Brad Katsuyama: The next exchange

December 17, 2015 04:00 PM

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Brad Katsuyama burst onto the scene with the publication of Michael Lewis’ book “Flash Boys: A Wall Street Revolt” as the fair haired boy saving ordinary retail market participants from the evil high speed traders. Katsuyama, founder and CEO of IEX, launched his alternative trading system, IEX, on Oct. 25, 2013, with plans to create a competitive stock exchange. Two years later, IEX is close to becoming an exchange, so we thought it was a good time to catch up with Katsuyama. 

Modern Trader: Give us an update on your exchange application and IEX’s growth. 

Brad Katsuyama: I estimate we have grown 100% in year over year volume. We filed for exchange application [in October], since that time we have had $2 trillion in assets come in from investment managers so we are pretty pleased with how the exchange application has been received publicly. I don’t think asset managers have commented on an exchange application before, that is unprecedented and greatly appreciated from our side that a lot of those big names stood behind us. 

MT: How big is your market share?

BK: We crossed 2% on a daily basis [recently]. On average the last week or so has been about 1.75%, but it keeps trending higher. Volume has been growing and in August [we set a] record of 414 million shares. Prior to that our highest day was somewhere in the 
200 million range. It all is pointing in the right direction. 

MT: How did the August volatility affect IEX?

BK: We held our ground. ATSs tend to lose market share in volatile times because traders want to trade with more certainty, so they will trade on exchanges where they can see quotes. We actually maintained our market share, which is why we hit a lot of those records. People used us in those volatile times. [The volatile swings] put a magnifying glass on some of these issues, especially around the opening and closing auctions that you saw in NYSE and Nasdaq. It brought a lot of attention to IEX and how we could be a different kind of exchange. Aug.24 opened a lot of people’s eyes to some of the issues out there in the equity markets. Inefficiencies in systems are magnified in periods of duress, and at that time you saw a lot of people complaining about how the exchanges handled Aug. 24 and I don’t think they are wrong in their critique. 

MT: What problems did it highlight and where are you adding value in those types of stressful periods?

BK: You saw with NYSE and Rule 48 the delayed openings. The issue cascaded into ETFs and openings were delayed significantly. Until we are an exchange it is hard to say [how we will be different]. We have a lot of ideas but we have to wait until SEC approval to do that. There are definite ways that we feel that we can [differentiate from] the exchange model and how that can create a more orderly market. 

MT: BATs has complained to the SEC about your model that includes a “speed bump.” Is it a potential stumbling block? 

BK: It is a 350 microsecond delay. We can’t comment on that. We have to respond through the SEC. Nothing we have seen surprises us. When you look at who has responded positively and who has responded negatively, it is exactly who we thought. We are crafting our responses now. It will be some time in the next 30-45 days. 

MT: Speak to the issue of spoofing. Is there anything in your model that would prevent this type of activity? 

BK: In principle, the things that we have done at IEX are to ensure that we are incentivizing people who have an intent to trade. We are a market that looks to minimize some of the inefficiencies that we see in the market, minimize the number of order types, minimize the conflicts of interests, minimize the advantages sold by exchanges; by doing that you actually eliminate a lot of noise. As a result, we have a lot of people come into our market who have a real intent to trade. 

MT: Does the speed help avoid spoofing orders?

BK: What it does is it ensures that people do not respond to a change in the market before IEX can, which means that people cannot trade with advance knowledge of that information. It levels the playing field for fast and slow traders so there is less incentive for the faster traders to come in to the market. 

MT: Some traders feel that Michael Coscia  of Panther Trading may be a scapegoat as the larger HFTs were the ones claiming to be harmed. 

BK: What we see in that trial is that orders entered into the market should be bona-fide orders with an intent to trade. It sets an interesting precedent and I am not sure how regulators are going to sort it out. CFTC Chair Massad basically said, ‘if you are entering orders in the market without an intent to trade you better call your lawyer.’  That may make people think twice about some of the strategies out there. 

MT: Is it that simple?

BK: It is never that simple, but at the same time people have hidden behind the complexity of language. As that language becomes clearer, it does start to draw a line between what is black and what is white and right now we have a lot of grey. Rulings like this make it simpler. 

MT: Who has been signing up for IEX?

BK: We have all the major brokers; we have a small number of high speed traders that have signed up including Virtu. We have a good balance of users of our markets. There is still a fairly large portion of the market who aren’t trading on IEX. It will be interesting to see how that changes when we become an exchange. It has been a steady stream of brokers, about 170.

MT: Have you delivered what you promised?

BK: There have been studies by a number of brokers that consistently rate IEX among the highest quality markets they interact with. A lot of the validation of our market is coming from third parties. The second largest pension fund in Europe, PGGM, executed a large basket trade on our market, published the data basically saying the quality of execution on IEX was one of the highest they have seen. A number of different sources stated that what we designed and built is working exactly as we intended. 

MT: How does it work?

BK: If a client sends us an order that is routable, we will route it to another exchange, but if a client sends us an order that is not routable it will sit on IEX until it gets an execution. The biggest benefit of trading on IEX is because we are not selling co-location, we are not giving HFT traders a speed advantage on our market, a lot of those traders aren’t showing up. As a result of the interaction between our participants, it is more about individuals with natural trading interests as opposed to people who are trading because they have an advantage. By definition trading happening on a neutral playing field, more people will be pleased with the outcomes of those trades than would consistently be the one who are picked off. 

MT: Are you worried that you could lose this edge once you become an exchange?

BK: There are non-displayed orders on an exchange as well. Right now IEX is optional for people to trade but once you are part of the national market system, traders will be required to connect to us and route to us so that will help volume. Exchanges today have non-displayed functionality so orders don’t have to get displayed and that will still be on our market. 

MT: Would you like to see more rules on HFT?

BK: Our intent all along was for IEX to be a market-based solution. The rules that we were hoping for revolved around disclosure and transparency. We do think there are a lot of parts of the markets that aren’t properly disclosed to all participants, we think there are trading statistics that need to be standardized and disclosed; there are parts of this problem that can be solved just by making the market more transparent, providing more information and standardizing the information. [Too many rules] create many unintended consequences; regulations should focus on transparency and disclosure. 

MT: How do we get there?

BK: Creating standardized metrics that all trading centers have to report. Right now there is no way to measure execution quality across 50 marketplaces in the United States in a standardized way. That makes it onerous for asset managers and brokers looking for best execution. 

MT: When do you anticipate becoming approved as an exchange? How will it change things? 

BK: The biggest change is that the orders that we display will be protected under reg NMS, that definitely increases IEX’s value proposition. We are hoping to be approved sometime early in 2016. The value proposition increases and allows us to compete directly with the NYSE and Nasdaq. We definitely plan on being a disruptor in the exchange space. We have been competing with the ATSs—we’ve gone in two years from #40 to #3 [in terms of market share].

MT: Is the goal to reverse the fragmentation of equity markets?

BK: At IEX our goal is to have one exchange. NYSE has three, Nasdaq has three, BATs has four. With the goal of an exchange to match buyer and seller you’d think the best way to do that is to only have one. For us it is to be a central place where natural trading interests can meet on the fairest possible terms. That’s the goal and the best possible way to do that is for people to continuously try and meet at the same place. 

MT: Are market makers able to do that? Does that define the difference between good HFT and bad HFT? Are users actually providing liquidity?

BK: The right market makers can thrive on a single market. There are definitely some forms of HFT that benefit from 11 stock exchanges in the United States and there are some [for whom] that is a burden because they have to connect and buy market data from all these different places. The industry overall benefits from there being less markets and the markets that are remaining being more liquid. 

MT: Does your model by reaching out to “natural trading interests” attract “real” market makers? 

BK: If you build a market with a lot of natural trading interest, market makers will naturally want to go there. There is a role for market making in any marketplace, and it is not necessarily because there are 11 equity exchanges. It is not market making that benefits from 11 exchanges. 

MT: Are you referring to traders benefiting from different market structures?

BK: Without question. We call them structural inefficiencies. You build a market that is purposely inefficient and then you sell the ability for someone to monetize that inefficiency. 

MT: Will this reduce the market participants who aren’t truly adding liquidity?

BK: The more efficient the market, the less predatory trading there is because there aren’t these opportunities to pick up a signal someplace and race someplace else. The goal is to make a market simple, transparent and fair; the more that happens, ultimately you are weeding out some of the bad actors. 

MT: What is Virtu’s role on IEX?

BK: I can only comment about what they do on IEX. They are a market maker, they are adding liquidity a majority of the time. They are a large trader in ETFs, they are a large trader in inter-listed stocks and ADRs; they are playing the role that you would want an automated market maker to play. To their credit, when we talked about IEX and what we designed, from the very first day they said ‘we will participate in that market.’ I would compare that to a number of other HFT firms who refused to trade on IEX so it does say something about Virtu and it probably says something about the other folks who won’t trade here. About what their role is in the market and what they actually do. It is very convenient for people to call themselves market makers without ever having to actually prove that they are market makers. Virtu is proving that they are market makers. 

MT: Who is your largest customer?

BK: Our largest client in 2015 was Goldman Sachs.

MT: Is that customer flow or proprietary trading?

BK: It is a combination of both. 

MT: What is your goal for the first year? How much market share do you think you can gain?

BK: We haven’t stated that publicly so I can’t do that now but our goal is to be one of the largest exchanges in the United States, however long it takes us to do that.

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.