time ago.”  He suggests that Reg NMS could be “an easy scapegoat to talk about if you don’t want to see anything change for five years.” Focusing on Reg NMS is one way to avoid any change, he said.

Most industry participants point out that the market is better than it was 20 years ago. It’s faster and has lower trading costs and tighter spreads. On those points, Katsuyama agrees. “Of course it’s better. Technology was going to deliver all of those great benefits -- faster, cheaper, better, all of that was going to happen anyway. But people are also using technology to scalp from other people unnecessarily.”

Katsuyama said he doesn’t think high-frequency trading is to blame. “If you asked Michael Lewis if high-frequency trading is to blame, he would say the system has let down the investor. I firmly believe that.”

Virtu Financial, one of the largest HFT market makers, participates on the IEX marketplace. Though IEX has made presentations to 12 of the 15 largest HFT firms, Virtu is one of the few that agreed to connect given the 350-microsecond delay that IEX imposes on each order. Virtu accounts for 6 to 8% of IEX’s volume. “They are not our largest customer, but they contribute,” said Katsuyama. Virtu is also IEX’s No.2 participant in ETFs and No. 1 in inter-listed arbitrage. “They are adding value in the places you would want computerized traders adding value.”

Rather than blame HFT, Katsuyama said, “Everyone in the room in IEX almost, including myself, has had a hand in corrupting the markets in various roles over the past decade." Those who worked for exchanges, HFT firms, and even brokers, including himself, who routed orders around to earn rebates that offset escalating costs, all had a part to play. “The system has corrupted itself and let down the average investor, and I think our job as an industry is to step up and do whatever we can to fix it. Stop the talking, and let’s see some action.”

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
5/22/2014 | 2:30:05 PM
Strong words
That is a pretty strong statement from Katsuyama. Does this fall under "aiding and abetting?"
IvySchmerken
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IvySchmerken,
User Rank: Author
5/22/2014 | 3:11:17 PM
Re: Strong words
Yes, these are strong words. I think he is saying that everyone who has done convoluted things to maximize rebates is part of the problem.

In reality, all of this is legal, under the current market structure.  By saying that everyone is complicit in corrupting the market structure, he's shifting the focus away from HFT and putting the onus on the overall industry to move forward with improvements rather than wallow in inertia.
Nathan Golia
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Nathan Golia,
User Rank: Author
5/22/2014 | 4:34:09 PM
Re: Strong words
Probably true, but if everyone has a role, certainly HFT is a component. Pointing fingers everywhere is still pointing fingers. Can the industry look beyond short-term myopia to drive needed reforms without government intervention?
IvySchmerken
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IvySchmerken,
User Rank: Author
5/22/2014 | 5:32:18 PM
Re: Strong words
Disclosure and more transparency are steps the industry can take. Exchanges could simplify order types or eliminate those that are clearly meant for HFT to earn rebates. Some dark pools (ITG, IEX) have begun to post their ATS forms on their web sites, providing information on their trading rules and order types. Brokers could explain their order routing practices to the buy side. Liquidnet is going further by creating transparency controls, letting members opt-in/or opt-out of certain liquidity.

This is not really reforming the market, but sharing information that's been opaque or hidden.

To reform the bigger structural issues, like maker-taker system or locked/crossed markets which are banned by Reg NMS, it would seem that government (SEC) intervention is necessary.
Becca L
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Becca L,
User Rank: Author
5/23/2014 | 1:50:06 PM
Re: Strong words
From my view, Katsuyama is arguing for a market that follows the spirit of the law rather than the letter of the law. His overview of the situation is rather blunt - traders will toe the line when it's most convenient, but making it the normal behavior rather than an exception is rather disappointing, and too great a strain on average investors.
IvySchmerken
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IvySchmerken,
User Rank: Author
5/23/2014 | 6:01:09 PM
Re: Strong words
Just because certain practices are legal, doesn't make them right, would be the message that Brad Katsuyama expressed in the interview. He is looking out for what's best for the market - investors that want to own a stock as opposed to firms that are using technology to earn rebates scalp investors. He believes there is a legitimate arbitrage activity for high speed traders, in ETFs versus the underlying constituents of a basket and in interlisted stocks. But he's not too crazy about the intricate order types that have been created by exchanges for HFT to comply with Reg NMS and earn a rebate, since certain order types allow them to trade ahead of an institution who is willing to buy stock at the same price.
tomrbusdev
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tomrbusdev,
User Rank: Apprentice
6/4/2014 | 7:27:59 PM
Re: Strong words
Brad seems to be zeroing in on the methodology of manipulating the order book by allowing cancelations simultaneously with an order. So he says that the dark pools and internalized orders have an advantage because they can post an order and then cancel it when an offer comes in but beofre the offer executes. That's the 350 ms gap.

The whole issue is really no different than the fat spreads that used to be the OTC market now NASDAQ. Along came the daytraders like Harvey Houtkin with faster execution on an ATS that allowed them to pick off orders in between the bid and offer. In those days, folks like Madoff, Herzog, Fidelity, GS, Lehman.... were running market maker books with spreads of 1/4 to a half in cases. The market makers, NASDAQ brokers of the day were crazy up the walls about campaigning that the day traders were ruining the business and should be banned from participating in the OTC market. 

Today, it's a little different because the HFT firms are exploiting a subtle difference between the rules of operation for certain institutions using dark pools for example and the individual investor. First there is the ability to cancel more rapidly, therefore creating what Brad says is an artificial book. Secondly, they have the ability to enter orders on both sides of the book using a 350 ms programmed simultaneous order to call and put and cancel in two different accounts for the same options contract.  This allows them to create an artifical book, and also to act upon new orders against that artifical book with a 350ms edge. I think this is what Brad is saying.

Hi Ivy
Greg MacSweeney
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Greg MacSweeney,
User Rank: Author
6/10/2014 | 1:30:50 PM
Re: Strong words
Agreed. The situation is different than the market makers vs day traders from years ago. Today's technology does allow for false, or fake, order books, that allow certain firms to exploit orders.

What will be done, or what can be done, remains to be seen, however.
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