What does IEX’s upcoming exchange application mean for market-structure?

On September 3rd, IEX announced that they had raised $75 million in funding to continue their rapid growth and, more importantly, to pursue registration as a U.S. exchange. But with IEX’s differentiated offering, what does this mean for market structure? There has been quite a bit of fracas in the twittersphere and among industry participants and analysts regarding IEX’s “unique” price/broker/time priority matching logic versus the price/time priority logic commonly found on existing U.S. Exchanges.

Is IEX’s priority logic unique?  Actually, not really. Broker preferencing has long been an established regime in Canadian markets. Not too long ago, preferencing also had its place in U.S. market-structure. Indeed, some readers may recall this preferencing on the Cincinnati “CSE” and Boston Stock Exchanges “BSE,” both with roots dating back to the late 70’s. Both the CSE and BSE exchanges had SEC approved rules permitting preferencing similar to that of the current IEX model. In those days, preferencing was an important component of the market, allowing the smaller regional exchanges to compete with larger exchanges.

With regional volumes growing, Congress requested, in 1996, that the SEC conduct a study on the practice of preferencing. The study found that preferencing did not have a deleterious effect on the national market system and that, to the contrary, market quality for preferencing exchanges is at least as good as that of other regional exchanges, and in some cases, better. Moreover, the SEC found that preferencing furthered the ability of CSE and BSE to compete in the national market system and that preferencing is not inconsistent with the best execution of customer orders. Both CSE and BSE were absorbed in the past decade and their models no longer exist, however variations of them do.

Nasdaq OMX PSX has approved rules that provide for a 40% allocation under the Price Setter Pro Rata priority structure. NYSE, in 2011, introduced the Retail Liquidity Program “RPI” that was later adopted by other exchanges. RPI preferences one class of participants over another for a small and typically insignificant amount of price improvement, thus subverting the price/time priority model which is much like the notion of customer priority contained within the options markets. The question many keep asking is, ‘will the SEC approve IEX’s price/broker/time model?’ Given current market structure and past history, it would be difficult to envision the SEC not approving IEX’s model.

What of other market structure issues? Notably, with IEX’s technology, matching engine updates are delayed for 350 microseconds. This begs the question, would IEX qualify as an automated market under Regulation NMS? Regulation NMS differentiates market centers based on manual or automated quotations. A manual quotation is one that is considered not immediately and automatically accessible and which does not receive protection against trade-throughs. On the other hand, an automated market center must, by definition, offer IOC functionality (which IEX does), and must also provide for automatic, immediate, ”no human discretion” in responding to the order. The SEC defines “immediate” as the fastest response possible without any programmed delay. In the case of IEX, there is no programmed delay, just a coil of fiber. Further, the SEC defines a material delay as a market center failing to respond to orders within a one-second time frame. IEX is not programmed to create a delay; rather the response time is merely a result of the coiled cable inside the “magic shoebox” to get to the matching engine where all participants are afforded equal access. This is, in many aspects, no different from a co-location center equally measuring connectivity cable to matching engines. In this regard, IEX would qualify as an automated market center under Reg NMS.

Finally, exchanges receive revenue from market data collected by the Consolidated Tape Authority and Unlisted Trading Privilege plans. Each exchange (SRO) is a participant in the plan and receives credits based on their quotes and trades. In order to collect a quote credit, an exchange must display a quotation for a minimum of one full second. Prior to Reg NMS, market data was paid to exchanges solely based on trading activity. This gave rise to the unintended consequence of tape shredding whereby a larger order would be broken down into smaller component trades to garner a larger share of revenue. The revised NMS formula sought to end tape shredding and to allocate revenues to those exchanges that benefit investors by contributing useful quotations to the consolidated data stream. With its proposed model, there is a high likelihood that IEX will be able to garner additional revenue through longer maximum quote life versus other exchanges.

Without a doubt, there are many sides to each of the issues posed above. There is, however, one item that will not draw much contention and perhaps this is the most important one. At present, the SEC and FINRA prohibit IEX from utilizing their full name, “Investors Exchange.” Attaining exchange status would allow unfettered use of the full name.