Finding the beauty in the markets' own processes of self-correction
Markets are truly wonderful things. When they work, they efficiently discover prices, assign value, impose penalties and reward results. Over time, they can also act as intelligent, self-correcting organisms.
Two elements are necessary for all that magic to happen. First, with competition as the driving force, all players must have an equal shot at rewards and be exposed to penalties based on their own choices and skills - so markets must represent a level playing field. Second, participants must believe the level playing field is real. Markets can be raucous, unsympathetic and blunt instruments, deaf to nuance, wrongly discounting the future, chasing immediate reward and avoiding current penalties. Price and value can become temporarily unhinged from one another before they come back into line again. That's what makes a market.
From time to time, however, markets get themselves muddled and a non-level playing field arises, parceling out gains and losses quite unequally. It often falls to governments, regulatory authorities and self-regulating organizations to try to correct those imbalances. But if they fail to act, the market itself wakes up and responds almost with a sense of self-preservation. And that's what's happening today, with IEX, the equity market established by Brad Katsuyama, formerly of RBC, and a bunch of mostly Canadian colleagues.
With backing from major buy-side firms, IEX has set out to counteract the imbalance that high-frequency trading (HFT) imposes on the markets. Launched in late 2013 after two years of planning, IEX shot to the top of public awareness in a well-orchestrated publicity campaign when financial journalist Michael Lewis' newest book, Flash Boys, rolled out in March 2014.
Proponents argue that HFT is the natural evolution of markets, harnessing technology to provide liquidity and drive down transaction costs to near zero - and there is an element of truth to that. As Katsuyama discovered - and as Lewis' book lays out - however, HFT as it has been implement and practiced tilts the field in three specific ways: electronic front-running, rebate arbitrage and slow-market arbitrage. To my mind, though, the most damning charge Lewis' book makes is that major brokers with HFT operations have used their own clients' order flow to their advantage - and to their clients' detriment.
The exchanges, which have colluded in this mess by selling privileged access to HFT computers located next to their own, have abandoned their self-regulatory function when it comes to this form of trading. The ills of HFT, from the flash crash to the allegations of front-running, have caused much hand-wringing but prompted little action from flummoxed regulators, uncertain how to respond.
Their hesitation comes in part because HFT resulted from a well-intentioned rule. Regulation National Market System, implemented by the SEC in 2005, directed traders to execute orders in whatever market showed the best price. This broke the quasi-monopoly that listed exchanges held and started the boom in dark pools and electronic communication networks - thereby opening the door to HFT.
Katsuyama, who ran the New York trading desk for RBC, partnered with several colleagues and figured out how to defend against high-frequency traders. Their seemingly counter-intuitive solution was to slow down order flow in IEX enough to neutralize HFT's advantages. They weren't trying to outsmart high-frequency traders, just to be as smart as they are (read Lewis' book if you want a full explanation).
In one of his media interviews, Katsuyama said he found it odd that he was able to sell trust and transparency as differentiators in a service business, but that is what he is offering. IEX stepped in to fill a void, creating a market where institutions could be confident that they were not being disadvantaged. If IEX is successful, it will make a lot of money along the way. Markets are wonderful things.
