In today’s stock market, the large stock exchanges often brag that spreads have never been lower and commissions have never been cheaper. The popular investing app Robin Hood even offers free trading, as do E-Trade and Charles Schwab.
The part of the story they don’t like to mention is the hidden tax on trades common in the market known as latency arbitrage. This is a practice that some exchanges facilitate for their high-speed trading clients in which these speedy computerized traders are sold high-speed, digital information about the direction of stock prices. They use this high-speed information to pick off unsuspecting investors and thereby profit at the expense of the other order.
This latency tax is costly. British financial regulators recently estimated that latency arbitrage costs investors $5 billion per year globally. Professor Marius-Andrei Zoican describes the problem this way: “The presence of latency arbitrage leads to a zero-sum race in trading execution which negatively impacts liquidity and harms execution quality for retail investors.”
Latency arbitrage is a costly tax on the market, a tax made possible by the enormous regulatory advantages exchanges receive. Only one of the 13 U.S. stock exchanges has proposed to do something about it with a new innovation called D-Limit.
IEX, the fintech startup profiled in the Michael Lewis book (and Netflix special in development) “Flash Boys,” has invented a new way of processing stock trades. The new invention is awaiting SEC approval. Traders who ask to have their orders processed as “D-Limit” orders can have their order shielded from the high-speed latency arbitrageurs.
The order links to a warning system installed on IEX’s exchange called the “crumbling quote indicator” or “CQI.” It’s like an air raid system that warns when high-speed predators are active in the market. The CQI indicator will trigger a process whereby D-Limit orders will automatically be repriced to foil the high-speed trader’s attempt to impose the latency arbitrage tax.
This private market innovation to the problems inherent in the SEC’s market structure regulatory system should be encouraged. Unfortunately, competitors who benefit from the current system have sought to delay its approval.
This solution to the latency arbitrage tax does not require a centralized, bureaucratic structure to oversee it; rather it is publicly filed and completely transparent. Neither does it require some nebulous new duty with attendant enforcement.
It simply creates a sophisticated, financial markets version of the home security system used by many homeowners. IEX has the economies of scale to afford the high-speed data and technology that most retail investors lack. And IEX is allowing everyday investors to rent those resources to achieve better prices when trading.
D-Limit also harnesses decentralized information in real time rather than relying on a less efficient, slow and centralized regulatory system.
This innovation has a unique coalition of supporters, from progressive group Better Markets, to Vanguard, to Goldman Sachs, to this author (a libertarian securities law professor at Antonin Scalia Law School). On the other side of the debate is a large competitor threatened by this innovation and some high-speed trading firms, and…that’s it.
A rival exchange and some high-speed traders offered comment letters with exaggerated and unsubstantiated claims of investor harm. Competitors alternatively suggested that not all of the anticipated benefits of this new order type have been fully proven. What major innovation in American history, from the telephone to the automobile, would pass that test for early approval?
The SEC should ignore the calls from competitors for the SEC to kill the new innovation. As horse and buggy operators warned of the dangers of the automobile and taxi cabs fought the widespread use of ride sharing with outsized claims of safety issues, rival exchanges similarly fought this new innovation.
But this innovation will either succeed or fail based on whether investors find it useful. The SEC should be encouraged to take a pro-innovation approach to regulatory approvals of these kinds of pro-investor innovations.
With this approval, the SEC can embrace a new mode of regulatory approval long sought in various aspects of technology policy, one that scholar Adam Thierer calls “permissionless innovation.” Safety warnings that are often either a result of excessive risk aversion by regulators or simply self-interested advocacy by competitors should give way to a pro-innovation philosophy for regulatory review of financial technology. This new innovation in stock exchange operation is a good place to start.
J.W. Verret is an associate professor at the Antonin Scalia Law School at George Mason University and a member of the SEC’s Investor Advisory Committee.