Flash Boys: A Wall Street Revolt (12 page)

Schwall wanted to think of himself as a guy who lived by a few simple principles, a good soldier. After the financial crisis he was more like the Resentful Butler. He had a taste for asking complicated questions, and for tracking the answers into whatever rabbit hole they might lead him. He had, in short, an obsessive streak.

It wasn’t until after he’d hired Schwall away from Bank of America to work for RBC that Brad noticed this side of Schwall. He should have seen it before, simply from Schwall’s chosen role on Wall Street: product manager. A product manager, to be any good, had to be obsessive. The role had been spawned by the widespread belief that traders didn’t know how to talk to computer geeks and that computer geeks did not respond rationally to big, hairy traders hollering at them. A product manager stood between the two groups, to sort out which of the things the traders wanted that were the most important and how best to build them. For instance, an RBC stock market trader might demand a button on his screen that said “Thor,” which he could hit when he wanted Thor to execute his order to buy stock. To design that button might require twenty pages of mind-numbingly detailed specifications. That’s where Schwall came in. “He goes into details that no one else will go into, because for some reason that’s what he likes to do,” said Brad.

The first hint that Schwall’s obsession with detail might take a sharp turn into some private cul-de-sac came in company meetings. “He’d go off on complete tangents,” said Brad. “Semi-related but outer space–type stuff.” Another way Brad saw how Schwall’s mind worked was in a fight that Schwall picked not long after he started working at RBC. The bank had declined an offer to serve as a lead sponsor for a charity called Wings Over Wall Street. Wings Over Wall Street raised money to combat amyotrophic lateral sclerosis (ALS)—Lou Gehrig’s disease. In response, and without explaining why, Schwall blasted a system-wide email explaining the importance of ALS research and encouraging all RBC employees to get behind Wings Over Wall Street. The RBC executives who had made the original decision understandably saw this rogue email as a political act intended to undermine their authority. For no apparent reason, Schwall had alienated a bunch of important people who had the power to fire him.

Brad now found himself between his new, extremely valuable employee and a top RBC executive who wanted his scalp. When pressed, Schwall finally explained to Brad that his mother had just died of ALS. “And he hadn’t thought to mention it,” said Brad. “He’d spent years trying to figure out how to help his mother. The fact his mother died of the disease would have won the argument, and he never mentions it. He said it would have been underhanded and unprincipled.” Schwall’s problem wasn’t an uncharming taste for corporate politics but a charming ineptitude at playing them, Brad decided. (“Anyone who was politically astute never would have done this.”) He nevertheless stumbled into politics often enough and played them badly enough that Brad finally came up with a name for the resulting mess: a Schwalling. “A Schwalling is when he does something unintentionally idiotic that makes him look stupid,” said Brad.

All Schwall would say is, “I just sort of get crazy from time to time.” He’d become obsessed with something, and his obsessions sent him on a trip to a place from which the journey’s origin could no longer be glimpsed. The result was a lot of activity without an obvious motive.

Thor had triggered Schwall’s private process. Thor, and what it implied about the U.S. financial system, became Schwall’s greatest obsession. Before Brad explained to him how Thor worked and why, Schwall hadn’t thought twice about the U.S. stock markets. After he met Brad, he was certain that the market at the heart of capitalism was rigged. “As soon as you realize this,” he said, “as soon as you realize that you are not able to execute your orders because someone else is able to identify what you are trying to do and race ahead of you to the other exchanges, it’s over,” he said. “It changes your mind.” He stewed on the situation; the longer he stewed, the angrier he became. “It really just pissed me off,” he said. “That people set out this way to make money from everyone else’s retirement account. I knew who was being screwed, people like my mom and pop, and I became hell-bent on figuring out who was doing the screwing.” He reconsidered what he’d seen at Merrill Lynch after they had taken over Bank of America’s stock trading department. He hunted down the analyst who had done the controversial analysis of Merrill’s dark pool, for instance. The analyst told him that he had found that the dark pool was actually costing the customers (while profiting Merrill Lynch), but that management did not want to hear it. “They kept on telling him to change his report,” said Schwall. “He was basically told that he had to find a different way to do it to get the answer they needed.”

Early one Monday morning, in the summer of 2011, Brad had a call from Schwall. “He said, ‘Hey, I’m not coming in today,’ ” recalls Brad. “And I said, ‘What’s going on?’ He just said, ‘Trust me.’ Then he disappeared.”

The previous night Schwall had gone out into his backyard, with nothing but a cigar, a chair, and his iPad. “I had the belief that some people were perpetuating a fraud. When you think HFT, what do you think? You think nothing. You don’t have a person. You don’t have a face. You think a
computer.
But there are specific people behind this.” He’d started by Googling “front-running” and “Wall Street” and “scandal.” What he was looking for, at first, was the cause of the problem Thor had solved: How was it legal for a handful of insiders to operate at faster speeds than the rest of the market and, in effect, steal from investors? He soon had his answer: Regulation National Market System. Passed by the SEC in 2005 but not implemented until 2007, Reg NMS, as it became known, required brokers to find the best market prices for the investors they represented. The regulation had been inspired by charges of front-running made in 2004 against two dozen specialists on the floor of the old New York Stock Exchange—a charge the specialists settled by paying a $241 million fine.

Up till then the various brokers who handled investors’ stock market orders had been held to the loose standard of “best execution.” What that meant in practice was subject to interpretation. If you wanted to buy 10,000 shares of Microsoft at $30 a share, and the broker went into the market and saw that there were only 100 shares offered at $30, he might choose not to buy those hundred shares and wait until more sellers turned up. He had the discretion not to spook the market, and to play your hand on your behalf as smartly as he could. After the brokers abused the trust implicit in that discretion once too often, the government took the discretion away. Reg NMS replaced the loose notion of best execution with the tight legal one of “best price.” To define best price, Reg NMS relied on the concept of the National Best Bid and Offer, known as the NBBO. If an investor wished to buy 10,000 shares of Microsoft, and 100 shares were offered on the BATS exchange at $30 a share, while the full 10,000 listed on the other twelve exchanges were offered at $30.01, his broker was required to purchase the 100 shares on Bats at $30 before moving on to the other exchanges. “It mandated routing to more exchanges than you might otherwise have to go to,” said Schwall. “And so it created more opportunities for people to front-run you.” The regulation also made it far easier for high-frequency traders to predict where brokers would send their customers’ orders, as they must send them first to the exchange that offered the best market price.

That would have been fine but for the manner in which the best market price was calculated. The new law required a mechanism for taking the measure of the entire market—for creating the National Best Bid and Offer—by compiling all the bids and offers for all U.S. stocks in one place. That place, inside some computer, was called the Securities Information Processor, which, because there is no such thing on Wall Street as too many acronyms, became known as the SIP. The thirteen stock markets piped their prices into the SIP, and the SIP calculated the NBBO. The SIP was the picture of the U.S. stock market most investors saw.

Like a lot of regulations, Reg NMS was well-meaning and sensible. If everyone on Wall Street abided by the rule’s spirit, the rule would have established a new fairness in the U.S. stock market. The rule, however, contained a loophole:
It failed to specify the speed of the SIP.
To gather and organize the stock prices from all the exchanges took milliseconds. It took milliseconds more to disseminate those calculations. The technology used to perform these calculations was old and slow, and the exchanges apparently had little interest in improving it. There was no rule against high-frequency traders setting up computers inside the exchanges and building their own, much faster, better cared for version of the SIP. That’s exactly what they’d done, so well that there were times when the gap between the high-frequency traders’ view of the market and that of ordinary investors could be twenty-five milliseconds, or twice the time it now took to travel from New York to Chicago and back again.

Reg NMS was intended to create equality of opportunity in the U.S. stock market. Instead it institutionalized a more pernicious inequality. A small class of insiders with the resources to create speed were now allowed to preview the market and trade on what they had seen.

Thus—for example—the SIP might suggest to the ordinary investor in Apple Inc. that the stock was trading at 400–400.01. The investor would then give his broker his order to buy 1,000 shares at the market price, or $400.01. The infinitesimal period of time between the moment the order was submitted and the moment it was executed was gold to the traders with faster connections. How much gold depended on two variables: a) the gap in time between the public SIP and the private ones and b) how much Apple’s stock price bounced around. The bigger the gap in time, the greater the chance that Apple’s stock price would have moved; and the more likely that a fast trader could stick an investor with an old price. That’s why volatility was so valuable to high-frequency traders: It created new prices for fast traders to see first and to exploit. It wouldn’t matter if some people in the market had an early glimpse of Apple’s price if the price of Apple’s shares never moved.

Apple’s stock moved a lot, of course. In a paper published in February 2013, a team of researchers at the University of California, Berkeley, showed that the SIP price of Apple stock and the price seen by traders with faster channels of market information differed 55,000 times in a single day. That meant that there were 55,000 times a day a high-frequency trader could exploit the SIP-generated ignorance of the wider market. Fifty-five thousand times a day, he might buy Apple shares at an outdated price, then turn around and sell them at the new, higher price, exploiting the ignorance of the slower-footed investor on either end of his trades. And that was only the most obvious way a high-frequency trader might use his advance view of the market to make money.

Schwall already knew a lot about the boring nitty-gritty details of Reg NMS, as he had been in charge of implementing the new rule for the whole of Bank of America. He’d seen to the bank’s need to build so-called smart order routers that could figure out which exchange had the official best price of any given stock (the NBBO) and send the customers’ orders to that exchange. By complying with Reg NMS, he now understood, the smart order routers simply marched investors into various traps laid for them by high-frequency traders. “At that point I just got very, very pissed off,” he said. “That they are ripping off the retirement savings of the entire country through systematic fraud and people don’t even realize it. That just drives me up the fucking wall.”

His anger expressed itself in a search for greater detail. When he saw that Reg NMS had been created to correct for the market manipulations of the old NYSE specialists, he wanted to know: How had
that
corruption come about? He began another search. He discovered that the New York Stock Exchange specialists had been exploiting a loophole in some earlier regulation—which of course just led Schwall to ask: What event had led the SEC to create
that
regulation? Many hours later he’d clawed his way back to the 1987 stock market crash, which, as it turned out, gave rise to the first, albeit crude, form of high-frequency trading. During the 1987 crash, Wall Street brokers, to avoid having to buy stock, had stopped answering their phones, and small investors were unable to enter their orders into the market. In response, the government regulators had mandated the creation of an electronic Small Order Execution System so that the little guy’s order could be sent into the market with the press of a key on a computer keyboard, without a stockbroker first taking it from him on the phone. Because a computer was able to transmit trades must faster than humans, the system was soon gamed by smart traders, for purposes having nothing to do with the little guy.
†
At which point Schwall naturally asked: From whence came the regulation that had made brokers feel comfortable not answering their phones in the midst of the 1987 stock market crash?

As it turns out, when you Google “front-running” and “Wall Street” and “scandal,” and you are hell-bent on following the search to its conclusion, the journey cannot be finished in an evening. At five o’clock Monday morning Schwall finally went back inside his house. He slept for two hours, then rose and called Brad to tell him he wasn’t coming to work. Then he set off for a Staten Island branch of the New York Public Library. “There was quite a bit of vengeance on my mind,” he said. As a high school junior Schwall had been New York City’s wrestling champion in the 119-pound division. “He’s the nicest guy in the world most of the time,” said Brad. “But then sometimes he’s not.” A streak of anger ran through him, and exactly where it came from Schwall could not say, but he knew perfectly well what triggered it: injustice. “If I can fix something and fuck these people who are fucking the rest of this country, I’m going to do it,” he said. The trigger for his most recent burst of feeling was Thor, but if you had asked him on Wednesday morning why he was still digging around the Staten Island library instead of going to work, Schwall wouldn’t have thought to mention Thor. Instead he would have said, “I am trying to understand the origins of every form of front-running in the history of the United States.”