It isn’t often that an SEC decision involves the star of a best seller, a “magic shoe box,” and fundamental questions about the meaning of words like “immediate” and “fair.” The SEC made such a decision on Friday.
Last fall, the trading system IEX applied for designation as a stock exchange. IEX, and its CEO Brad Katsuyama, rose to fame several years ago with the publication of Michael Lewis’s popular book Flash Boys. Lewis, ever the artful storyteller, cast Katsuyama as the likeable underdog, exposing and undermining high-frequency traders (HFTs) through the development of IEX. IEX, an alternative trading system, or in the more colorful industry jargon, a “dark pool,” has allowed investors to trade away from market scrutiny and the HFTs that populate “lit” exchanges. But there are advantages to being an exchange, and IEX wants in.
At issue in determining whether to approve the application was the meaning of the word “immediate” in an SEC regulation known as Regulation NMS. Regulation NMS, approved by the SEC in 2005, was intended to increase competition among trading exchanges, resulting in better execution of trades and better prices for investors. In furtherance of that goal, a part of the regulation requires that trades be made at the best price listed on any exchange and that exchanges make their quotations “immediately” and automatically available. In the past “immediate” has been defined as “immediately and automatically executable, without any programmed delay.” Seems clear enough, right?
Well, here’s where we get to the “magic shoe box.” IEX’s claim to fame is that it slows down the trading process, just a little, just enough to make it impossible for HFTs to get ahead of big orders. Because for those who dislike HFTs, it’s this very habit that makes them a problem. The argument is that HFTs see a trade coming and are fast enough to get ahead of it, buy up the shares, and then resell them immediately at a higher price. IEX introduces a 350-microsecond delay, a short enough time to be unnoticeable to any human, but long enough to make this type of trading unprofitable. The way that IEX introduces this delay is to run the orders through a long cable, which is kept coiled up in a box. The magic box is a shoebox-sized box of coiled cable.
See the problem? “Immediate” has been defined as “without any programmed delay.” It seems that running the order through a length of cable with the intent of introducing a delay is, well, a “programmed delay.” If the delay is only 350 microseconds – less time, Katsuyama has said, than it takes to blink – does it count? It has to count. It doesn’t matter whether it’s essentially imperceptible to humans. If it didn’t make a difference to HFTs, IEX wouldn’t have introduced it via the shoebox.
Well, then that’s clear enough, right? If intentionally included, a delay is impermissible because it’s a “programmed delay.” Thus, IEX can’t use its magic shoebox and be in compliance with the rules. The SEC should have denied the application.
Not so fast. Other exchanges also intentionally introduce delays through coiled cable. That’s where IEX likely got the idea. Except these other exchanges don’t delay everyone. It may seem that when you send an email to a friend in China, it arrives “instantly” in your friend’s inbox. But of course, it doesn’t. It’s really fast, but not instant. In the trading world, speed has become so essential that the difference between having a server pressed right up against the exchange’s servers means being faster (and better able to make money) than being located just on the other side of the same room. To even out these differences (entirely imperceptible to humans, but very visible to computers) exchanges will attach all the servers with the same length of cable, coiling the excess cable for the servers located closest to the front of the room. That is to say that many existing exchanges have their own shoeboxes, also filled with coiled cable. But those boxes are designed not to slow down the whole exchange, but to even the playing field within the exchange.
What should the SEC have done? Was it right in approving IEX’s application, allowing them to introduce an intentional exchange-wide delay? There are those who support that position, for very compelling reasons. Regulation NMS has caused more problems than it solved. Former SEC Commissioner Daniel Gallagher has dubbed it the “poster child of unintended consequences,” pointing to the fact it was Regulation NMS that essentially created high-frequency trading. If IEX’s 350-microsecond delay can starve out the HFTs, it will provide a market-based solution to any perceived problems posed by HFTs. (I am not, to be clear, saying that HFTs are problematic. There is evidence that they improve market quality.)
To make the approval work within the strictures of Regulation NMS, the SEC simultaneously released updated guidance stating that any delay of less than one millisecond will be considered de minimis. In legal terms, Black’s Law Dictionary defines de minimis as “trifling” or “so insignificant that a court may overlook it in deciding an issue or case.” As a microsecond is significantly shorter than a millisecond, IEX’s 350-microsecond delay fits neatly into the new guidance.
But is the solution to bad regulation to create one-off exemptions, essentially regulating by fiat? Another former commissioner, Paul Atkins, who voted against the regulation when it came up for a vote during his tenure, has argued that the real solution is to fix Regulation NMS. Not surprisingly, many existing exchanges have also voiced their opposition to approval of the application. While much of this may be chalked up to their aversion to increased competition, several have raised credible arguments about the unfairness of creating loopholes for specific parties, while also highlighting potential technical problems with designating IEX as an exchange. These technical problems, of course, would not exist but for Regulation NMS.
Ultimately the SEC’s solution is a band-aid, and a poor one at that. While 350 microseconds, or even 1 millisecond, is truly less than a blink of an eye, no one spending the kind of fortune IEX must have spent in not only its application but in the attendant lobbying efforts would view the delay as de minimis. The delay is the issue. Deciding that it’s too trivial to be worth considering is simply disingenuous. Introducing competition into a marketplace is good. But creating regulatory carve-outs for special interests is not. The solution is to fix Regulation NMS.