April 21, 2014 / 7:26 AM / 5 years ago

IEX'S exchange plan stirs U.S. stocks queue jumping argument

NEW YORK (Reuters) - For more than a decade, queue jumping by traders has been a big no-no in U.S. stock market, prevented in the name of fairness. Now, an upstart trading platform has revived a debate on whether it may be just what markets need to become more transparent.

IEX Group, which recently featured positively in Michael Lewis’ new book on high frequency trading, “Flash Boys: A Wall Street Revolt,” gives brokers trading in its dark pool, an off-exchange trading venue, the first shot at trading against orders that come from their own firms. That occurs even if someone else had placed a bid at the same price before them.

On U.S. stock exchanges, such as the New York Stock Exchange, bids at the same price are executed in the order they are received, with the first in being the first served.

IEX harbors ambitions to become a regulated exchange. And the expectation has set off a debate in the industry about whether the U.S. Securities and Exchange Commission would - and should - allow IEX to continue to offer brokers preferential treatment if it were to become an exchange.

IEX and other proponents for the change say allowing exchanges to give brokers priority in trading against their own order flow would help bring more trading to public stock markets and reduce fragmentation of the marketplace, both issues of increasing concern for investors and other market participants.

Almost 40 percent of U.S. equities now trade away from exchanges, in dark pools and other off-exchange platforms, up from around 16 percent six years ago. Because these trades are not reported until after they take place, some academics believe the quality of price discovery and other market information is now being compromised.

Further, the U.S. market has become much more complex, with 13 exchanges, around 45 private dark pools, or alternative trading systems (ATS), and as many as 200 firms that internalize their orders, which means the broker matches the trade inside the firm.

If brokers get first dibs at trading against their own order flow in public markets, proponents of the move say, it would take away a major reason for them to go off-exchange.

The exchanges might be able to take back some of the volume they’ve lost in recent years. And for the brokers that operate dark pools and other off-exchange markets, being able to match their own client’s trades on an exchange - for free in the case of IEX - could present a cheaper option without running the risk of snafus that they could be blamed for.

“Does broker priority allow a certain form of queue jumping?

I guess you can say that,” said Matt Trudeau, head of product at IEX. “But the only other alternative is to create a private market to cross those shares - and that is how we ended up with 45 ATSs. This is a trade-off that seems to make sense for the good of the industry.”


Although there is no explicit rule against an exchange allowing brokers to jump the queue for their own order flow, they would need the SEC’s approval to do so.

A source familiar with the SEC’s thinking said if IEX intends to become a public exchange the practice might not pass regulatory muster.

The SEC has rejected attempts by both Nasdaq OMX Group Inc and the New York Stock Exchange, a unit of IntercontinentalExchange Group Inc, to put in place similar models in the past, according to sources familiar with the situation. Nasdaq and NYSE declined to comment.

According to the source close to the SEC, the regulator fears that allowing brokers to jump the queue would make markets appear unfair, and defeat the very purpose of having a public exchange. In other words, if brokers get the first dibs on their choicest orders, what’s in it for other market participants?

“It’s an exchange execution in name only - functionally it’s no different than executing it in the over-the-counter market,” the source said. “But in terms of rewarding people who quote on exchanges and contribute to exchange market quality, you are doing nothing.”

Further complicating matters, queue jumping has recently been associated with predatory forms of high-frequency trading, as well as the use of exotic order types, ultra-fast telecom links, microwaves, and even lasers to get in orders ahead of others.

The criticism of the high-frequency traders though, is that by being quicker to execute orders they can take advantage more quickly from news or from knowledge of order flow than those who have slower links. Allowing brokers to trade against their own order flow would be a different issue.


In 1996, when certain U.S. exchanges, like the Cincinnati Stock Exchange, were still allowed to offer broker priority, the U.S. Congress had the SEC conduct a study on the effects of the practice. The study, released the following year, found no proof that it had negative effects on the market.

But, the study added, the “findings should not be taken to mean that the Commission believes that such adverse effects may not arise in the future.”

One of the sources familiar with Nasdaq’s interactions with the SEC on the matter said that the agency appeared more receptive to the idea in recent months.

The possibility of such flexibility is evidenced by other moves by the SEC. When Nasdaq opened its third exchange in 2010, for example, the SEC allowed it to rank orders first by price, and then by size, rather than by the time they reached the exchange - another departure from existing practice.

Several big brokers and market makers, including Goldman Sachs Group Inc, Royal Bank of Canada and Virtu Financial, have already signed on to IEX’s platform, which was launched in October with the backing of fund companies and individual investors.

Around half a percent of all U.S. equities trade on IEX. Of that, less than 3 percent comes from brokers trading against their own orders.

IEX said it saw nothing controversial about giving brokers the chance to occasionally trade against their own orders, as they do it on their own private trading venues anyway.

“If the goal is to help buyers and sellers find each other, this certainly is a step in the right direction,” Trudeau said.

When asked about regulators’ fears of potential abuse of broker priority, Trudeau said the trading venue monitors closely for that.

IEX has dealt with other issues that appear to give an unfair advantage to some traders over others. To avoid high frequency trading firms from gaining an advantage over others because of their speed, for example, IEX has added electronic “speed bumps” to its marketplace and has only four order types, compared to hundreds on some other exchanges.

Proponents of the move also point to Canada, which has had broker priority on exchanges for years. Several industry executives cited that as a major reason why the Canadian market has seen much less fragmentation and managed to restrict the growth of dark pools. Dark pools have less than 5 percent of stock volume in Canada.

“The benefit of it, at least over here, is that it keeps more flow on the lit markets,” said Jos Schmitt, chief executive of Toronto-based exchange startup Aequitas Innovations Inc.

Editing by Paritosh Bansal and Martin Howell

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