Upstart IEX Holds a Candle Above Dark Pools

In Michael Lewis’s book <em>Flash Boys</em>, alternative trading system IEX is cast as a leader in demurking the high frequency trading waters.

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Financial pundit Michael Lewis’s latest book, Flash Boys: A Wall Street Revolt , has not caused a revolution in electronic stock trading, but it may have sparked a gradual move from the dark side.

Observers say there has yet to be a retreat from the anonymous electronic exchanges known as dark pools, despite Lewis’s portrayal of these venues as lairs of unscrupulous high frequency traders. Nonetheless the Securities and Exchange Commission is rumored to be debating limiting use of the pools. Meanwhile, New York–based buy-side-owned alternative trading system IEX Group, the semilit dark pool that serves as the hero of Lewis’s piece, is steadily gaining market share as Goldman Sachs Group and others throw their weight behind it, and one major rival has joined IEX in making its pool more transparent.

Last week news broke that the New York State Attorney General’s office has launched an investigative probe of firms that use dark pools, including Goldman Sachs, Barclays and Credit Suisse. The Federal Bureau of Investigation, the U.S. Department of Justice and the SEC are conducting their own investigations.

Estimates vary on the proportion of U.S. stock trading in dark pools, which don’t display orders on the public exchanges, but it’s likely more than one third of the total. Of the roughly 45 U.S. dark pools, 22 report volume data to research firm TABB Group. In March those pools reported average daily volume of 903 million shares, or roughly 13 percent of the 6.9 billion shares traded on public exchanges. The only dark pool volume data available for April — after the March 30 Flash Boys launch on the CBS news program 60 Minutes — so far comes from newcomer IEX, which reported average daily volume of 28 million shares, up from 19 million in March. That would have bumped Lewis’s protagonist, which only launched in October, up to 12th from 14th in the TABB Group’s March league table of dark pools. The leading pool, Barclays LX, reported average daily volume of 110 million shares in March.

IEX’s daily reports suggest that its volumes continue to grow. The firm has said it would convert into a public exchange once it reached 2 percent of the overall market volume. Its executives believe that goal is in sight, with its May tally at about 0.5 percent.

“If you look at the way in which our trajectory seems to run, month over month you kind of almost double,” says Ronan Ryan, IEX chief strategy officer and one of the main characters in Flash Boys. “I think you’ll find volume will continue to grow at a fairly rapid pace.”

Ryan does not ascribe his company’s growth in April to the book. He has, however, seen noticeable changes in his working life. “Almost every day, we’ve got a dinner that a broker sponsors, bringing 30, 40 firms,” Ryan says. “That’s something we didn’t command before the book.”

Lewis argues in Flash Boys that most dark pools — particularly broker-operated pools — were designed to feed high frequency traders with inflows from money managers. In Lewis’s telling, these pools were a lot darker for the banks’ conventional clients than they were for the lightning-speed computers working for automated-trading firms.

A high frequency trader “could front run an order in a dark pool on a bicycle,” is how Brad Katsuyama, the president and chief executive of IEX, puts it in Lewis’s book.

Lewis’s book is “going to push brokers and dark pool providers to explain who are the players, what are the rules [in their pool] and any schemes they are using to prevent gaming,” says Haoxiang Zhu, an assistant professor of finance at Massachusetts Institute of Technology’s Sloan School of Management, who has written about the role of dark pools in the stock market. “I think investors will push hard on that dimension. Trading venues bear the burden of proof to show that the rules of their markets are transparent.”

The week of April 28, POSIT, one of the largest non-broker-operated dark pools, run by New York financial technology firm Investment Technology Group (ITG), posted the confidential SEC form disclosing the government’s market rules on its web site. Of the other pools, this was something only IEX had previously done. On an earnings conference call May 1, ITG’s chief executive and president, Robert Gasser, said that this and other measures to increase transparency were a response to the newly stoked debate about market structure and reform.

Provisions in the SEC’s Regulation NMS, or National Market System, passed in 2005 and made effective in 2007, encourage electronic trading. Among them is Rule 611, also known as the Order Protection Rule, which protects the best bid and offer prices against traders’ bypassing an exchange for inferior prices. Dark pools, while long marketed as an alternative to exchanges, got a new shine after the promulgation of the regulations. Dark pools addressed the age-old institutional investor quandary: How do you buy and sell a large block of shares without moving the market against you when you post a bid or offer? The pool providers solved the problem by concealing the orders from the market until after trades were executed.

Traditionally, so-called upstairs brokers, who operate within broker-dealer firms rather than on exchanges, would negotiate deals on large blocks of shares, or the institution had to slice and dice the order. Either way, word inevitably leaked out that a money manager was in the market trying to buy or off-load a block.

A dark pool is a bit like a stock-trading version of online dating service Tinder for stocks, where users swipe right if they have any interest in the potential match on the smartphone screen. Orders are sent in anonymously and only interact with one another if they match up perfectly. If the order is not filled, it’s often canceled before anyone ever knew it existed.

As illustrated by Lewis, however, dark pools are also a favorite stalking ground for high frequency traders. Some of the more opaque HFT activities — such as latency arbitrage, which Lewis dubs “slow-market arbitrage,” and pinging, in which high frequency traders enter and cancel orders within a fraction of a second to try to get others to trade — are the most effective in dark pools. The first strategy relies on the quasiderivative nature of dark pool trading. As the pools do not publish their own bids and offers, many orders are priced according to bids and offers on the public exchanges. The dark pools set these prices according to data feeds they receive from the exchanges. High frequency traders use their warp speed and direct links with the public exchanges to arbitrage the infinitesimal lag between the stale price in the dark pool and the price on the exchange.

The second strategy described by Lewis takes advantage of the fact that money managers are less guarded about floating block orders in dark pools than they would be on a public exchange. As in the board game Battleship, the HFT firm’s algorithms torpedo small pilot orders into the pool until they reveal the presence of a supposedly invisible aircraft carrier of an order.

Not everyone — on Wall Street, at least — agrees the stock market is “rigged,” as Lewis attests, but many do agree with the Flash Boys author that it is too complex and “fragmented.” If regulators address fragmentation, they will have to consider dark pools.

Last month Terrence Duffy, chairman and president of Chicago-headquartered derivatives exchange CME Group, advocated to Bloomberg News closing down dark pools altogether. He argued that futures markets work more smoothly than the stock market because everything is transparent.

Some people have speculated that the SEC, rather than shutting down dark pools, will take another look at an idea it proposed in 2010 following the “flash crash” that May. This “trade-at rule” would have forced dark pools to route certain types of orders to public exchanges. The Financial Industry Regulatory Authority will soon require dark pools to disclose volume data in a standardized fashion.

“People are waiting to see what regulators want to do here about dark pools,” says one exchange’s spokesman, who didn’t wish to be named.

Goldman Sachs president and chief operating officer Gary Cohn argued in a March 20 op-ed in the Wall Street Journal that the fragmented electronic stock market was too unstable and required new regulations.

Goldman’s chief financial officer, Harvey Schwartz, said last month on the bank’s first-quarter earnings call that it had no plans to shut its dark pool, nixing speculation to that end. Nevertheless, the influential bank, known for crushing its competitors, has endorsed IEX. A recent internal document sent to employees of the bank’s equity unit spells out the bank’s position: “While we think that a regulatory response may be needed to address these market structure issues, we believe that it would be best for the overall market if IEX achieved critical mass, even if that results in reduced volumes in our U.S. dark pool, Sigma X.”

IEX originally was to call itself the Investors Exchange. Funded by an alliance of money managers and firms, including David Einhorn’s hedge fund firm, Greenlight Capital, the dark pool was designed to be the diametric opposite of those described by Lewis. It would be as equitable and transparent as possible with its rules, rather than paying rebates or selling flow, and it would equalize the HFT-bots’ advantages in speed.

All orders sent to IEX are subject to a what as known as a speed bump, in which order signals are run through a length of cable that slows them down for 350 millionths of a second before they are executed in the pool’s matching engine. That’s enough to ensure that HFT firms cannot flip shares as fast as required for controversial strategies like latency arbitrage to be profitable, according to IEX.

“38 miles of cable in a box: That is the buffer,” says Ryan. “Nobody else cares that it takes 350 microseconds to get to the venue. It’s totally irrelevant to anyone actually looking to invest and trade. But if you were running a strategy where you were used to collocating next to the engine so that you can get in there in a few microseconds, 350 microseconds then seems like a long time.” Ryan says that he has made IEX presentations to several high frequency trading firms. “Some won’t even take the meeting; some say their strategies won’t work here,” he says. Yet some HFT firms, such as Virtu Financial, which last month, amid the Flash Boys–induced furor, put off its plans for an initial public offering, are active in IEX.

“We’re not anti-HFT; we’re anti–predatory HFT,” stresses Ryan.

IEX’s popularity is more than a “Lewis bump,” says Zhu of MIT’s Sloan School. It’s an acknowledgment that, for a certain niche of traders at least, there are priorities higher than speed of execution, priorities such as security from gamers. “It reveals a preference,” he adds. “The fact that they [at IEX] do manage to attract order flows shows they offer something to investors that other dark pools do not.”

The market may be the better for it. “Market structure is important for investors,” says Zhu. “It’s actually a good thing that we all try to understand what’s going on. I do think the market structure debate in the end will prove to be fruitful and positive for the overall market.”