This is a long read but if you get bored...in a
nutshell, it explains how computers did high
speed trades that exploited the exchanges that
were physically farther away from the source of
the order...in other words, it took data longer
to get to them (milliseconds count), and in those
few milliseconds, the computer would exploit that
advantage to buy and sell shares of that
stock. The big houses were exploiting it big
time. It's an interesting read about using
technology to gain advantage, the ethics of which are perhaps open to debate.
John Lee
The Wolf Hunters of Wall Street
An Adaptation From ‘Flash Boys: A Wall Street Revolt,’ by Michael Lewis
By
<http://topics.nytimes.com/top/reference/timestopics/people/l/michael_lewis/index.html>MICHAEL
LEWISMARCH 31, 2014
Photo
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From left: Rob Park, Brad Katsuyama and Ronan
Ryan. Credit Stefan Ruiz for The New York Times
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Before the collapse of the U.S. financial system
in 2008, Brad Katsuyama could tell himself that
he bore no responsibility for that system. He
worked for the Royal Bank of Canada, for a start.
RBC might have been the fifth-biggest bank in
North America, by some measures, but it was on
nobody’s mental map of Wall Street. It was stable
and relatively virtuous and soon to be known for
having resisted the temptation to make bad
subprime loans to Americans or peddle them to
ignorant investors. But its management didn’t
understand just what an afterthought the bank was
on the rare occasions American financiers
thought about it at all. Katsuyama’s bosses sent
him to New York from Toronto in 2002, when he was
23, as part of a “big push” for the bank to
become a player on Wall Street. The sad truth was
that hardly anyone noticed it. “The people in
Canada are always saying, ‘We’re paying too much
for people in the United States,’ ” Katsuyama
says. “What they don’t realize is that the reason
you have to pay them too much is that no one
wants to work for RBC. RBC is a nobody.”
Before arriving there as part of the big push,
Katsuyama had never laid eyes on Wall Street or
New York City. It was his first immersive course
in the American way of life, and he was instantly
struck by how different it was from the Canadian
version. “Everything was to excess,” he says. “I
met more offensive people in a year than I had in
my entire life. People lived beyond their means,
and the way they did it was by going into debt.
That’s what shocked me the most. Debt was a
foreign concept in Canada. Debt was evil.”
For his first few years on Wall Street, Katsuyama
traded U.S. energy stocks and then tech stocks.
Eventually he was promoted to run one of RBC’s
equity-trading groups, consisting of 20 or so
traders. The RBC trading floor had a no-jerk rule
(though the staff had a more colorful term for
it): If someone came in the door looking for a
job and sounding like a typical Wall Street jerk,
he wouldn’t be hired, no matter how much money he
said he could make the firm. There was even an
expression used to describe the culture: “RBC
nice.” Although Katsuyama found the expression
embarrassingly Canadian, he, too, was RBC nice.
The best way to manage people, he thought, was to
persuade them that you were good for their
careers. He further believed that the only way to
get people to believe that you were good for
their careers was actually to be good for their careers.
His troubles began at the end of 2006, after RBC
paid $100 million for a U.S. electronic-trading
firm called Carlin Financial. In what appeared to
Katsuyama to be undue haste, his bosses back in
Canada bought Carlin without knowing much about
the company or even electronic trading. Now they
would receive a crash course. Katsuyama found
himself working side by side with a group of
American traders who could not have been less
suited to RBC’s culture. The first day after the
merger, Katsuyama got a call from a worried
female employee, who whispered, “There is a guy
in here with suspenders walking around with a
baseball bat in his hands.” That turned out to be
Carlin’s chief executive, Jeremy Frommer, who
was, whatever else he was, not RBC nice.
Returning to his alma mater, the University at
Albany, years later to speak about the secret of
his success, Frommer told a group of business
students: “It’s not just enough to fly in first
class; I have to know my friends are flying in coach.”
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Installed in Carlin’s offices, RBC’s people in
New York were soon gathered to hear a
state-of-the-financial-markets address given by
Frommer. He stood in front of a flat-panel
computer monitor that hung on his wall. “He gets
up and says the markets are now all about speed,”
Katsuyama says. “And then he says, ‘I’m going to
show you how fast our system is.’ He had this guy
next to him with a computer keyboard. He said to
him, ‘Enter an order!’ And the guy hit Enter. And
the order appeared on the screen so everyone
could see it. And Frommer goes: ‘See! See how
fast that was!!!’ ” All the guy did was type the
name of a stock on a keyboard, and the name was
displayed on the screen, the way a letter, once
typed, appears on a computer screen. “Then he
goes, ‘Do it again!’ And the guy hits the Enter
button on the keyboard again. And everyone nods.
It was 5 in the afternoon. The market wasn’t
open; nothing was happening. But he was like,
‘Oh, my God, it’s happening in real time!’ ”
Katsuyama couldn’t believe it. He thought: The
guy who just sold us our new electronic-trading
platform either does not know that his display of
technical virtuosity is absurd or, worse, he thinks we don’t know.
As it happened, at almost exactly the moment
Carlin Financial entered Brad Katsuyama’s life,
the U.S. stock market began to behave oddly.
Before RBC acquired this supposed
state-of-the-art electronic-trading firm,
Katsuyama’s computers worked as he expected them
to. Suddenly they didn’t. It used to be that when
his trading screens showed 10,000 shares of Intel
offered at $22 a share, it meant that he could
buy 10,000 shares of Intel for $22 a share. He
had only to push a button. By the spring of 2007,
however, when he pushed the button to complete a
trade, the offers would vanish. In his seven
years as a trader, he had always been able to
look at the screens on his desk and see the stock
market. Now the market as it appeared on his screens was an illusion.
This made it impossible for Katsuyama to do his
job properly. His main role as a trader was to
play the middleman between investors who wanted
to buy and sell big amounts of stock and the
public markets, where the volumes were smaller.
Say some investor wanted to sell a block of three
million Intel shares, but the markets showed
demand for only one million shares: Katsuyama
would buy the entire block from the investor,
sell off a million shares instantly and then work
artfully over the next few hours to unload the
other two million. If he didn’t know the actual
demand in the markets, he couldn’t price the
larger block. He had been supplying liquidity to
the market; now whatever was happening on his
screens was reducing his willingness to do that.
By June 2007 the problem had grown too big to
ignore. At that point, he did what most people do
when they don’t understand why their computers
aren’t working the way they’re supposed to: He
called tech support. Like tech-support personnel
everywhere, their first assumption was that
Katsuyama didn’t know what he was doing. " ‘User
error’ was the thing they’d throw at you,” he
says. “They just thought of us traders as a bunch of dumb jocks.”
Photo
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A facility in Secaucus, N.J., is home to some IEX
servers. Credit Stefan Ruiz for The New York Times
Finally he complained so loudly that they sent
the developers, the guys who came to RBC in the
Carlin acquisition. “They told me it was because
I was in New York and the markets were in New
Jersey and my market data was slow,” Katsuyama
says. “Then they said that it was all caused by
the fact that there are thousands of people
trading in the market. They’d say: ‘You aren’t
the only one trying to do what you’re trying to
do. There’s other events. There’s news.’ ”
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If that was the case, he asked them, why did the
market in any given stock dry up only when he was
trying to trade in it? To make his point, he
asked the developers to stand behind him and
watch while he traded. “I’d say: ‘Watch closely.
I am about to buy 100,000 shares of AMD. I am
willing to pay $15 a share. There are currently
100,000 shares of AMD being offered at $15 a
share 10,000 on BATS, 35,000 on the New York
Stock Exchange, 30,000 on Nasdaq and 25,000 on
Direct Edge.’ You could see it all on the
screens. We’d all sit there and stare at the
screen, and I’d have my finger over the Enter
button. I’d count out loud to five. . . .
“ ‘One. . . .
“ ‘Two. . . . See, nothing’s happened.
“ ‘Three. . . . Offers are still there at 15. . . .
“ ‘Four. . . . Still no movement. . . .
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“ ‘Five.’ Then I’d hit the Enter button, and
boom! all hell would break loose. The offerings
would all disappear, and the stock would pop higher.”
At which point he turned to the developers behind
him and said: “You see, I’m the event. I am the news.”
Photo
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While You Were Blinking
High-frequency-trading activity is not constant;
it occurs in microbursts. The line at the bottom
of this graphic is the stock-market activity
involving General Electric shares over 100
milliseconds (one-tenth of a second) at 12:44
p.m. on Dec. 19, 2013. The gray box magnifies a
five-millisecond window, during which GE
experienced heavy bid and offer activity and a
total of 44 trades. Credit Graphic: CLEVERºFRANKE. Data source: IEX.
To that, they had no response. Katsuyama
suspected the culprit was Carlin’s setup. “As the
market problem got worse,” he says, “I started to
just assume my real problem was with how bad their technology was.”
But as he talked to Wall Street investors, he
came to realize that they were dealing with the
same problem. He had a good friend who traded
stocks at a big-time hedge fund in Stamford,
Conn., called SAC Capital, which was famous (and
soon to be infamous) for being one step ahead of
the U.S. stock market. If anyone was going to
know something about the market that Katsuyama
didn’t know, he figured, it would be someone
there. One spring morning, he took the train up
to Stamford and spent the day watching his friend
trade. Right away he saw that, even though his
friend was using software supplied to him by
Goldman Sachs and Morgan Stanley and the other
big firms, he was experiencing exactly the same
problem as RBC: He would hit a button to buy or
sell a stock, and the market would move away from
him. “When I see this guy trading, and he was
getting screwed I now see that it isn’t just
me. My frustration is the market’s frustration.
And I was like, ‘Whoa, this is serious.’ ”
People always assumed that because he was Asian,
Brad Katsuyama must be a computer wizard. In
reality, he couldn’t (or wouldn’t) even program
his own DVR. What he had was an ability to
distinguish between computer people who actually
knew what they were talking about and those who
didn’t. So he wasn’t exactly shocked when RBC
finally gave up looking for someone to run its
mess of an electronic-trading operation and asked
him if he would take over and try to fix it. He
shocked his friends and colleagues, however, when
he agreed to do it, because A) he had a safe and
cushy $1.5-million-a-year job running the human
traders, and B) RBC had nothing to add to
electronic trading. The market was cluttered; big
investors had use for only so many trading
algorithms sold by brokers; and Goldman Sachs and
Morgan Stanley and Credit Suisse had long since overrun that space.
So Katsuyama was in charge of a business called
electronic trading with only Carlin’s inferior
software to sell. What he had, instead, was a
fast-growing pile of unanswered questions.
Between the public stock exchanges and the dark
pools private exchanges created by banks and
brokers that did not have to report in real time
what trading activities took place within them
why were there now nearly 60 different places,
most of them in New Jersey, where you could buy
any listed stock? Why did one public exchange pay
you to do something sell shares, say when
another exchange charged you to do the same exact
thing? Why was the market displayed on Wall Street trading screens an illusion?
He hired Rob Park, a gifted technologist, to
explain to him what actually happened inside all
these new Wall Street black boxes, and together
they set out to assemble a team to investigate
the U.S. stock market. Once he had a team in
place, Katsuyama persuaded his superiors at RBC
to conduct what amounted to a series of
experiments. For the next several months, he and
his people would trade stocks not to make money
but to test theories. RBC agreed to let his team
lose up to $10,000 a day to figure out why the
market in any given stock vanished the moment RBC
tried to trade in it. Katsuyama asked Park to come up with some theories.
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They started with the public markets 13 stock
exchanges scattered over four different sites run
by the New York Stock Exchange, Nasdaq, BATS and
Direct Edge. Park’s first theory was that the
exchanges weren’t simply bundling all the orders
at a given price but arranging them in some kind
of sequence. You and I might each submit an order
to buy 1,000 shares of Intel at $30 a share, but
you might somehow obtain the right to cancel your
order if my order was filled. “We started getting
the idea that people were canceling orders,” Park
says. “That they were just phantom orders.”
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This box kept at the facility in Secaucus, N.J.,
contains a 38-mile coil of fiber-optic cable that
creates a slight delay in the processing of
orders, which levels the playing field among
traders. Credit Stefan Ruiz for The New York Times
Katsuyama tried sending orders to a single
exchange, fairly certain that this would prove
that some, or maybe even all, of the exchanges
were allowing these phantom orders. But no: To
his surprise, an order sent to a single exchange
enabled him to buy everything on offer. The
market as it appeared on his screens was, once
again, the market. “I thought, [expletive], there
goes that theory,” Katsuyama says. “And that’s our only theory.”
It made no sense: Why would the market on the
screens be real if you sent your order to only
one exchange but prove illusory when you sent
your order to all the exchanges at once? The team
began to send orders into various combinations of
exchanges. First the New York Stock Exchange and
Nasdaq. Then N.Y.S.E. and Nasdaq and BATS. Then
N.Y.S.E., Nasdaq BX, Nasdaq and BATS. And so on.
What came back was a further mystery. As they
increased the number of exchanges, the percentage
of the order that was filled decreased; the more
places they tried to buy stock from, the less
stock they were actually able to buy. “There was
one exception,” Katsuyama says. “No matter how
many exchanges we sent an order to, we always got
100 percent of what was offered on BATS.” Park
had no explanation, he says. “I just thought, BATS is a great exchange!”
One morning, while taking a shower, Rob Park came
up with another theory. He was picturing a bar
chart he had seen that showed the time it took
orders to travel from Brad Katsuyama’s trading
desk in the World Financial Center to the various exchanges.
The increments of time involved were absurdly
small: In theory, the fastest travel time, from
Katsuyama’s desk in Manhattan to the BATS
exchange in Weehawken, N.J., was about two
milliseconds, and the slowest, from Katsuyama’s
desk to the Nasdaq exchange in Carteret, N.J.,
was around four milliseconds. In practice, the
times could vary much more than that, depending
on network traffic, static and glitches in the
equipment between any two points. It takes 100
milliseconds to blink quickly it was hard to
believe that a fraction of a blink of an eye
could have any real market consequences. Allen
Zhang, whom Katsuyama and Park viewed as their
most talented programmer, wrote a program that
built delays into the orders Katsuyama sent to
exchanges that were faster to get to, so that
they arrived at exactly the same time as they did
at the exchanges that were slower to get to. “It
was counterintuitive,” Park says, “because
everyone was telling us it was all about faster.
We had to go faster, and we were slowing it
down.” One morning they sat down to test the
program. Ordinarily when you hit the button to
buy but failed to get the stock, the screens lit
up red; when you got only some of the stock you
were after, the screens lit up brown; and when
you got everything you asked for, the screens lit up green.
The screens lit up green.
Photo
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Trading in the Fast Lane
In the microseconds it takes a high-frequency
trader depicted in blue to reach the various
stock exchanges housed in these New Jersey towns,
the conventional trader’s order, theoretically,
makes it only as far as the red line. The time
differences now under investigation by New
York’s attorney general can be financially
advantageous in a number of ways. Credit Graphic:
CLEVERºFRANKE. Data source: IEX.
“It’s 2009,” Katsuyama says. “This had been
happening to me for almost two years. There’s no
way I’m the first guy to have figured this out.
So what happened to everyone else?” The question
seemed to answer itself: Anyone who understood
the problem was making money off it.
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Now he and RBC had a tool to sell to investors:
The program Zhang wrote to build delays into the
stock-exchange orders. The tool enabled traders
like Katsuyama to do the job they were meant to
do take risk on behalf of the big investors who
wanted to trade big chunks of stock. They could
once again trust the market on their screens. The
tool needed a name. The team stewed over this,
until one day a trader stood up at his desk and
hollered: “Dude, you should just call it Thor!
The hammer!” Someone was assigned to figure out
what Thor might be an acronym for, and some words
were assembled, but no one remembered them. The
tool was always just Thor. “I knew we were onto
something when Thor became a verb,” Katsuyama
says. “When I heard guys shouting, ‘Thor it!’ ”
The other way he knew they were on to something
was from conversations he had with a few of the
world’s biggest money managers. The first visit
Katsuyama and Park made was to Mike Gitlin, who
oversaw global trading for billions of dollars in
assets for the money-management firm T. Rowe
Price. The story they told didn’t come to Gitlin
as a complete shock. “You could see that
something had just changed,” Gitlin says. “You
could see that when you were trading a stock, the
market knew what you were going to do, and it was
going to move against you.” But what Katsuyama
described was a far more detailed picture of the
market than Gitlin had ever considered and in
that market, all the incentives were screwy. The
Wall Street brokerage firm that was deciding
where to send T. Rowe Price’s buy and sell orders
had a great deal of power over how and where
those orders were submitted. Some exchanges paid
brokerages for their orders; others charged for
those orders. Did that influence where the broker
decided to send an order, even when it didn’t
sync with the interests of the investors the
broker was supposed to represent? No one could
say. Another wacky incentive was “payment for
order flow.” As of 2010, every American brokerage
and all the online brokers effectively auctioned
their customers’ stock-market orders. The online
broker TD Ameritrade, for example, was paid
hundreds of millions of dollars each year to send
its orders to a hedge fund called Citadel, which
executed the orders on behalf of TD Ameritrade.
Why was Citadel willing to pay so much to see the
flow? No one could say with certainty what Citadel’s advantage was.
Katsuyama and his team did measure how much more
cheaply they bought stock when they removed the
ability of some other unknown trader to front-run
them. For instance, they bought 10 million shares
of Citigroup, then trading at roughly $4 per
share, and saved $29,000 or less than 0.1
percent of the total price. “That was the
invisible tax,” Park says. It sounded small until
you realized that the average daily volume in the
U.S. stock market was $225 billion. The same tax
rate applied to that sum came to nearly $160
million a day. “It was so insidious because you
couldn’t see it,” Katsuyama says. “It happens on
such a granular level that even if you tried to
line it up and figure it out, you wouldn’t be
able to do it. People are getting screwed because
they can’t imagine a microsecond.”
Ronan Ryan didn’t look like a Wall Street trader.
He had pale skin and narrow, stooped shoulders
and the uneasy caution of a man who has survived
one potato famine and is expecting another. He
also lacked the Wall Street trader’s ability to
seem more important and knowledgeable than he
actually was. Yet from the time he first glimpsed
a Wall Street trading floor, in his early 20s,
Ryan badly wanted to work there. “It’s hard not
to get enamored of being one of these Wall Street
guys who people are scared of and make all this money,” he says.
Born and raised in Dublin, he moved to America in
1990, when he was 16. Six years later, his father
was recalled to Ireland; Ronan stayed behind. He
didn’t think of Ireland as a place anyone would
ever go back to if given the choice, and he
embraced his version of the American dream. After
graduating from Fairfield University in 1996, he
sent letters to all the Wall Street banks, but he
received just one flicker of interest from what,
even to his untrained eyes, was a vaguely
criminal, pump-and-dump penny-stock brokerage firm.
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Eventually he met another Irish guy who worked in
the New York office of MCI Communications, the
big telecom company. “He gave me a job strictly
because I was Irish,” Ryan says.
Photo
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Brad Katsuyama and his team at IEX. Credit Stefan Ruiz for The New York Times
He had always been handy, but he never actually
studied anything practical. He knew next to
nothing about technology. Now he started to learn
all about it. “It’s pretty captivating, when you
take the nerdiness out of it” and figure out how
stuff works, he says. How a copper circuit
conveyed information, compared with a glass
fiber. How a switch made by Cisco compared with a
switch made by Juniper. Which hardware companies
made the fastest computer equipment and which
buildings in which cities contained floors that
could withstand the weight of that equipment (old
manufacturing buildings were best). He also
learned how information actually traveled from
one place to another not in a straight line run
by a single telecom carrier, usually, but in a
convoluted path run by several. “When you make a
call to New York from Florida, you have no idea
how many pieces of equipment you have to go
through for that call to happen. You probably
just think it’s like two cans and a piece of
string. But it’s not.” A circuit that connected
New York City to Florida would have Verizon on
the New York end, AT&T on the Florida end and MCI
in the middle; it would zigzag from population center to population center.
Ryan hadn’t been able to find a job on Wall
Street, but by 2005 his clients were more likely
than ever to be big Wall Street banks. He spent
entire weeks inside Goldman Sachs and Lehman
Brothers and Deutsche Bank, finding the best
routes for their fiber and the best machines to
execute their stock-market trades.
In 2005, he went to work for BT Radianz, a
company that was born of 9/11, after the attacks
on the World Trade Center knocked out big pieces
of Wall Street’s communication system. The
company promised to build a system less
vulnerable to outside attack. Ryan’s job was to
sell the financial world on the idea of
subcontracting its information networks to
Radianz. In particular, he was meant to sell the
banks on “co-locating” their computers in
Radianz’s data center in Nutley, N.J., to be
closer, physically, to where the stock exchanges were located.
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‘Thank God,’ a big investor said, ‘finally
there’s someone who knows something about
high-frequency trading who isn’t an Area 51 guy.’
Not long after he started his job at Radianz,
Ryan received an inquiry from a hedge fund based
in Kansas City, Kan. The caller said he worked at
a stock-market trading firm called Bountiful
Trust and that he heard Ryan was an expert at
moving financial data from one place to another.
Bountiful Trust had a problem: In making trades
between Kansas City and New York, it took too
long to determine what happened to the firm’s
orders that is, what stocks had been bought and
sold. They also noticed that, increasingly, when
they placed their orders, the market was
vanishing on them. “He says, ‘My latency time is
43 milliseconds,’ ” Ryan recalls. “And I said,
‘What the hell is a millisecond?’ ”
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“Latency” was simply the time between the moment
a signal was sent and when it was received.
Several factors determined the latency of a
trading system: the boxes, the logic and the
lines. The boxes were the machinery the signals
passed through on their way from Point A to Point
B: the computer servers and signal amplifiers and
switches. The logic was the software, the code
instructions that operated the boxes. Ryan didn’t
know much about software, except that more and
more it seemed to be written by guys with thick
Russian accents. The lines were the glass
fiber-optic cables that carried the information
from one box to another. The single-biggest
determinant of speed was the length of the fiber,
or the distance the signal needed to travel. Ryan
didn’t know what a millisecond was, but he
understood the problem with this Kansas City
hedge fund: It was in Kansas City. Light in a
vacuum travels at 186,000 miles per second or,
put another way, 186 miles a millisecond. Light
inside fiber bounces off the walls and travels at
only about two-thirds of its theoretical speed.
“Physics is physics this is what the traders didn’t understand,” Ryan says.
By the end of 2007, Ryan was making hundreds of
thousands of dollars a year building systems to
make stock-market trades faster. He was struck,
over and over again, by how little those he
helped understood the technology they were using.
Beyond that, he didn’t even really know much
about his clients. The big banks Goldman Sachs,
Citigroup everyone had heard of. Others
Citadel, Getco were famous on a small scale. He
learned that some of these firms were hedge
funds, which meant they took money from outside
investors. But most of them were proprietary
firms, or prop shops, trading only their own
founders’ money. A huge number of the outfits he
dealt with Hudson River Trading, Eagle Seven,
Simplex Investments, Evolution Financial
Technologies, Cooperfund, DRW no one had ever
heard of, and the firms obviously intended to
keep it that way. The prop shops were especially
strange, because they were both transient and
prosperous. “They’d be just five guys in a room.
All of them geeks. The leader of each five-man
pack is just an arrogant version of that geek.”
One day a prop shop was trading; the next, it
closed, and all the people in it moved on to work
for some big Wall Street bank. One group of guys
Ryan saw over and over: four Russian, one
Chinese. The arrogant Russian guy, clearly the
leader, was named Vladimir, and he and his boys
bounced from prop shop to big bank and back to
prop shop, writing the computer code that made
the actual stock-market trading decisions, which
made high-frequency trading possible. Ryan
watched them meet with one of the most senior
guys at a big Wall Street bank that hoped to
employ them and the Wall Street big shot sucked
up to them. “He walks into the meeting and says,
‘I’m always the most important man in the room,
but in this case, Vladimir is.’ ”
“I needed someone from the industry to verify
that what I was saying was real,” Katsuyama says.
He needed, specifically, someone from deep inside
the world of high-frequency trading. He spent the
better part of a year cold-calling strangers in
search of a high-frequency-trading strategist
willing to defect. He now suspected that every
human being who knew how high-frequency traders
made money was making too much money doing it to
stop and explain what they were doing. He needed to find another way in.
In the fall of 2009, Katsuyama’s friend at
Deutsche Bank mentioned this Irish guy who seemed
to be the world’s expert at helping the world’s
fastest stock-market traders be faster. Katsuyama
called Ronan Ryan and invited him to interview
for a job on the RBC trading floor. In his
interview, Ryan described what he witnessed
inside the exchanges: The frantic competition for
nanoseconds, clients’ trying to get their
machines closer to the servers within the
exchanges, the tens of millions being spent by
high-frequency traders for tiny increments of
speed. The U.S. stock market was now a class
system of haves and have-nots, only what was had
was not money but speed (which led to money). The
haves paid for nanoseconds; the have-nots had no
idea that a nanosecond had value. The haves
enjoyed a perfect view of the market; the
have-nots never saw the market at all. “I learned
more from talking to him in an hour than I
learned from six months of reading about
[high-frequency trading],” Katsuyama says. “The
second I met him, I wanted to hire him.”
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He wanted to hire him without being able to fully
explain, to his bosses or even to Ryan, what he
wanted to hire him for. He couldn’t very well
call him vice president in charge of explaining
to my clueless superiors why high-frequency
trading is a travesty. So he called him a
high-frequency-trading strategist. And Ryan
finally landed his job on a Wall Street trading floor.
Katsuyama and his team were having trouble
turning Thor into a product RBC could sell to
investors. They had no control over the path the
signals took to get to the exchanges or how much
traffic was on the network. Sometimes it took
four milliseconds for their orders to arrive at
the New York Stock Exchange; other times, it took
seven milliseconds. In short, Thor was
inconsistent because, Ryan explained, the paths
the electronic signals took from Katsuyama’s desk
to the various exchanges were inconsistent. The
signal sent from Katsuyama’s desk arrived at the
New Jersey exchanges at different times because
some exchanges were farther from Katsuyama’s desk
than others. The fastest any high-speed trader’s
signal could travel from the first exchange it
reached to the last one was 465 microseconds, or
one two-hundredth of the time it takes to blink.
(A microsecond is a millionth of a second.) That
is, for Katsuyama’s trading orders to interact
with the market as displayed on his trading
screens, they needed to arrive at all the
exchanges within a 465-microsecond window.
To make his point, Ryan brought in oversize maps
of New Jersey showing the fiber-optic networks
built by telecom companies. The maps told a
story: Any trading signal that originated in
Lower Manhattan traveled up the West Side Highway
and out the Lincoln Tunnel. Perched immediately
outside the tunnel, in Weehawken, N.J., was the
BATS exchange. From BATS the routes became more
complicated, as they had to find their way
through the clutter of the Jersey suburbs. “New
Jersey is now carved up like a Thanksgiving
turkey,” Ryan says. One way or another, they
traveled west to Secaucus, the location of the
Direct Edge family of exchanges owned in part by
Goldman Sachs and Citadel, and south to the
Nasdaq family of exchanges in Carteret. The New
York Stock Exchange, less than a mile from
Katsuyama’s desk, appeared to be the stock market
closest to him but Ryan’s maps showed the
incredible indirection of fiber-optic cable in
Manhattan. “To get from Liberty Plaza to 55 Water
Street, you might go through Brooklyn,” he
explained. “You can go 50 miles to get from
Midtown to Downtown. To get from a building to a
building across the street, you could travel 15 miles.”
Photo
[]
The IEX office in Manhattan. Credit Stefan Ruiz for The New York Times
To Katsuyama the maps explained, among other
things, why the market on BATS had proved so
accurate. The reason they were always able to buy
or sell 100 percent of the shares listed on BATS
was that BATS was always the first stock market
to receive their orders. News of their buying and
selling hadn’t had time to spread throughout the
marketplace. Inside BATS, high-frequency-trading
firms were waiting for news that they could use
to trade on the other exchanges. BATS,
unsurprisingly, had been created by high-frequency traders.
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Eventually Brad Katsuyama came to realize that
the most sophisticated investors didn’t know what
was going on in their own market. Not the big
mutual funds, Fidelity and Vanguard. Not the big
money-management firms like T. Rowe Price and
Capital Group. Not even the most sophisticated
hedge funds. The legendary investor David
Einhorn, for instance, was shocked; so was Dan
Loeb, another prominent hedge-fund manager. Bill
Ackman runs a famous hedge fund, Pershing Square,
that often buys large chunks of companies. In the
two years before Katsuyama turned up in his
office to explain what was happening, Ackman had
started to suspect that people might be using the
information about his trades to trade ahead of
him. “I felt that there was a leak every time,”
Ackman says. “I thought maybe it was the prime
broker. It wasn’t the kind of leak that I
thought.” A salesman at RBC who marketed Thor
recalls one big investor calling to say, “You
know, I thought I knew what I did for a living,
but apparently not, because I had no idea this was going on.”
Katsuyama and Ryan between them met with roughly
500 professional stock-market investors who
controlled many trillions of dollars in assets.
Most of them had the same reaction: They knew
something was very wrong, but they didn’t know
what, and now that they knew, they were outraged.
Vincent Daniel, a partner at Seawolf, took a long
look at this unlikely pair an Asian-Canadian
guy from a bank no one cared about and an Irish
guy who was doing a fair impression of a Dublin
handyman who just told him the most incredible
true story he had ever heard and said, “Your
biggest competitive advantage is that you don’t want to [expletive] me.”
Trust on Wall Street was still just possible.
The big investors who trusted Katsuyama began to
share whatever information they could get their
hands on from their other brokers. For instance,
several demanded to know from their other Wall
Street brokers what percentage of the trades
executed on their behalf were executed inside the
brokers’ dark pools. Goldman Sachs and Credit
Suisse ran the most prominent dark pools, but
every brokerage firm strongly encouraged
investors who wanted to buy or sell big chunks of
stock to do so in that firm’s dark pool. In
theory, the brokers were meant to find the best
price for their customers. If the customer wanted
to buy shares in Chevron, and the best price
happened to be on the New York Stock Exchange,
the broker was not supposed to stick the customer
with a worse price inside its own dark pool. But
the dark pools were opaque. Their rules were not
published. No outsider could see what went on
inside them. It was entirely possible that a
broker’s own traders were trading against the
customers in its dark pool: There were no rules
against doing that. And while the brokers often
protested that there were no conflicts of
interest inside their dark pools, all the dark
pools exhibited the same strange property: A huge
percentage of the customer orders sent into a
dark pool were executed inside the pool. Even
giant investors simply had to take it on faith
that Goldman Sachs or Merrill Lynch acted in
their interests, despite the obvious financial
incentives not to do so. As Mike Gitlin of T.
Rowe Price says: “It’s just very hard to prove
that any broker dealer is routing the trades to
someplace other than the place that is best for
you. You couldn’t see what any given broker was
doing.” If an investor as large as T. Rowe Price,
which acted on behalf of millions of investors,
had trouble obtaining the information it needed
to determine if its brokers had acted in their
interest, what chance did the little guy have?
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The deep problem with the system was a kind of
moral inertia. So long as it served the narrow
self-interests of everyone inside it, no one on
the inside would ever seek to change it, no
matter how corrupt or sinister it became though
even to use words like “corrupt” and “sinister”
made serious people uncomfortable, so Katsuyama
avoided them. Maybe his biggest concern, when he
spoke to investors, was that he’d be seen as just
another nut with a conspiracy theory. One
compliment that made him happiest was when a big
investor said, “Thank God, finally there’s
someone who knows something about high-frequency
trading who isn’t an Area 51 guy.” It took him a
while to figure out that fate and circumstance
had created for him a dramatic role, which he was
obliged to play. One night he turned to his wife,
Ashley, and said: “It feels like I’m an expert in
something that badly needs to be changed. I think
there’s only a few people in the world who can do
anything about this. If I don’t do something
right now me, Brad Katsuyama there’s no one to call.”
Photo
[]
In May 2011, the small team Katsuyama created
Ronan Ryan, Rob Park and a couple of others sat
around a table in his office, surrounded by the
applications of past winners of The Wall Street
Journal’s Technology Innovation Awards. RBC’s
marketing department had informed them of the
awards the day before submissions were due and
suggested they put themselves forward so they
were scrambling to figure out which of several
categories they belonged in and how to make Thor
sound life-changing. “There were papers
everywhere,” Park says. “No one sounded like us.
There were people who had, like, cured cancer.”
“It was stupid,” Katsuyama says, “there wasn’t
even a category to put us into. I think we ended up applying under Other.”
With the purposelessness of the exercise hanging
in the air, Park said, “I just had a sick idea.”
His idea was to license the technology to one of
the exchanges. The line between Wall Street
brokers and exchanges had blurred. For a few
years, the big Wall Street banks had been running
their own private exchanges. The stock exchanges,
for their part, were making a bid (that
ultimately failed) to become brokers. The bigger
ones now offered a service that enabled brokers
to simply hand them their stock-market orders,
which they would then route to their own
exchange, of course, but also to other exchanges.
The service was used mainly by small regional
brokerage firms that didn’t have their own
routers, but this brokeragelike service opened
up, at least in Park’s mind, a new possibility.
If just one exchange was handed the tool for
protecting investors from market predators, the
small brokers from around the country might flock
to it, and it might become the mother of all exchanges.
Forget that, Katsuyama said. “Let’s just create our own stock exchange.”
“We just sat there for a while,” Park says, “kind
of staring at each other. Create your own stock
exchange. What does that even mean?”
A few weeks later Katsuyama flew to Canada and
tried to sell his bosses on the idea of an
RBC-led stock exchange. Then in the fall of 2011,
he canvassed a handful of the world’s biggest
money managers (Capital Group, T. Rowe Price,
BlackRock, Wellington, Southeastern Asset
Management) and some of the most influential
hedge funds (run by David Einhorn, Bill Ackman,
Daniel Loeb). They all had the same reaction.
They loved the idea of a stock exchange that
protected investors from Wall Street’s predators.
They also thought that for a new stock exchange
to be credibly independent of Wall Street, it
could not be created by a Wall Street bank. Not
even a bank as nice as RBC. If Katsuyama wanted
to create the mother of all stock exchanges, he
would need to quit his job and do it on his own.
The challenges were obvious. He would need to
find money. He would need to persuade a lot of
highly paid people to quit their Wall Street jobs
to work for tiny fractions of their current
salaries and possibly even supply the capital
to pay themselves to work. “I was asking: Can I
get the people I need? How long can we survive
without getting paid? Will our significant others
let us do this?” They did, and Katsuyama’s team
followed him to his new venture.
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But he also needed to find out if the nine big
Wall Street banks that controlled nearly 70
percent of all investor orders would be willing
to send those orders to a truly safe exchange. It
would be far more difficult to start an exchange
premised on fairness if the banks that controlled
a vast majority of the customers’ orders were not
committed to fairness themselves.
Back in 2008, when it first occurred to Brad
Katsuyama that the stock market had become a
black box whose inner workings eluded ordinary
human understanding, he went looking for
technologically gifted people who might help him
open the box and understand its contents. He’d
started with Rob Park and Ronan Ryan, then
others. One was a 20-year-old Stanford junior
named Dan Aisen, whose résumé Katsuyama
discovered in a pile at RBC. The line that leapt
out at him was “Winner of Microsoft’s College
Puzzle Challenge.” Every year, Microsoft
sponsored this one-day, 10-hour national
brain-twisting marathon. It attracted more than a
thousand young math and computer-science types.
Aisen and three friends competed in 2007 and won
the whole thing. “It’s kind of a mix of
cryptography, ciphers and Sudoku,” Aisen says. To
be really good at it, a person needed not only
technical skill but also exceptional pattern
recognition. “There’s some element of mechanical
work and some element of ‘Aha!’ ” Aisen says.
Katsuyama gave Aisen both a job and a nickname,
the Puzzle Master, soon shortened, by RBC’s
traders, to Puz. Puz was one of the people who had helped create Thor.
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‘We just sat there for a while, kind of staring
at each other. Create your own stock exchange. What does that even mean?’
Puz’s peculiar ability to solve puzzles was
suddenly even more relevant. Creating a new stock
exchange is a bit like creating a casino: Its
creator needs to ensure that the casino cannot in
some way be exploited by the patrons. Or at
worst, he needs to know exactly how his system
might be gamed, so that he might monitor the
exploitation as a casino follows card counters
at the blackjack tables. “You are designing a
system,” Puz says, “and you don’t want the system
to be gameable.” The trouble with the stock
market with all of the public and private
exchanges was that they were fantastically
gameable, and had been gamed: first by clever
guys in small shops, and then by prop traders who
moved inside the big Wall Street banks. That was
the problem, Puz thought. From the point of view
of the most sophisticated traders, the stock
market wasn’t a mechanism for channeling capital
to productive enterprise but a puzzle to be
solved. “Investing shouldn’t be about gaming a
system,” he says. “It should be about something else.”
The simplest way to design a stock exchange that
could not be gamed was to hire the very people
best able to game it and encourage them to take
their best shots. Katsuyama didn’t know any other
national puzzle champions, but Puz did. The only
problem was that none of them had ever worked
inside a stock exchange. “The Puzzle Masters needed a guide,” Katsuyama says.
Enter Constantine Sokoloff, who had helped build
Nasdaq’s matching engine the computer that
matched buyers and sellers. Sokoloff was Russian,
born and raised in a city on the Volga River. He
had an explanation for why so many of his
countrymen wound up in high-frequency trading.
The old Soviet educational system channeled
people into math and science. And the
Soviet-controlled economy was horrible and
complicated but riddled with loopholes, an
environment that left those who mastered it well
prepared for Wall Street in the early 21st
century. “We had this system for 70 years,”
Sokoloff says. “The more you cultivate a class of
people who know how to work around the system,
the more people you will have who know how to do it well.”
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The Puzzle Masters might not have thought of it
this way at first, but in trying to design their
exchange so that investors who came to it would
remain safe from predatory traders, they were
also divining the ways in which high-frequency
traders stalked their prey. For example, these
traders had helped the public stock exchanges
create all sorts of complicated “order types,”
The New York Stock Exchange, for one, had created
an order type that traded only if the order on
the other side of it was smaller than itself
the purpose of which seemed to be to protect
high-frequency traders from buying a small number
of shares from an investor who was about to
depress the market in these shares with a huge sale.
As they worked through the order types, the
Puzzle Masters created a taxonomy of predatory
behavior in the stock market. Broadly speaking,
it appeared as if there were three activities
that led to a vast amount of grotesquely unfair
trading. The first they called electronic
front-running seeing an investor trying to do
something in one place and racing ahead of him to
the next (what had happened to Katsuyama when he
traded at RBC). The second they called rebate
arbitrage using the new complexity to game the
seizing of whatever legal kickbacks, called
rebates within the industry, the exchange offered
without actually providing the liquidity that the
rebate was presumably meant to entice. The third,
and probably by far the most widespread, they
called slow-market arbitrage. This occurred when
a high-frequency trader was able to see the price
of a stock change on one exchange and pick off
orders sitting on other exchanges before those
exchanges were able to react. This happened all
day, every day, and very likely generated more
billions of dollars a year than the other strategies combined.
All three predatory strategies depended on speed.
It was Katsuyama who had the crude first idea to
counter them: Everyone was fighting to get in as
close to the exchange as possible why not push
them as far away as possible? Put ourselves at a
distance, but don’t let anyone else be there. The
idea was to locate their exchange’s matching
engine at some meaningful distance from the place
traders connected to the exchange (called the
point of presence) and to require anyone who
wanted to trade to connect to the exchange at
that point of presence. If you placed every
participant in the market far enough away from
the exchange, you could eliminate most, and maybe
all, of the advantages created by speed. Their
matching engine, they already knew, would be
located in Weehawken (where they’d been offered
cheap space in a data center). The only question
was: Where to put the point of presence? “Let’s
put it in Nebraska,” someone said, but they all
knew it would be harder to get the already
reluctant Wall Street banks to connect to their
market if the banks had to send people to Omaha
to do it. Actually, though, it wasn’t necessary
for anyone to move to Nebraska. The delay needed
only to be long enough for their new exchange,
once it executed some part of a customer’s buy
order, to beat high-frequency traders in a race
to the shares at any other exchange that is, to
prevent electronic front-running. The necessary
delay turned out to be 320 microseconds; that was
the time it took them, in the worst case, to send
a signal to the exchange farthest from them, the
New York Stock Exchange in Mahwah. Just to be
sure, they rounded it up to 350 microseconds.
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To create the 350-microsecond delay, they needed
to keep the new exchange roughly 38 miles from
the place the brokers were allowed to connect to
the exchange. That was a problem. Having cut one
very good deal to put the exchange in Weehawken,
they were offered another: to establish the point
of presence in a data center in Secaucus. The two
data centers were less than 10 miles apart and
already populated by other stock exchanges and
all the high-frequency stock-market traders.
(“We’re going into the lion’s den,” Ryan said.) A
bright idea came from a new employee, James Cape,
who had just joined them from a
high-frequency-trading firm: Coil the fiber.
Instead of running straight fiber between the two
places, why not coil 38 miles of fiber and stick
it in a compartment the size of a shoe box to
simulate the effects of the distance. And that’s what they did.
Creating fairness was remarkably simple. They
would not sell to any one trader or investor the
right to put his computers next to the exchange
or special access to data from the exchange. They
would pay no rebates to brokers or banks that
sent orders; instead, they would charge both
sides of any trade the same amount: nine
one-hundredths of a cent per share (known as nine
mils). They’d allow just three order types:
market, limit and Mid-Point Peg, which meant that
the investor’s order rested in between the
current bid and offer of any stock. If the shares
of Procter & Gamble were quoted in the wider
market at 80–80.02 (you can buy at $80.02 or sell
at $80), a Mid-Point Peg order would trade only
at $80.01. “It’s kind of like the fair price,” Katsuyama says.
Finally, to ensure that their own incentives
remained as closely aligned as they could be with
those of investors, the new exchange did not
allow anyone who could trade directly on it to
own any piece of it: Its owners were all ordinary
investors who needed first to hand their orders to brokers.
But the big Wall Street banks that controlled a
majority of all stock-market investor orders
played a more complicated role than an online
broker like TD Ameritrade. The Wall Street banks
controlled not only the orders, and the
informational value of those orders, but also
dark pools in which those orders might be
executed. The banks took different approaches to
milking the value of their customers’ orders. All
of them tended to send the orders first to their
own dark pools before routing them out to the
wider market. Inside the dark pool, the bank
could trade against the orders itself; or it
could sell special access to the dark pool to
high-frequency traders. Either way, the value of
the customers’ orders was monetized by the big
Wall Street bank for the big Wall Street bank. If
the bank was unable to execute an order in its
own dark pool, the bank could direct that order
first to the exchange that paid the biggest rebate for it.
If the Puzzle Masters were right, and the design
of their new exchange eliminated the advantage of
speed, it would reduce the informational value of
investors’ stock-market orders to zero. If those
orders couldn’t be exploited on this new exchange
if the information they contained about
investors’ trading intentions was worthless who
would pay for the right to execute them? The big
Wall Street banks and online brokers that routed
investors’ stock market orders to the new
exchange would surrender billions of dollars in
revenues in the process. And that, as everyone
involved understood, wouldn’t happen without a fight.
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Their new exchange needed a name. They called it
the Investors Exchange, which wound up being
shortened to IEX. Before it opened, on Oct. 25,
2013, the 32 employees of IEX made private
guesses as to how many shares they would trade
the first day and the first week. The median of
the estimates came in at 159,500 shares the first
day and 2.75 million shares the first week. The
lowest estimate came from the only one among them
who had ever built a new stock market from
scratch: 2,500 shares the first day and 100,000
the first week. Of the nearly 100 banks and
stockbrokerage firms in various stages of
agreeing to connect to IEX, most of them small
outfits, only about 15 were ready on the first
day. Katsuyama guessed, or perhaps hoped, that
the exchange would trade between 40 and 50
million shares a day by the end of the first year
that’s about what IEX needed to trade to cover
its running costs. If it failed to do that, there
was a question of how long it could last.
Katsuyama thought that their bid to create an
example of a fair financial market and maybe
change Wall Street’s culture could take more
than a year. And, he said, “It’s over when we run out of money.”
On the first day, IEX traded 568,524 shares. Most
of the volume came from regional brokerage firms
and Wall Street brokers that had no dark pools
RBC and Sanford C. Bernstein. The first week, IEX
traded a bit over 12 million shares. Each week
after that, the volume grew slightly, until, in
the third week of December, IEX was trading
roughly 50 million shares each week. On
Wednesday, Dec. 18, it traded 11,827,232 shares.
But IEX still wasn’t attracting many orders from
the big banks. Goldman Sachs, for example, had
connected to the exchange, but its orders were
arriving in tiny lot sizes, resting for just a few seconds, then leaving.
The first different-looking stock-market order
sent by Goldman to IEX landed on Dec. 19, 2013,
at 3:09.42 p.m. 662 milliseconds 361 microseconds
406 nanoseconds. Anyone who was in IEX’s one-room
office when it arrived would have known that
something unusual was happening. The computer
screens jitterbugged as the information flowed
into the market in an entirely new way
lingering there long enough to trade. One by one,
the employees arose from their chairs. Then they began to shout.
“We’re at 15 million!” someone yelled, 10 minutes
into the surge. In the previous 331 minutes they
had traded roughly 14 million shares.
“Twenty million!”
“Thirty million!”
“We just passed AMEX,” shouted John Schwall,
their chief financial officer, referring to the
American Stock Exchange. “We’re ahead of AMEX in market share.”
“And we gave them a 120-year head start,” Ryan
said, playing a little loose with history.
Someone had given him a $300 bottle of Champagne.
He’d told Schwall that it was worth only $100,
because Schwall didn’t want anyone inside IEX
accepting gifts worth more than that from
outsiders. Now Ryan fished the contraband from
under his desk and found some paper cups.
Someone put down a phone and said, “That was J.
P. Morgan, asking, ‘What just happened?’ They say
they may have to do something.”
Someone else put down a phone. “That was Goldman.
They say they aren’t even big. They’re coming big tomorrow.”
J. P. Morgan, in other words, might actually
route investors’ trades to IEX, and Goldman might
route more of them than they had done so far.
“Forty million!”
Fifty-one minutes after Goldman Sachs gave them
their first honest shot at Wall Street customers’
stock-market orders, the U.S. stock market
closed. Katsuyama walked off the floor and into a
small office, enclosed by glass. He thought
through what had just happened. “We needed one
person to buy in and say, ‘You’re right,’ ” he
said. “It means that Goldman Sachs agrees with
us. Now the others can’t ignore this. They can’t
marginalize it.” Then he blinked and said, “I could [expletive] cry now.”
He’d just been given a glimpse of the future he
felt certain of it. If Goldman Sachs was willing
to acknowledge to investors that this new market
was the best chance for fairness and stability,
the other banks would be pressured to follow. The
more orders that flowed onto IEX, the better the
experience for investors and the harder it would
be for the banks to evade this new, fairer market.
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IEX had made its point: That to function
properly, a financial market didn’t need to be
rigged in someone’s favor. It didn’t need payment
for order flow and co-location and all sorts of
unfair advantages possessed by a small handful of
traders. All it needed was for investors to take
responsibility for understanding it, and then to
seize its controls. “The backbone of the market,”
Katsuyama says, “is investors coming together to trade.”
Three weeks later, two months after IEX opened
for business, 14 men the chief executives or
the head traders of some of the world’s biggest
money managers gathered in a conference room on
top of a Manhattan skyscraper. Together they
controlled roughly $2.6 trillion in stock market
investments, or about 20 percent of the U.S.
market. They had flown in from around the country
to hear Katsuyama describe what he learned about
the U.S. stock market since IEX opened for
trading. “This is the perfect seat to figure all
this out,” Katsuyama said. “It’s not like you can
stand outside and watch. We had to be in the game to see it.”
What he had discovered was just how badly the
market wanted to remain in the shadows. Despite
Goldman’s activity, many of the big banks were
not following the instructions from investors,
their customers, to send orders to IEX. A few of
the investors in the room knew this; the rest now
learned as much. One of them said: “When we told
them we wanted to route to IEX, they said: ‘Why
would you want that? We can’t do that!’ ” After
the first six weeks of IEX’s life, a big Wall
Street bank inadvertently disclosed to one big
investor that it hadn’t routed a single order to
IEX despite explicit directions from the
investor to do so. Another big mutual fund
manager estimated that when he told the big banks
to route to IEX, they had done so “at most 10
percent of the time.” A fourth investor was told
by three different banks that they didn’t want to
connect to IEX because they didn’t want to pay
their vendors the $300-a-month connection fee.
Other banks were mostly passive-aggressive, but
there were occasions when they became simply
aggressive. Katsuyama heard that Credit Suisse
employees had spread rumors that IEX wasn’t
actually independent but owned by RBC and thus
just a tool of a big bank. He also heard what the
big Wall Street banks were already saying to
investors to dissuade them from sending orders to
IEX: The 350-microsecond delay IEX had introduced
to foil the stock-market predator made IEX too slow.
Soon after it opened for trading, IEX published
statistics to describe, in a general way, what
was happening in its market. Despite the best
efforts of Wall Street banks, the average size of
IEX’s trades was by far the biggest of any stock
exchange, public or private. Trades on IEX were
also four times as likely as those elsewhere to
trade at the midpoint between the current market
bid and offer which is to say, the price that
most would agree was fair. Despite the reluctance
of the big Wall Street banks to send orders to
IEX, the new exchange was already making the dark
pools and public exchanges look bad, even by their own screwed-up standards.
Katsuyama opened the floor for questions.
“Do you think of [high-frequency traders]
differently than you did before you opened?” someone asked.
“I hate them a lot less than before we started,”
Katsuyama said. “This is not their fault. I think
most of them have just rationalized that the
market is creating the inefficiencies, and they
are just capitalizing on them. Really it’s
brilliant what they have done within the bounds
of the regulation. They are much less of a
villain than I thought. The system has let down the investor.”
“How many good brokers are there?” asked an investor.
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“Ten,” Katsuyama said. (IEX had dealings with
94.) The 10 included RBC, Bernstein and a bunch
of even smaller outfits that seemed to be acting
in the best interests of their investors. “Three
are meaningful,” he added: Morgan Stanley, J. P. Morgan and Goldman Sachs.
One investor asked, “Why would any broker behave well?”
“The long-term benefit is that when the
[expletive] hits the fan, it will quickly become
clear who made good decisions and who made bad
decisions,” Katsuyama said. In other words, when
some future stock-market crash happened, perhaps
a result of the market’s technological
complexity, the big Wall Street banks would get the blame.
The stock market really was rigged. Katsuyama
often wondered how enterprising politicians and
plaintiffs’ lawyers and state attorneys general
would respond to that realization. (This March,
the New York attorney general, Eric Schneiderman,
announced a new investigation of the stock
exchanges and the dark pools, and their
relationships with high-frequency traders. Not
long after, the president of Goldman Sachs, Gary
Cohn, published an op-ed in The Wall Street
Journal, saying that Goldman wanted nothing to do
with the bad things happening in the stock
market.) The thought of going after those who
profited didn’t give Katsuyama all that much
pleasure. He just wanted to fix the problem. At
some level, he still didn’t understand why some
Wall Street banks needed to make his task so difficult.
Technology had collided with Wall Street in a
peculiar way. It had been used to increase
efficiency. But it had also been used to
introduce a peculiar sort of market inefficiency.
Taking advantage of loopholes in some
well-meaning regulation introduced in the
mid-2000s, some large amount of what Wall Street
had been doing with technology was simply so
someone inside the financial markets would know
something that the outside world did not. The
same system that once gave us subprime-mortgage
collateralized debt obligations no investor could
possibly truly understand now gave us
stock-market trades involving fractions of a
penny that occurred at unsafe speeds using order
types that no investor could possibly truly
understand. That is why Brad Katsuyama’s desire
to explain things so that others would understand
was so seditious. He attacked the newly automated
financial system at its core, where the money was
made from its incomprehensibility.
This article is adapted from “Flash Boys: A Wall
Street Revolt,” by Michael Lewis, published by W. W. Norton & Company.
<mailto:[log in to unmask]>Michael Lewis is
the author of “Boomerang” and “The Big Short.”
Editor: <mailto:[log in to unmask]>Dean Robinson
A version of this article appears in print on
April 6, 2014, on page MM27 of the Sunday
Magazine with the headline: The Wolf Hunters of
Wall Street.
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