By John McCrank
NEW YORK (Reuters) - U.S regulators may relax rules that require the fastest possible execution of securities trades, potentially helping upstart trading venue IEX Group's plans to become a full-fledged stock exchange.
IEX was described in author Michael Lewis' book "Flash Boys: A Wall Street Revolt" earlier this year as a place for investors to place buy and sell orders without worrying that they are being "front-run" by other traders whose order transmission speeds are faster than theirs.
IEX has put in place a "speed bump" – delaying incoming orders by 350 millionths of a second, or a thousandth of the time it takes to blink -- on its trading venue, letting it update prices faster than the fastest market participants can calculate them, so that high-frequency trading firms cannot use their speed advantage to front-run others.
The strategy has proved popular with investors, who have made IEX the 7th most used alternative trading system in the U.S. for the week of July 7, according to data from the Financial Industry Regulatory Authority. However, instituting any sort of trading delay clashes with current market rules for exchanges, which is eventually what IEX has said it wants to be.
The U.S. Securities and Exchange Commission may decide to revisit the rules, keeping with its stated goal of protecting investors, while allowing IEX to keep its speed bump when it becomes an exchange, according to a person familiar with the SEC's thinking.
Though the commissioners will make a decision only after IEX applies to become an exchange, the SEC is likely take into consideration that the high-speed trading phenomenon and the proliferation of such firms took hold only after the rules were written in 2005, the person said.
IEX and the SEC declined to comment on the use of speed bumps and their legality under the current exchange rules, called Regulation National Market System (Reg NMS).
OPPORTUNITY AND FLEXIBILITY
The regulator's willingness to consider altering the rules underscores growing worries about the potentially disruptive effects of high-frequency trading. High-speed computerized trading has been around since at least the late 1990s and has become a dominant force in the markets since then, accounting for more than half of all trading in U.S. stock markets.
Supporters of high frequency trading say these firms provide essential liquidity to stock markets, as they always stand ready to buy and sell stocks. They say the ability of such firms to quickly spot and act on price differences across markets and asset classes creates a more efficient market.
But critics say ultra-fast trading leads to unfair markets. In his book, Lewis said that it creates a two-tiered system, where the fastest firms can effectively front-run slower traders. IEX's speed bump was featured in the book as a way to counteract potentially harmful speed advantages.
Several regulators have said they have active investigations into high-speed and automated trading, including the SEC, the New York State Attorney General, the Commodity Futures Trading Commission, and the Federal Bureau of Investigation.
In a June 5 speech, SEC Chair Mary Jo White questioned whether the pursuit of speed in the markets has gone beyond the point of benefiting investors and whether current rules are getting in the way of trading venues designing systems to level the playing field.
"A key question is whether trading venues have sufficient opportunity and flexibility to innovate successfully with initiatives that seek to deemphasize speed as a key to trading success in order to further serve the interests of investors," White said. "If not, we must reconsider the SEC rules and market practices that stand in the way."
In a statement to Reuters, IEX Chief Operating Officer John Schwall said, "We endorse SEC Chair White's recent statement that 'secondary markets exist for investors and public companies, and their interests must be paramount,' and continue to make that the focus of what we build at IEX."
AHEAD OF ITS TIME
Since launching in October, IEX has said it aims to create what it sees as a fairer, less complex market, while operating within the current set of market rules.
The rule in question is a section of Reg NMS about automatic quotations. It says exchanges must give trading firms the option of immediately canceling orders that are not immediately filled. The term "immediately", it says, "precludes any coding of automated systems or other type of intentional device that would delay the action taken with respect to a quotation."
Further, the rule says that to qualify as "automatic," "no human discretion in determining any action taken with respect to an order may be exercised after the time an order is received" and "a trading center's systems should provide the fastest response possible without any programmed delay."
About five years ago, Nasdaq OMX Group ran up against the same rule when it sought to include a speed bump in one of its trading venues, called PSX, according to a former Nasdaq employee who was involved in those discussions.
Nasdaq nixed the idea after a presentation to the SEC, where the regulator directed the exchange operator's executives to the rule, which appeared to conflict with an exchange using such a device, this person said.
Nasdaq declined to comment.
IEX has already grown bigger than PSX -- IEX said it handled a record 122.1 million shares on Tuesday, for a 0.9 percent share of all U.S. trades. PSX's market share was closer to 0.5 percent, according to BATS Global Markets data.
The source familiar with the SEC's thinking on the matter said PSX may have been ahead of its time. The regulator now will likely look at the IEX case with the perspective that Reg NMS was written some 10 years ago, the source said.
(Reporting by John McCrank. Editing by Paritosh Bansal and John Pickering)