Contrary to popular belief, the way to ensure workaday investors can deal fairly with high-frequency traders isn’t to speed up, but to slow down, says Ronan Ryan, chief strategy officer and co-founder of alternative trading system IEX.
IEX slows trades down by 350 microseconds to give institutional investors the chance to trade fairly against super-fast traders. Ryan worked at RBC Capital Markets in New York between 2009 and 2012. There, Ryan was head of the bank’s electronic trading strategy. His team’s work was profiled in Flash Boys, Michael Lewis’s book on high-frequency trading (HFT).
He says HFT isn’t inherently good or bad for the markets. It can provide liquidity across trading venues, but it can also be used to profit at the expense of traders who can’t act on bids or offers as quickly.
“We’re taking the battle out of the conversation about whether high-frequency is good or bad, is necessary or unnecessary. That’s not our fight — our fight is to create the fairest experience when you come to our trading venue,” says Ryan.
IEX opened for business in fall 2013. It now handles an average of 1.2% of U.S. equity market volume. While it’s currently an alternative venue to trade investments, Ryan says it’s larger than three of the 11 American exchanges. IEX is working on becoming a full exchange.
Ryan was in Toronto in early June speaking to portfolio mangers at the annual PMAC CEO dinner. He spoke to Advisor.ca about what he’s learned since starting a trading venue, why technology can ensure fairness and how HFT affects small investors.
Combatting predatory HFT practices by slowing down trades seems counter-intuitive. How does it work?
Ryan: We delay the acknowledgment of trades on IEX by 350 microseconds. That’s one-one thousandth of a blink of an eye. It means absolutely nothing to brokers like RBC, [or] to buy-side institutions, whether they’re long-only or hedge funds. It means absolutely nothing to low-latency market makers, but [it does] to someone who is trying to garner a signal, and use that signal to [his] advantage. So it negates the value of that signal to someone whose strategy needs to determine it in single-digit microseconds.
[The strategy could be] to get ahead of a large institutional order looking to buy a bunch of stock. Your intent is to buy it ahead of them and sell it back to them. I think anybody would say, “That’s not exactly fair, is it?”
No one on IEX gets an advantage over anyone else on IEX, but we’re still matching orders in a few hundred microseconds. We’re not saying, “Bring this back to the old specialist system.”
It’s been nearly two years since IEX opened. What have you learned since?
Ryan: [I’ve learned] that you need a mix of constituents on a trading venue. You need market makers, buy side and sell side. We want as many contra-interests as possible, and to that end we even allow high-frequency traders on IEX. It’s a matter of getting all the constituents of the market on our platform, monitoring, and then evolving if need be.
About 10 to 12 months after we launched, we noticed some behaviour [where] certain participants would trade against quotes on IEX a few milliseconds before the quote would tick one way or the other. For example, the stock may be trading at $10, so we have someone willing to buy stock at $10 on our venue. Suddenly, someone comes in and sells it to them at $10, and within three milliseconds (three one-thousandths of a second) we would see stock at $9. The [trader] was coming in and making a prediction that the stock was going to trade [lower] and they were trading against a quote on our venue that was about to become stale. [This strategy was being used less than 3% of the time.]
If the quote is going to change, someone [should] be willing to sell to you for cheaper. So as a [trader with this strategy] you try to plug someone at the midpoint, and sell to them knowing you can cover that sell a few milliseconds later.
[We created a new order type that pegs orders at the bid or the offer.] We will hold you pegged to the bid until the quote has changed because we don’t want you to express to the midpoint and get picked off.
Why is creating a trading venue the way to ensure fairness in the market, rather than regulation or another means?
Ryan: You need market participants to address the issue. The regulators somewhat get a raw deal, because they make a regulation, the regulation is arbitraged, and then people say [the regulators] didn’t know what they were doing.
[Regulators] should monitor venues like IEX and Aequitas that are trying different business models, to see how they address those issues. A lot of these issues revolve around technological fairness — giving people the same access to data at the same speed. When you look at those structural inefficiencies and you try to sort them out through technology, they are addressable. Basically, it’s fighting technology with technology.
One pro-HFT argument is it provides liquidity across an increasingly fragmented market. By creating IEX did you worry about adding to fragmentation?
Ryan: It is kind of ironic that we’re against fragmentation and in order to solve it, we further fragment the market.
In the U.S. you have over 50 venues in which you can trade stock. There are buyers and sellers in the market at the same time, but the buyers and sellers are not interacting with each other because they’re in fragmented pools, so there’s a lot of intermediation that’s mainly unnecessary.
When we worked at RBC, we found a solution to [protect clients from exploitative HFT strategies], but the solution was only usable when the client traded through RBC. When they traded through a different broker, we had no control. In order for us to affect change, we had to insert ourselves into this eco system, and to do that we had to create a trading venue.
We get asked quite often: Once you become an exchange, are you going to launch another exchange? We always answer: Why would we further fragment the market? We want buyers and sellers to come together on one market.
Are retail investors affected by HFT?
Ryan: [Yes, some are, like] Mom and Pop who have their mutual funds with companies like T. Rowe Price. In those instances, they’re susceptible to these practices because companies like T. Rowe Price aggregate all the buying and selling for thousands of people, so that when they’re entering the market, they’re entering the market with big orders.