On September 2, 2016, the Investors' Exchange, LLC (IEX) commenced full operations as a registered national securities exchange. After receiving over 400 comment letters during the The U.S. Securities and Exchange Commission’s (SEC) review and a spirited debate on equity market structure, the SEC approved IEX’s application to become a national securities exchange on June 17, 2016.1 As highlighted in the widely read book Flash Boys, by Michael Lewis, IEX employs a speed bump or delay on market participants accessing liquidity on IEX (IEX access delay).
Contemporaneous with approval of IEX as an exchange, the SEC adopted interpretative guidance that would allow an exchange to impose certain delays in access its quotations and still have such quotations remain “protected” within the meaning of Regulation NMS (Interpretive Guidance).2 The adopted Interpretive Guidance will allow quotations on IEX to be treated the same as quotations on any other automated exchange despite the IEX access delay. Other exchanges, such as the Chicago Stock Exchange, Inc.,3 the NASDAQ Stock Market LLC,4 and the New York Stock Exchange LLC (NYSE) and its affiliated exchanges,5 have announced that they are contemplating adoption of intentional access delays of their own.
The summary below provides a brief overview of the SEC’s Interpretative Guidance and highlights some of the unique features of IEX.
IEX’s Access Delay and the Protected Quotation Debate
The IEX access delay requires IEX exchange members to connect to IEX through an IEX “Point of Presence”(IEX POP) that imposes a 350 microsecond delay or speed bump on member communications sent to the IEX trading system. The IEX POP also imposes an additional 350 microsecond delay on communications from the IEX trading system back to members, resulting in a total round trip delay of 700 microseconds for an IEX member to receive acknowledgment of how its order was handled (e.g., executed, posted, rejected, etc.). The stated purpose of the IEX access delay is to equalize access among IEX members and prevent an individual IEX member from having a speed advantage over others in accessing quotations on the IEX.
Prior to adoption of the SEC’s Interpretive Guidance, an exchange may not have been permitted to impose an intentional delay in access to the exchange’s quotations while still having those quotations considered to be “protected” under Regulation NMS and accompanying guidance. In general, if a quotation is considered protected, other trading centers must honor that quotation by not executing trades at inferior prices, also known as “trading through,” the protected quotation pursuant to the SEC Rule 611 (the Order Protection Rule).6
In other words, if an exchange’s quotes are considered protected and represent the national best bid or national best offer (NBBO), i.e., the best available price to buy or sell a particular security, market participants must generally either match that price in executing trades in that security on other trading centers or route to execute against the protected quotation on the exchange displaying it. If an exchange’s quotations are not considered protected, market participants may be able execute trades at inferior prices to those displayed on that exchange.7 Accordingly, without protected quotation status, IEX would likely have been a less attractive venue for market participants to submit aggressively priced quotations, i.e., those at or better than the NBBO, because market participants have ignored these quotations.
Under Rule 600 of Regulation NMS a protected quotation must be, among other things, an “automated quotation.”8 An “automated quotation” generally requires that a quotation “immediately and automatically” execute, cancel, transmit a response to the sender, or display updated information regarding the quotation.9 In adopting Regulation NMS in 2005, the SEC explained that “[t]he term ‘immediate’ precludes any coding of automated systems or other type of intentional device that would delay the action taken with respect to a quotation.”10
In order to accommodate IEX’s goal of having protected quotations, the SEC proposed interpretive guidance on March 18, 2016, that would have provided that intentional delays of less than one millisecond are de minimis and would not impair a market participant’s ability to access a quotation.11 The SEC stated, at the time, that adopting this proposed guidance “could encourage innovative ways to address market structure issues.”
SEC’s Adopted Interpretive Guidance on Automated Quotations
In adopting the Interpretive Guidance, the SEC backed away from the originally proposed one millisecond standard for intentional delays that could still allow quotations to be considered automated and therefore protected. Instead, the SEC adopted a more qualitative standard that may change over time as technology evolves. The SEC stated that it believes it is necessary to update its interpretation of the term “immediate” in Regulation NMS in response to technological and market developments that have occurred over the last 10 years.
Specifically, the SEC will assess whether an intentional delay is “so short as to not frustrate the purposes of [the Order Protection Rule] by impairing fair and efficient access to an exchange’s quotations.” Thus, if an intentional delay meets this standard, the intentional delay will be considered de minimis and therefore “immediate” for the purposes of SEC Rule 600(b)(3) (defining “automated quotation”) and the Order Protection Rule. In other words, quotations for which there is a de minimis intentional delay in access will still be considered immediately accessible and therefore an automated quotation that is protected. The SEC will consider each access delay proposed by an exchange individually to determine whether it meets the de minimis standard.
The SEC has also committed to conduct a study within the next two years to understand the effects of access delays on market quality and may reassess its guidance in light of its findings.
Notable Features of IEX
Employing the standard described above, the SEC granted IEX protected quotation status noting that, because the IEX access delay is "well within geographic and technological latencies experienced today that do not impair fair and efficient access to an exchange’s quotations or otherwise frustrate the objectives of [the Order Protection Rule] . . . an intentional 700 microsecond delay is de minimis."
With approval of IEX as an exchange with protected quotations, IEX will operate with the same status as other electronic exchanges. However, IEX also offers a number of unique features that distinguish it from other exchanges, the most significant of which are described below:
- IEX Access Delay – As noted, all IEX members access IEX through the IEX POP. The IEX POP is located 38 miles from the IEX matching engine and adds 350 microseconds of intentional delay to all incoming and outgoing messages. This equates to a 700 microsecond roundtrip delay with respect to the handling of an order by IEX (e.g., 350 microseconds for an order to reach IEX and 350 microseconds for IEX to send a response notifying the member that the order was executed, canceled, posted, etc.).
- The IEX Router – Orders eligible for routing to IEX will experience a longer delay than non-routable orders sent to IEX. Specifically, routable orders sent to IEX will experience a 700 microsecond intentional delay in executing against the IEX order book upon entry.12 This equates to a 1050 microsecond (1.05 millisecond) roundtrip delay with respect to the handling of the portion of the routable order sent to IEX (i.e., 700 microseconds to access IEX plus 350 microseconds to receive a response message from IEX). The portion of routable orders that are routed to away markets will only experience a 350 microsecond delay before the IEX Router routes to away markets.
- Discretionary Peg Orders – The Discretionary Peg Order is a unique order type that generally operates by posting to the primary quote (i.e., the national best bid for buy orders and national best offer for sell orders), where it rests non-displayed and, limit price permitting, will execute up to the midpoint of the NBBO. However, the Discretionary Peg Order will not exercise discretion (i.e., it will continue to rest on the primary quote) in the event that IEX determines that a quote is “crumbling,” which is generally measured by assessing the number of other venues that have fallen away from the primary quote over a given period of time. In other words, if IEX determines that the market may be moving against a Discretionary Peg Order, IEX will prevent the order from executing at a price worse than the primary quote until the market settles at a new price. The SEC recently approved a proposal by NYSE Arca to adopt a nearly identical order type.13
- IEX Pegged Orders – All IEX pegged orders (i.e., orders for which the price is pegged to a reference price based on the NBBO and that automatically adjust in response to changes to the NBBO) are non-displayed, including the IEX Discretionary Peg Order. In contrast to IEX, certain pegged orders on other exchanges are eligible for display. Additionally, IEX pegged orders are subject to the IEX access delay upon entry but will reprice in response to changes to the NBBO without further delay.
- Midpoint Price Constraint – On IEX, all non-displayed interest priced more aggressive than the NBBO midpoint price will be slid back to the midpoint of the NBBO. Thus, a non-displayed order will never rest on IEX at a price more aggressive than the midpoint. On some other exchanges, a non-displayed order could rest at a price more aggressive than the midpoint price and would only slide if the order crossed a protected quotation of an away market.
- Price Sliding – On some other exchanges, orders subject to price sliding are generally ranked at their limit price but are displayed at their slid price. On these other exchanges, such orders will maintain order priority at their ranked price. On IEX, orders subject to price sliding are both ranked and displayed at their slid price. Thus, on IEX, an aggressively priced limit order that was slid back would not maintain priority at its more aggressive limit price.
The approval of IEX and the SEC’s decision to now permit certain de minimis access delays to quotations may mark a shift in the U.S. equity market structure. While it is possible that widespread adoption of de minimis access delays of varying lengths could create a more complicated market structure and the resulting operational challenges cited by some commenters to the IEX exchange application, these delays may also act to curb certain high-frequency trading strategies such as latency arbitrage. Whether that in turn has a positive or adverse impact on market quality remains to be seen. Consequently, market participants are likely to eagerly await the results of the SEC’s two-year study on the effect of de minimis intentional delays.
1 See Securities Exchange Act of 1934 Release No. 78101, 81 FR 41142 (June 23, 2016).
2 See Securities Exchange Act Release No. 78102, 81 FR 40785 (June 23, 2016).
3 Dave Michaels, Chicago Stock Exchange Targets Rapid-Fire Traders with Speed Bump, Echoing IEX, The Wall Street Journal, (August 30, 2016), available at: http://www.wsj.com/articles/chicago-stock-exchange-targets-rapid-fire-traders-with-speed-bump-echoing-iex-1472591832.
4 Dave Michaels, Nasdaq Tries to Appeal to Investors Lured by New Rival IEX, The Wall Street Journal, (August 30, 2016), available at: http://www.wsj.com/articles/nasdaq-tries-to-appeal-to-investors-lured-by-new-rival-iex-1471213052.
5 Dave Michaels, NYSE Explores Next Move to Compete with Speed Bumps, The Wall Street Journal, (June 30, 2016), available at: http://www.wsj.com/articles/nyse-explores-own-speed-bump-to-respond-to-iex-its-president-says-1467331121.
6 17 CFR 242.611.
7 A broker-dealer executing a trade on behalf of a customer may nonetheless be required to honor a better priced quotation displayed on an exchange without protected quotations in fulfilling its duty of best execution.
8 17 CFR 242.600(b)(57).
9 17 CFR 242.600(b)(3).
10 See Securities Exchange Act of 1934 Release No. 51808, 70 FR, 37496, 37534 (June 9, 2005).
11 See Securities Exchange Act of 1934 Release No. 77407, 81 FR 15660, 15665 (March 24, 2016).
12 The longer intentional delay for routable orders sent to IEX appears to have been adopted in response to the concerns of commenters on IEX’s exchange application that the IEX router would have an unfair advantage over other market participants routing to away venues. Specifically, if a market participant were to send an order to IEX and wait for a response before routing the order to another venue, it would take 700 microseconds (i.e., 350 microseconds to reach IEX and 350 microseconds to reject the order back). If the market participant had used the IEX router prior to IEX adding the longer delay for routable orders, IEX would have routed the order immediately after receipt to another venue, saving 350 microseconds (i.e., the time it took to reject the order back to the market participant). By adding a longer delay for routable orders, the IEX router would not have a 350 microsecond head-start over other market participants routing orders to other trading centers.
13 Securities Exchange Act of 1934 Release No. 78181, 81 FR 43297 (July 1, 2016).
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