Can IEX Really Challenge the NYSE and Nasdaq?

The new kind of stock exchange levels the playing field, but it still isn't bulletproof

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Unless you were trading Windstream Holdings, Inc. (NASDAQ:WIN) or Vonage Holdings Corp. (NYSE:VG) on Friday, you may not have even realized a new stock exchange has opened for business; those two tickers were the only two trading hands on this new trading venue as of its inaugural session.

Can IEX Really Challenge the NYSE and Nasdaq?You may be far more familiar with the exchange than you realize, however, as it’s the result of 2014’s hit book Flash Boys, which exposed the dirty world of high frequency trading and how the nefarious activity was screwin’ over the little guy.

Called the IEX, the alternative exchange poses a superficial threat the NYSE and to Nasdaq Inc (NASDAQ:NDAQ). The question is, does the entire premise of the IEX — computers that prevent high frequency traders from acting on information before smaller traders see it — have enough mettle to actually matter?

Probably not.

Introducing IEX

It’s not a simple matter for the average investor to get their head around, and even the professional traders who have read Michael Lewis’ Flash Boys aren’t entirely sure his assessment is completely on target.

His research allowed him to conclude that high-frequency-trading firms can “see” a large trade order from a major fund, like a pension plan on a traditional stock exchange, and then buy (or sell) that stock knowing there’s going to be pricing pressure in a certain direction just a few seconds later. This is made possible by tapping straight into the exchanges’ data feed (a privilege they pay for) rather than waiting for it to be piped through the Security Information Processor system. It’s not hyperbole to say these traders knew the outcome of a trade before it was made.

The IEX eliminates this advantage by routing its order data through miles and miles of fiber optic cable coiled up beneath the exchange building. The result? A 350 microsecond delay in the time it would normally take to receive a trade, act on it, and then publicly confirm it.

It’s not much, but it’s just enough to prevent high-frequency traders from placing and cancelling a trade in an effort to make the supply/demand look better or worse than it really is, or buying and selling from themselves — for no gain or loss — to raise apparent activity levels… practices called “spoofing” and “wash trades,” which paint a misleading picture of what’s going on with a particular stock.

For money managers with massive trades coming and going all the time though, the nickels and dimes add up to millions if not tens of millions of dollars per year. That’s why large firms that trade big positions are decidedly in support of the IEX. Or, maybe some of them wouldn’t. Whereas the NYSE and the Nasdaq offer rebates to some firms for providing liquidity — a revenue source for some of those firms — the IEX doesn’t offer rebates. It just charges lower prices.

As for the individual “ma and pa” investor, they won’t notice the absence of wash trades and spoofing on the IEX, nor will they care. They may get a slightly better price some of the time by routing through this new exchange rather than through the Nasdaq or NYSE, but the pennies (or penny) they may save will mostly go unnoticed; a simple limit order for them will make the IEX’s level playing field moot anyway.

Of course, the exchanges are far more worried about the big guy than the little guy. An estimated 90% of the market’s trades on any given day are institutional-level trades, and high-frequency traders are an even more important revenue source.

In that light, it’s no coincidence that both the NYSE and the Nasdaq petitioned the Securities and Exchange Commission to disapprove the new exchange, pointing out the delayed-by-design IEX violates an SEC rule requiring the dissemination of information as quickly as possible.

Impact on Nasdaq and NYSE

Kudos to exchange founder Brad Katsuyama for being willing to do something different, offering client protection when the NYSE and Nasdaq didn’t. It has already incited change from other exchanges — the Nasdaq is now looking to push some institutional traders’ orders to the front of the line if those traders agree not to cancel them immediately afterwards.

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Article printed from InvestorPlace Media, http://investorplace.com/2016/08/iex-challenge-nyse-nasdaq/.

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