The average person today equates the term “snake oil salesman” with someone selling a product that they know does not work for the ailments they promote it for. What is less well known is that snake oil is a legitimate cure for some ailments. Snake oil is rich in omega-3 fatty acids, particularly the Chinese water snake, which was what 19th century Chinese immigrants used as a folk remedy. Interestingly, “Research since the 1980s has demonstrated the necessity—and efficacy—of omega-3 fatty acids. These acids not only reduce inflammation, such as arthritis pain, but also improve cognitive function and reduce blood pressure, cholesterol and even depression.”
Snake oil was first popularized by Chinese immigrants, who, while working in the old west, extolled its virtues as a cure. It is interesting to note that the snake oil they brought from home likely did work, as the Chinese water snake contained as much as 20% Omega-3 fatty acids. Unfortunately, the “old west version” was originally based on rattlesnake oil, which only had an 8.5% concentration of Omega-3, and dishonest peddlers sold variations which contained none. As a result, “in time, snake oil became a generic name for many compounds marketed as panaceas or miraculous remedies whose ingredients were usually secret, unidentified, or mischaracterized and mostly inert or ineffective.”
So, why am I comparing IEX to snake oil? To understand, let us review the history and value proposition of IEX.
IEX was started, to incredible fanfare, as the antidote to High Frequency Trading (HFT), which was demonized in Michael Lewis’s book, “Flashboy’s”. In that book, Mr. Lewis weaves together several stories which chronicle issues created by the rapid advance of technology in the equity markets. The main narrative, however, centered on founders of IEX and how they “discovered” that poorly architected routing technology resulted in information leakage and the failure to access displayed liquidity. At the core of their discovery was an understanding of the interplay of physics (the speed of light), routing technology, and network topology connecting the main datacenters housing the NYSE, Nasdaq and BATS exchanges in Mahwah, Carteret and Secaucus NJ, respectively. Some of the claims in the book, (particularly the claim that retail orders were being “front run”) were preposterous, but the book did identify two real issues: poor routing, and latency arbitrage.
Poor routing was described in detail in “Flashboys”, and, although the book oversimplifies the issue, routers would often handle orders poorly. HFT firms could see an execution on one exchange (BATS in the book) and use their speedy technology to get to the other exchanges before the balance of that order made it to the other exchanges. It is fair to say that IEX provides a solution to this problem. While it is not unique, they did implement a router that addressed this issue by timing their routing so that orders would arrive at multiple exchanges simultaneously. Thus, it is reasonable for IEX to claim that they provide some protection against HFT firms in this regard.
The second problem that the book describes is something it calls latency arbitrage (LA). Simply put, LA occurs when a trading firm accesses liquidity at a market center at a stale price, meaning a price that no longer exists, but the speed of light (or poor market data architecture) creates a delay in updating the quote and communicating that update to the market prior to an execution. IEX’s dynamic PEG (DPEG) Order type DOES help solve this problem for market makers and institutions within their dark pool with a matching engine that prevents executions when pricing data indicates an unstable quote. IEX users can use the DPEG to capture bid/offer spread, without the risk of trades being priced at a bid or offer that had already disappeared. This truly was an innovation in the dark pool space.
Unfortunately, however, IEX’s marketing has created the impression that its capabilities go beyond these two areas of value, and has used imagery and wording that seems to target retail investors. There are two problematic examples: 1) Posting of displayed orders; and 2) Routing of retail sized market orders.
Despite repeated requests from yours truly and others, I have never seen IEX show any statistics, or provide any rationale, how displayed limit orders on their exchange are protected from latency arbitrage. Displayed limit orders on IEX are processed in the same sequence as “price time” exchange matching engines. The only difference is that it takes longer to post an order or be informed of a trade that took place on IEX, because of the speed bump. If an HFT firm practicing latency arbitrage was trying to “pick off” displayed orders, (orders that are typically the last ones left at a price), they could access the IEX quotes as easily as any other exchange. Even though the HFT firm’s order would take 350 extra microseconds to get through, it would still occur before an IEX client, without HFT technology, could cancel their displayed order, since both would be subject to the same speed bump. I am working on statistical evaluation of displayed orders on all exchanges, so will stop short of making any claims about the execution quality on IEX for the moment. What is clear, however, is that the common conception that IEX is anti-HFT for everything they do, is simply wrong. More important, however, is IEX’s misleading marketing that encouraged the impression that it is, and the damage that has occurred to the retail investors who believed it.
Last year, I pointed out in both a commentary and an SEC comment letter, that IEX had explicitly solicited retail investors to route orders to IEX. They created a form letter for individuals to download on their website that would direct their brokers to route to IEX. This letter included language that instructed the retail investor’s broker that it would not be “required to make a best execution determination beyond this specific instruction”. (Meaning that IEX was well aware that the brokers would need to ignore their own best execution obligations in order to heed the client’s instruction).
At the time, I wrote that if all retail investors routed to IEX that it would cost a substantial amount ($600 million) to the retail community, but did not quantify what losses their actual clients incurred. I have now remedied that situation.
Courtesy of an expert new firm providing 605/606 and regulatory reporting, Best X Stats, I have been able to quantify how much money was lost by clients who routed market orders to IEX. In the full year of 2016, market orders sent to IEX cost their clients roughly $1.4 million on the executed shares and $3.7 million overall, relative to what they would have likely received had they been routed to Citadel or KCG. The difference between the two numbers is that IEX only executed roughly 36% of the shares from market orders routed to them. Had they executed the cancelled shares with the same execution quality, the excess cost would have been $3.7 million. Considering that there was no liquidity on IEX’s book in these situations, it is clear that the execution quality would have been worse than the average, so this is a very conservative assumption. This analysis is based on a direct comparison between the execution quality on market orders provided by IEX and what their clients would have received had they routed those orders to Citadel or KCG, whose execution quality statistics were substantially better. It is worth noting that there is no way to know what percentage of the market orders sent to IEX is from retail investors, but such orders are generally not used by institutions. (Institutions use limit orders) If a material percentage of these orders were not from retail broker dealers, then these numbers could overstate the problem.
When I published the first analysis, IEX claimed that it was unfair, since market orders were such a small percentage of their order flow. This claim, however, is completely irrelevant. They directly solicited retail investors to send them market orders, and, according to the BestXStats data, over 330 million shares of market orders were routed to IEX during 2016. Even if they did an exemplary job handling limit orders, the market orders sent to IEX, since they solicited those orders and never retracted that solicitation, would constitute a serious problem.
So, the only remaining questions are if this analysis is aberrant in any way and can we be certain that IEX knew about this issue? The answers are “no” and “yes”. The Effective divided by Quoted Spread (EQ) metric, which shows IEX’s poor execution quality for market orders, has been remarkably consistent. When I published my original commentary, based on 2015 data, the IEX EQ was in the range of 130%. In 2016, according to the data provided by Best X Stats, IEXs EQ also averaged over 131%. Since these stats are publicly available, IEX management had to be aware of the fact that investors would lose money by directing market orders to IEX.
There is even more direct proof, however. IEX management attempted to suppress my analysis when it first came out. Early last year, after publishing my initial analysis of their handling of retail flow, IEX’s chief counsel sent a letter to both the CEO and the general counsel of the public company I worked for (without even contacting me), demanding that the firm retract the analysis, accusing me (and my firm) of defamation. At the same time, they verbally threatened Markets Media for publishing that article, accusing them of defamation and demanded a retraction. While the firm and Markets Media DID pull the commentary, the analysis was confirmed to be accurate and was subsequently published as a SEC comment letter. Thus, the only person defamed was yours truly, as IEX’s unfounded accusation about my analysis earned me the discomfort of the executive suite of my employer. I will leave it to the readers of this note to decide if using such bullying tactics is reasonable behavior for a firm, whose stated mission is to provide “fairness and transparency.”
The FDA was created, in part, to prosecute snake oil salesman and stop their fraudulent marketing practices. The SEC was created to protect investors from fraudulent claims. Why have they not brought action against IEX for their direct marketing to retail when management knew that such orders would receive inferior execution quality? IEX’s response to my original commentary was to claim that market orders constituted less than 1% of their order flow, so should not matter. This is absurd, as the SEC recently fined Citadel $22 million for misleading clients on how they handled trades on less than .4% of the orders they received, despite delivering aggregate execution quality on those orders that was better than available alternatives. In that case, the issue was about failure to disclose, which is certainly true with IEX, but, retail clients sending market orders to IEX also suffered clear harm. The last difference is that Citadel ended the practice in 2010, well before the SEC action, while IEX has never publicly admitted to being an inappropriate venue for retail market orders. On the contrary, they continue to include language about directed orders in their FAQs and have posted a YouTube video, which extols IEX as a solution to Wall Street issues without any disclaimers. It uses retail imagery, makes claims about being “the simple answer”, and yet, does not disclose any downside risks to retail traders.
Thus, in my opinion, the SEC should order IEX to include specific disclaimers about both displayed quotes and their handling of retail investor orders. They should also be required to distinguish between dark pegged orders and displayed firm orders in all their marketing. In my opinion, it is truly a shame that IEX, which has delivered real innovation to the equity market along with a disruptive, investor friendly, policy agenda, has marketed their services in such a manner. Perhaps if they are forced to provide reasonable disclaimers attached to all their claims, the positive aspects of the exchange can be preserved, while limiting the damage caused to investors.
 Scientific American, November 2007, Cynthia Graber, “Snake oil really is a cure for what ails you, if that happens to be arthritis, heart disease or maybe even depression.” https://www.scientificamerican.com/article/snake-oil-salesmen-knew-something/
 Flashboys: A Wall Street Revolt, published March 31, 2014 by W.W. Norton & Company, ISBN 9780393244663.
 See FlashBoys: Not So Fast, Peter Kovac, 2014, Directissima Press, ISBN 0692336907.
 IEX’s router, from my perspective, seems to be similar to the RBC “Thor” router, which is designed specifically to avoid information leakage during sweeps.
 Although latency arbitrage is a higher risk in non-displayed venues, a risk of latency arbitrage does exist in displayed venues because of latency in the SIPS and direct feeds. But the point is that all displayed venues are similarly impacted by this risk and IEX’s speed bump does not mitigate it for its displayed liquidity unlike the DPEG impact on its non-displayed liquidity.
 Commentary on the Markit website and Markets Media was originally pulled and replaced with a formal SEC comment letter, as more fully detailed below.
 Based on IEX’s average EQ of 131.64% vs the average EQ of Citadel and KCG (52.335%) and the quoted spread from the 330,260,237 “605 covered” shares of market orders routed to IEX.
 IEX’s average EQ of over 131% is a blended average of price improved shares that interact with midpoint, shares executed with BBO liquidity on their book and routed shares. The routed component must, therefore, have a higher EQ and in this situation, IEX would have been forced to route the shares if the orders were to be fully executed.