Have you ever heard of Investors Exchange, better known as IEX? What does the IEX company do to make stock trading fair?
IEX is a stock exchange based in the United States and was founded by Canadian stock trader Brad Katsuyama. Michael Lewis details the creation of IEX and what the company does in his book, Flash Boys.
Keep reading to learn about what the IEX company does to improve the stock market’s standards in just five solutions.
What Does the IEX Company Do?
After discovering high-frequency trading, Katsuyama and his team decided to fight HFT rather than mimic its tactics to make money, so they quit their jobs at the Royal Bank of Canada to create their own stock exchange. They called it the Investors Exchange, or IEX. So what does the IEX company do? It makes investing fair by preventing the predatory behavior of high-frequency traders.
When creating IEX, Katsuyama and his team knew they couldn’t ban HFT on their exchange. But they could take preventative measures against the tactics HF traders used to exploit investors.
|IEX vs. Regulation|
While Lewis praises IEX for fighting HFT, some critics note that in doing so, he perpetuates the idea that stock exchanges will correct themselves without regulation. Critics believe that regulating bodies like the SEC—not exchanges or traders—should be responsible for keeping up with changes in stock trading—especially for something as influential as HFT—and taking actions to protect investors. Experts have suggested a small tax on every trade, called the Tobin Tax, that would have little effect on regular investors but deter HF traders by reducing the margins they make on their frequent trades.
However, Lewis and critics seem to agree on the fact that while the SEC should regulate HFT more, they’re not—and if they are, they’re acting too slowly. In 2021—seven years after the book’s publication—the SEC began considering new mandates for HFT firms that would require them to report all of their trades and to be subject to periodic exams. Lewis praises the IEX team for their actions in spite of the SEC’s failure to do so.
Solution 1: Counteract Speed Advantages
What does the IEX company do to fight against HF traders manipulating latency times? It increased the amount of time it would take for any investor—including HF traders—to access the exchange’s market. To do this, they moved their “point of presence,” or a point where traders connect to an exchange, 10 miles away from their matching engine in New Jersey and coiled the cable between the two locations to lengthen the time it took to get a signal from one to the other. In doing so, IEX created a 350-microsecond delay that slowed down HF traders accessing their exchange and therefore allowed IEX to interact with other exchanges at the same time as HF traders, instead of behind them.
Solution 2: Investors Can Request Banks Send Orders to IEX
Lewis explains that the IEX company wanted to prevent the banks from allowing customers’ orders to sit unfulfilled in the dark pool. IEX thus encouraged investors to request that their orders be sent to IEX.
However, many banks initially resisted these requests, as they didn’t want to send IEX the business nor did they want to decrease trading volumes in their own dark pools, as high volumes improved their statistics.
To solve this problem, Katsuyama met with a group of influential investors and explained to them exactly how banks had been exploiting them so that they would put pressure on their banks to send orders to IEX. He also met with Goldman Sachs executives and showed them that they would never be able to compete with HFT firms and their advanced algorithms. As a result, Goldman Sachs managers began directing their orders to IEX.
Solution 3: Eliminate Rebates
As their next solution, IEX eliminated rebates. What the IEX company did was charge the people involved in both sides of the trade $0.009 per share. This approach differed from the previous model, which charged one side of the trade and paid the other a rebate, thus removing HF traders’ ability to use rebates to predict where investors would sell orders and then get there first.
Solution 4: Three Order Types
To reduce information baiting, Katsuyama and his team limited the number of order types to three, as opposed to the 150 offered by other exchanges at the time. Lewis argues that fewer order types made trading more straightforward, encouraging investors who actually wanted to buy and sell stocks to trade with IEX. By limiting the number of order types, IEX prevented HF traders from baiting information out of investors: HF traders had fewer ways of determining which stocks an investor wanted or how much an investor was willing to pay.
Solution 5: Publish Trading Rules
To counteract the secrecy of dark pools, the IEX company published the trading rules they use for their matching engine. They also showed what order types they allowed on IEX, as well as whether or not any other investors were given special access to their exchange. They hoped being transparent would build investor trust and encourage other exchanges to do the same.
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Like what you just read? Read the rest of the world's best book summary and analysis of Michael Lewis's "Flash Boys" at Shortform .
Here's what you'll find in our full Flash Boys summary :
- Why high-frequency trading (HFT) is a threat to your investments
- A look at Wall Street’s greedy response to HFT
- How Canadian trader Brad Katsuyama tried to fight the problem