News at Smith

New ‘Flash Boys’ Exchange Is No Disruptor

Aug 24, 2016
World Class Faculty & Research

Comments

SMITH BRAIN TRUST — The 2014 book “Flash Boys” resonated with investors fed up with a market “rigged” in favor of high-frequency traders who use sophisticated software and algorithms to trade in and out of stocks in milliseconds. Now, the book has a companion exchange, the Investor’s Exchange (IEX) Group. It went live on Aug. 19, 2016, as an alternative to NASDAQ and the New York Stock Exchange and other SEC-approved exchanges.

IEX and its proponents say their “speed bump” model, based on a 35-microsecond trading delay, promotes fairness by limiting the ability of high-frequency traders to act on information before it’s seen by smaller traders. If this amounts to a speed bump that’s uniform, it inherently preserves the incentive to trade faster than the next trader, and the faster trader inherently acquires price information faster, whether fair or not, says finance professor Albert “Pete” Kyle at the University of Maryland’s Robert H. Smith School of Business.

Batch auctions

A more effective way to “level the playing field” is via “discreet batch auctions," Kyle says. "Instead of processing one order at a time, orders are batched together, perhaps one order per second. And, to be even more effective, go a step further and randomize the waiting time between the batching of each order.”

Niche, not mainstream

IEX co-founder and CEO Brad Katsuyama says his company aims to revolutionize the industry and attract a broad range of investors. Kyle, however, says the appeal of the new exchange likely will be limited. One class of investors that would like to see high-speed trading reined in is large-institution asset managers who trade at high volumes. They especially absorb the high cost of engaging in the high-speed, high-volume activity yielding millions of dollars from tiny profits on each trade. The IEX charging a flat fee per every 100 shares bought or sold offsets this cost disadvantage.

Unnecessary counter

NASDAQ nonetheless has reacted as though IEX looms as a disruptor by proposing an "extended life" order option to counter the speed bump. Investors who use the function would move ahead of other similarly priced orders if they agree not to cancel their orders for one second. Those Investors, according to Nasdaq, need not worry about the high-frequency traders able to order faster. But Kyle says the move, pending SEC approval, appears misguided. “HFTs make much of their money hitting stale orders in the limit order book,” he says. “If the orders are induced to remain for one second, they increase the probability an order is stale and therefore more vulnerable to being picked off by an HFT.”

HFT to accelerate

IEX, with its speed bump and minus a randomizing approach, is not likely to undo high-frequency trading’s attractiveness and perceived advantages, Kyle says. “And a larger and larger fraction of the market will shift to using HFT technology,” he says. “The technology itself will become commoditized, and you’ll either buy it or rent it from a securities firm or broker that handles your orders.”

GET SMITH BRAIN TRUST DELIVERED
TO YOUR INBOX EVERY WEEK

SUBSCRIBE NOW

About the University of Maryland's Robert H. Smith School of Business

The Robert H. Smith School of Business is an internationally recognized leader in management education and research. One of 12 colleges and schools at the University of Maryland, College Park, the Smith School offers undergraduate, full-time and part-time MBA, executive MBA, online MBA, specialty master's, PhD and executive education programs, as well as outreach services to the corporate community. The school offers its degree, custom and certification programs in learning locations in North America and Asia.