As IEX Prepares to Become an Exchange, What’s at Stake?

Most financial professionals are by now familiar with IEX — the company profiled in Michael Lewis’ Flash Boys. IEX levels the playing field for US cash equity market participants by changing the nature of trade execution. Up until now, IEX has operated as a dark pool; the company has grown steadily and trades a modest but respectable 1.5% to 2% of US cash equity volume. Yet IEX has set its sights much higher and recently applied to become a registered US stock exchange. Next year — assuming IEX is successful with its exchange application — we’ll have an opportunity to watch a fascinating case study unfold before our eyes with far-reaching implications beyond financial exchanges. Here are a few questions to consider.

Should incumbents be worried?

IEX threatens to reduce three core revenue streams for incumbents: in the near term, cash equity trading fees; in the medium term, listing fees; and in the long term, various fees tied to the high frequency trading (HFT) industry.

The threat to trading fees is pretty straightforward: IEX isn’t growing the equity trading pie, so every trade that goes through its exchange would be a loss for its competitors.

The threat to listing fees will play out over a longer time horizon. In July IEX CEO Brad Katsuyama wrote that, while IEX won’t be ready to accept listings when it becomes an exchange, listings are key part of the company’s future plans:

“We are honored to be receiving significant inbound inquiries from public companies regarding our intention around listings and while our focus so far has been to build a market that better serves the investor, we strongly believe we can help issuers improve their experience with the markets as well.”

And as for those HFT fees…if IEX starts taking meaningful trading share, HFTs will end up fishing in a smaller pond. HFT revenues — along with spending on services like data and colocation, as well as overall profits — will suffer.

Losing share of a stable or even shrinking revenue pie presents a major issue for incumbents. Running an exchange at scale is a wonderful business with very high margins and great operating leverage — an additional trade on your exchange costs nothing. Yet that operating leverage works in reverse too.

Can the exchanges mount a competitive response?

Unsurprisingly, the exchanges aren’t keen on having another competitor join the playing field. Nasdaq and ICE (owner of the NYSE) both formally recommended that the SEC refuse to grant exchange status to IEX, with ICE going so far as to compare IEX’s offering to that of the fake non-fat yogurt store from Seinfeld.

Opposition aside, let’s assume IEX’s application is successful. Normally, when a new entrant threatens market share, an incumbent will consider launching a competitive response. In this case, it seems easy: anyone can recreate IEX’s famed “magic shoe box” designed to slow down HFTs or announce tomorrow that they will no longer sell certain services to HFT clients. The irony is, of course, that incumbents are handcuffed from launching a counterattack — the short term profit hit from abandoning their HFT clients would likely be too painful (remember that operating leverage?). Better to take the chance that this whole fair marketplace thing doesn’t catch on.

Can IEX establish brand equity?

Here’s where it gets really interesting. We’re used to associating popular consumer brands with trust, but I had never given much thought to the brand of an exchange. As a former trader, I didn’t really care where my trades were executed — there was no obvious differentiation. But IEX’s success or failure may offer key insights into one of the pillars of the broader FinTech industry: the importance of trust in making financial decisions.

The financial crisis severely damaged the reputation of major global banks, leaving an opening for new entrants to establish brands for a new generation focused not only on a better product and user experience, but also on integrity. Exchanges have also seen their images suffer in recent years for many reasons, including the role of HFTs and some high profile market “accidents” like 2010’s flash crash and the botched Facebook IPO. Above all, there is an incredibly strong perception that existing exchanges are not structured in a fair way for the average market participant.

Bloomberg’s Matt Levine articulated this brand opportunity as it relates to the listing business in his (as usual) excellent recent piece on IEX:

“It doesn’t matter that much where a company lists… a lot of the decision comes down to perception and symbolism… It’s a symbolism of being, you know, for investors. A lot of investors worry that the market is rigged and that high-frequency traders are a menace. Listing on the Investors Exchange says to those investors: We care.”

What’s next?

It’s difficult to handicap IEX’s odds of success as a stock exchange. That said, they have a huge tailwind: pretty much every non-high-frequency trader has a vested interest in seeing IEX succeed and increasing exchange competition. And the stakes are higher than US cash equities.

While IEX’s early investors may have been focused on developing a fairer US cash equity exchange, I suspect its more recent VC investors are thinking bigger — as is the IEX team. If IEX can gain meaningful share in equities, what about other asset classes or derivatives? Those areas have the potential to be even more lucrative businesses, are riddled with many problems of their own, and are also attracting the eye of regulators. As an example, consider CME Group’s monopolistic grip on the interest rate derivative market as discussed in Josh Brown’s recent insightful post.

Of course, it’s unlikely regulators will be able to solve these issues on a non-glacial timeframe…which brings me to a final point regarding IEX’s brand opportunity: can IEX step in to guard investors’ interests? A private market solution to regulatory — and, in particular, SEC — shortcomings? It gets even more interesting when you consider that IEX can be much more dynamic in responding to changing market environments. Investors are a greedy — er…smart and motivated — group of people. For every fix a regulator (or IEX) introduces, many well-incentivized traders are going to try and figure out how to get around it. IEX has the potential to respond much more quickly and creatively than regulators to whatever challenges may arise in creating a fair marketplace.

This, for me, is why anyone interested in FinTech should be excited for IEX’s exchange prospects, even if you have little interest in financial markets. Disrupting an entrenched oligopoly, establishing a brand/platform based on integrity, and potentially representing a clean private market solution to insufficient regulation…what’s not to like?