The U.S. Securities and Exchange Commission proposes, enacts, and enforces America's securities laws and regulates the nation's stock and options exchanges.
Or... that's what it's supposed to do.
In practice, the SEC proposes and enacts overly complicated rules with loopholes big enough to drive dump trucks through, then selectively enforces those rules and regulations. It fosters competition among exchanges and "dark pools" and lets their private operators manipulate customers.
But right now, the SEC has a big opportunity to level the playing field for investors like you. One firm has proposed a "tiny" solution to the huge problem that high-frequency trading (HFT) poses to individual investors, challenging the way every other stock exchange does business.
But Wall Street's heavy hitters - especially the "Flash Boys" - are lining up to voice their opposition, demanding that the SEC continue to allow them to profit by front-running millions of trades per day.
Will the SEC allow this company to revolutionize how stock exchanges are run... or will it once again side with the big banks, hedge funds, and HFT companies?
We're about to find out...
A New Exchange Could Be the SEC's Worst Nightmare
As if 11 SEC-regulated stock exchanges in the United States weren't enough (and that doesn't include dozens of privately run dark pools), yet another company has filed an application with the SEC for registration as a National Securities Exchange.
The company is Investors Exchange LLC (IEX)... and it's the SEC's worst nightmare.
That's because IEX is challenging the way the SEC has allowed every other stock exchange to conduct business.
Which is the wrong way (I'll tell you why) - but an incredibly profitable way for the exchanges, for discount brokerage houses, and for the mega-profitable HFT desks at big banks, hedge funds, and listed HFT companies.
(Yep, you got that right. High-frequency trading is so profitable that stand-alone HFT trading companies have listed their shares for trading on national exchanges. Kind of ironic.)
IEX, which as a private company started executing customer orders in 2013, was prominently featured in Michael Lewis' bestselling 2014 book "Flash Boys: A Wall Street Revolt."
In the book, Brad Katsuyama, who founded IEX, is David going against the Goliaths of the HFT universe, all of whom have been coddled (I'm holding back the words I really want to use) by the SEC.
Katsuyama says HFT shops have an unfair advantage over everyone else because they have faster access to all related trading data.
He's absolutely right.
This Tiny "Speed Bump" Is a Huge Threat to High-Frequency Trading
IEX doesn't use high-speed access to trade on behalf of its customers or itself. In fact, its business model does the opposite - it actually slows down orders coming into the IEX platform, as well as the data going out.
By slowing down orders by 350 microseconds (a microsecond is one millionth of a second), IEX levels the playing field on its exchange platform so that super-fast HFT machines can't front-run everyone else's orders on its platform.
This causes a huge problem for HFT players, who are able to game the system because of their ability to read data and act on it faster than everyone else.
If IEX can level the playing field, it will draw a lot of business away from other exchanges and dark pools that let HFT shops read all their incoming data and trade against it.
Now the SEC has to decide whether to "sanctify" IEX by letting it become a National Securities Exchange, and in so doing threaten the profitability of high-frequency trading.
David vs. HFT Goliath
Of course all the big HFT shops have lined up against IEX with its annoying little "speed bump."
Citadel LLC is a huge alternative asset manager (or hedge fund complex), a big HFT player, and the firm that executes trading orders coming from Charles Schwab and TD Ameritrade, to name just two of its discount brokerage clients.
The company wrote a 12-page "comment" letter to the SEC challenging IEX's application.
While the Citadel letter makes several good points, every negative they point to can easily be overcome, and probably will have to be. While that's more of a reflection of IEX's less than thoroughly fleshed-out application, most of what's in the Citadel letter is just plain nonsense.
The main premise of Citadel's letter is this: IEX's application should be denied because by intentionally delaying the flow of orders and trading data via its "IEX access delay" (its "speed bump"), IEX is breaking the SEC's NMS (National Market System) rules 600, 610, and 611.
And Citadel is right.
But here's the thing...
The SEC allows all kinds of wolves into the henhouses it's supposed to protect because it makes everyone a lot of money, even if it disadvantages a lot of big investors and technically undermines capital markets, trading platforms, and the entire system.
On account of the fact that there are so many competing venues where trading orders can be executed, exchanges and other platform providers began to offer rebates on execution charges and pay to have orders directed to them, in order to win business.
All of which the SEC allows.
That works out well for discount brokerages, which don't have their own execution desks and ship their orders out to be executed. Middlemen pay discount brokerages for their order flow (which lowers customer brokerage fees) so they can "see" their customers' orders and direct them to where they get paid to send them.
And the SEC is fine with that.
The problem is all those orders are sent all over the place, and before they even get to where they're going, they can be intercepted by super-fast HFT computers that have the ability to know what the orders are (which means they know how those orders will affect prices) and can trade ahead of them, trade against them, or get out of the way if they have their own orders in transit that would be disadvantaged by trades about to be processed.
In other words, there's a "latency" problem. Not all players get order information or execution data at the same time.
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Everyone who doesn't have access to those computers (like you and me) has that latency problem. But it's our problem because the SEC let HFT shops put their servers next to exchange servers and let them front-run everyone's orders on account of being able to see them before they get to where they're going.
In short, HFT traders have this advantage because other market participants have latency problems, which the HFT computers created. And now HFT players are saying IEX will disadvantage them by intentionally delaying data because it creates a similar latency problem for them.
Yeah, it's that crazy out there.
The craziest thing is the SEC has let all this happen because it makes money for so many of the players it regulates, all of whom who spend a fortune lobbying Congress to make sure the SEC serves their profitability rather than the public interest.
If the suits at the SEC kill IEX's application, we'll know exactly who their masters are.
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About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.