What You Need To Know About The Awesome New IEX Exchange

Most experienced investors have some idea about the significant structural changes that have occurred in the U.S. equity market over the last six to seven years.

Regulatory changes and new technology have opened the way for significant fragmentation in the trading of stocks.

Today, there are numerous electronic stock exchanges and dark pools, where investor orders are matched up. Among the most well-known of the 13 American stock exchanges are the NASDAQ, NYSE, NYSE Arca, BATS, and DirectEdge.

There are also dozens of dark pools run by investment banks like Goldman Sachs and Credit Suisse. In all, there are roughly 40 different dark pools that account for around 14 percent of all equity trading volume. This adds up to more than 50 different liquidity venues that make up the modern stock market.

This dispersion in stock trading has contributed significantly to the rise of high-frequency trading, which depends on ultra-low latency algorithmic trading strategies to essentially front-run slower investors thousands of times per day.

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An example of a common high-frequency trading strategy, that depends on being milliseconds faster than competitors, is as follows:

An institutional investor attempts to purchase Apple shares on a number of different exchanges at a limit price of $602.32. Because of the difference in physical distance between where the investor is located and where the different exchanges' servers are located, the buy order arrives at NASDAQ, BATS, and NYSE Arca at different times. The high-frequency trader's algorithms react to the buy order, which reaches NASDAQ first by going to the other exchanges and purchasing Apple shares at $602.31 -- and then turns around and sells them to the institutional trader at $602.32 in the blink of an eye.

This trader has just earned a penny per share in a risk-less transaction, because of their speed advantage over the institutional trader. Often this speed advantage is due to having co-located servers directly next to the exchange servers and superior computing and networking capabilities.

This type of high-frequency trading is predatory in nature, and adds up to billions of dollars in profits per year. Many strategies that have been employed in recent years are essentially legalized front-running.

The most absurd thing about this entire segment of the market, which is estimated to account for more than 50 percent of an average day's volume, is it has essentially become a technological arms race. The entire goal for firms is to shave milliseconds off of their execution times.

In the process, the fundamental purpose of the stock market -- to efficiently allocate capital to productive companies -- has been turned on its head. Readers who are looking for an extremely in-depth overview of the potential ills of predatory high-frequency trading, along with an up-to-date look at the industry, will want to read Michael Lewis' new book, called Flash Boys.

The exchange the people mentioned Flash Boys built is known as the IEX exchange -- and it's getting more popular by the day. Among IEX's early backers are institutional and hedge fund investors such as Brandes Investment Partners, Capital Group, David Einhorn's Greenlight Capital, Daniel Loeb's Third Point Partners and Bill Ackman's Pershing Square Capital Management.

Essentially, these institutional traders got sick and tired of being constantly beaten to the punch by high-frequency traders, or ripped off inside of big Wall Street banks' dark pools.

The IEX exchange, launched by IEX Group, operates under a simple set of published rules that completely neutralizes the advantages high-frequency traders have over ordinary investors on other exchanges. These include having a limited number of simple and familiar order types, charging fixed fees, ensuring that market pricing data arrives at external points of presence simultaneously, slightly delaying market pricing data to all customers, outlawing co-location and refusing to pay for order flow.

The exchange opened for business on Oct. 25, 2013 and has seen a steady increase in trading volumes. By April of this year, it was executing average daily volume of 58 million shares, making it the ninth largest out of 13 American exchanges -- not bad for a startup.

Cambiar Investors' Brian Barish told Bloomberg the IEX is the future of equity trading. “There are a lot of people interested in working on an exchange or dark pool that flash traders won't be involved with,” he said.

“As the volume builds, there's more value in executing there versus other places,” he added.

IEX Group's founder and CEO Brad Katsuyama, former head of electronic equity trading at RBC Capital Markets, is described in Lewis' book as being obsessively driven with creating a fair playing field in U.S. equity trading. From the perspective of an investor, it is hard to complain about IEX's results.

It also seems likely that the new stock exchange will just keep gaining in popularity. IEX Spokesman Gerald Lam told Bloomberg in an email that the exchange has "looked to provide the fairest trading experience for all of our participants and our volume growth reflects the quality of trading happening on the IEX market.”

Surprisingly, one of IEX's most important allies has been Goldman Sachs, a firm that has been at the center of high-frequency trading and dark pools.

Goldman's Sigma X dark pool is among Wall Street's largest. Nevertheless, IEX said in March that Goldman was the biggest broker on its platform. In a memo, the firm told employees "it would be best for the overall market if IEX achieved critical mass even if that results in reduced volumes" in its Sigma X dark pool. In April, a number of leading financial news outlets, including Reuters and the Wall Street Journal, reported that the firm is even considering shuttering Sigma X altogether.