Building an exchange – the hard way

IEX has officially been cleared to launch as a stock exchange beginning today, but how did this ATS, described as a “Crusader against the system” get this far?

It all started with a Canadian trader, Bradley Katsuyama, born in 1978 in Markham, Ontario. After graduating from Wilfrid Laurier University, he began work at the Royal Bank of Canada (RBC), and was later appointed global head of electronic sales and trading. It was at RBC that Brad discovered serious issues with predatory, high-frequency trading (HFT).

In about 2007 when Katsuyama was performing daily operations at RBC, he began to notice some irregularities with the stock market. When he attempted to complete a trade, the offer would vanish instantaneously. He soon realised this problem was not independent of his own system. Other traders on Wall Street were experiencing the same occurrences.

To investigate he hired computer engineering expert, Rob Park. Park and Katsuyama conducted several experiments that tested the issues they were facing at RBC. He soon came to realise that predatory high-frequency traders were manipulating the market, and he and many others were falling victim to vanishing orders.

According to Brad, he found out that the stock exchanges sell high speed data and high speed technology that allows computerized traders to see information and react to it before other people even know that it exists. Brad said: “Predatory HFT created a multibillion dollar class system of haves and have nots”.

After the discovery of the problems associated with HFT, Katsuyama, Park, and their team developed a tactical hybrid order router (THOR). Thor is an electronic trading platform that manages securities orders and avoids the harmful effects of predatory HFT. Thor had allowed Brad to process trades without issue, and gave him a tool to sell to investors, who were facing the same issues.

This is where Ronan Ryan, current president of IEX, came into play. In 2007, Ryan was working as a telecom specialist who set up technology provided infrastructure for trade execution to the biggest banks on Wall Street. Katsuyama had wanted to learn more about the issues he knew many were experiencing and heard about someone who knew how the entire electronic system worked.

Ryan was that someone. After meeting Ryan in 2009, and talking to him about the processes of electronic trading, Katsuyama brought him onto his team at RBC as head of electronic trading.

With his team complete, Brad was able to observe all of the individuals being affected by HFT, and even identified some very experienced investors that were falling victim to this style of trading.

This prompted Katsuyama to come up with the idea that would change his life forever. “Let’s just create our own stock exchange”.

His team had taken a leap of faith and finally came up with an idea that would not only change their careers, but the entire industry.

The team originally pitched the idea as an RBC owned exchange; however, they knew for an exchange to be truly open and fair, it had to be independent of any Wall Street institutions.

Thus IEX was born.

The new trading venue was created to allow investors the opportunity to engage in a fair and transparent exchange, free of the unfair advantages that HFT firms exploited elsewhere.

IEX was funded by a collection of mutual funds, hedge funds, and venture capital funds. All ownership went to investors who were not allowed to trade on the exchange. The team then brought on just over 30 talented and experienced employees to design the matching engine for the exchange. They used technology similar to Thor, that allowed for a time delay that would neutralise the effectiveness of latency arbitrage strategies on the exchange and create a fair playing field for all investors

They named the company The Investors Exchange, or IEX. It was first set up as an alternative trading system (ATS), a dark trading venue intended for large orders. When it finally opened, IEX traded over 568,000 shares on day one, and then in the first week, over 12 million.

As IEX grew, the firm stayed true to its founding principles. IEX did not allow colocation, so groups could not put their servers closer to the exchange’s matching engine to be able to access it faster than other market participants. The exchange also clarified it would prevent latency arbitrage, or manipulation of market prices at high speeds due to predatory HFT.

On June 17th 2016, the SEC approved IEX’s application to become a registered national securities exchange with its launch as a full exchange scheduled for 19 August. IEX now hopes to take on the likes of Nasdaq and NYSE, though it has a long way to go to compete with these giants. Current market share totals at 1.451% and its average daily matched volume is 93,809,082 at the time of writing.

There remain some overhanging issues, other major exchanges have been critical of Katsuyama and IEX, particularly since the publication of Michael Lewis’ exposé of HFT, Flash Boys, which details the work both Katsuyama and Ryan. The SEC has even seen threats of legal action over its decision to grant IEX exchange status, with other major exchanges saying its time delay system breaches rules for US exchanges.

No doubt there are many challenges ahead for IEX as it seeks to find its place among the big fish in the US trading platform business, but today’s launch as an exchange shows how one man’s quest for fairer markets has just become a much bigger issue for US traders.