Flash Boys: A Wall Street Revolt (22 page)

To create the 350-microsecond delay, they needed to keep the new exchange roughly thirty-eight 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, New Jersey. The two data centers were less than ten miles apart, and already populated by other stock exchanges and all the high-frequency traders. (“We’re going into the lion’s den,” said Ronan.) A bright idea came from a new employee, James Cape, who had just joined them from an HFT firm:
Coil the fiber
. Instead of running straight fiber between the two places, coil thirty-eight miles of fiber and stick it in a compartment the size of a shoebox to simulate the effects of the distance. And that’s what they did. The information flowing between IEX and all the players on it would thus go round and round, in thousands of tiny circles, inside the magic shoebox. From the high-frequency traders’ point of view, it was as if they’d been banished to West Babylon, New York.

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 kickbacks to brokers or banks that sent orders; instead, they’d charge both sides of any trade the same amount: nine one-hundredths of a cent per share (known as 9 “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,” said Brad.

Finally, to ensure that their own incentives remained as closely aligned as they could be with those of stock market 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.

The design of the new stock exchange was such that it would yield all sorts of new information about the inner workings of the U.S. stock market—and, indeed, the entire financial system. For instance, it did not ban but welcomed high-frequency traders who wished to trade on it. If high-frequency traders performed a valuable service in the financial markets, they should still do so, after their unfair advantages had been eliminated. Once the new stock exchange opened for business, IEX would be able to see how much of what HFT did was useful simply by watching what, if anything, high-frequency traders did on the new exchange, where predation was not possible. The Puzzle Masters’ only question was whether, in their design, they had accounted for every possible form of market predation. That was the one thing even they did not know: whether they had missed something.

THE HIDDEN PASSAGES
and trapdoors that riddled the exchanges enabled a handful of players to exploit everyone else; the latter didn’t understand that the game had been designed precisely for the former. As Brad put it, “It’s like you run this casino, and you need to get players in to attract other players. You invite a few players in to start a game of Texas Hold’em by telling them that the deck doesn’t have any jacks or queens in it, and that you won’t tell the other people who come to play with them. How do you get people into the casino? You pay the brokers to bring them there.” By the summer of 2013, the world’s financial markets were designed to maximize the number of collisions between ordinary investors and high-frequency traders—at the expense of ordinary investors, and for the benefit of high-frequency traders, exchanges, Wall Street banks, and online brokerage firms. Around those collisions an entire ecosystem had arisen.

Brad had heard many firsthand accounts about the nature of that ecosystem. One came from a man named Chris Nagy, who, until 2012, had been responsible for selling the order flow for TD Ameritrade. Every year, people from banks and high-frequency trading firms would fly to Omaha, where TD Ameritrade was based, and negotiate with Nagy. “Most of the deals tend to be handshake deals,” Nagy said. “You go out to a steak dinner. ‘We’ll pay you two cents a share. Everything is good.’ ” The negotiations were always done face-to-face, because no one involved wanted to leave a paper trail. “The payment for the order flow is as off-the-record as possible,” said Nagy. “They never have an email or even a phone call. You had to fly down to meet with us.” For its part, TD Ameritrade was required to publish how much per share they were making from the practice but not the total amounts, which were buried on its income statements on a line labeled “Other Revenue.” “So you can see the income, but you can’t see the deals.”

In his years selling order flow, Nagy noticed a couple of things—and he related them both to Brad and his team when he came to visit them to find out why he kept hearing about this strange new thing called IEX. The first was that the market complexity created by Reg NMS—the rapid growth in the number of stock markets, and in high-frequency trading—raised the value of a stock market customer’s order. “It caused the value of our flow to triple, a least,” Nagy said. The other thing he couldn’t help but notice was that not all of the online brokers appreciated the value of what they were selling. TD Ameritrade was able to sell the right to execute its customers’ orders to high-frequency trading firms for hundreds of millions a year. The bigger Charles Schwab, whose order flow was even more valuable than TD Ameritrade’s, had sold its flow to UBS back in 2005, in an eight-year deal, for only $285 million. (UBS charged the high-frequency trading firm Citadel some undisclosed sum to execute Schwab’s trades.) “Schwab left at least a billion dollars on the table,” Nagy said. A lot of the people selling their customers’ orders, it seemed to Nagy, had no idea of the value of the information the orders contained. Even he was unsure; the only way to know would be to find out how much money high-frequency traders were making by trading against slow-footed individual investors. “I’ve tried over the years [to find out how much money was being made by high-frequency trading],” Nagy said. “The market makers are always reluctant to share their performance.” What Nagy did know was that the simple retail stock market order was, from the point of view of high-frequency traders, easy kill. “Whose order flow is the most valuable?” he said. “Yours and mine. We don’t have black boxes. We don’t have algos. Our quotes are late to the market—a full second behind.”
¶

High-frequency traders sought to trade as often as possible with ordinary investors, who had slower connections. They were able to do so because the investors themselves had only the faintest clue of what was happening to them, and also because the investors, even big, sophisticated ones, had no ability to control their own orders. When, say, Fidelity Investments sent a big stock market order to Bank of America, Bank of America treated that order as its own—and behaved as if it, not Fidelity, owned the information associated with that order. The same was true when an individual investor bought stock through an online broker. The moment he pressed the Buy icon on his screen, the business was out of his hands, and the information about his intentions belonged, in effect, to E*Trade, or TD Ameritrade or Schwab.

But the role in this of the nine big Wall Street banks that controlled 70 percent of all stock market orders was more complicated than the role played by TD Ameritrade. The Wall Street banks controlled not only the orders, and the informational value of those orders, but 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 themselves; or they 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 a stock market order in its own dark pool, the bank directed that order first to the exchange that paid the biggest kickback for it—when the kickback was simply the bait for some flash trap.

If the Puzzle Masters were right, and the design of IEX eliminated the advantage of speed, IEX would reduce the value of investors’ stock market orders to zero. If the orders couldn’t be exploited on this new exchange—if the information they contained was worthless—who would pay for the right to execute them? The big Wall Street banks and online brokers charged by investors with routing stock market orders to IEX would surrender billions of dollars in revenues in the process. And that, as everyone involved understood, wouldn’t happen without a fight.

One afternoon during the summer of 2013, a few months before the exchange planned to open for business, Brad called a meeting to figure out how to make the big Wall Street banks feel watched. IEX had raised more capital and hired more people and moved to a bigger room, on the thirtieth floor of 7 World Trade Center. There still was no separate place to meet, however, so they gathered in a corner of the big room, where a whiteboard met a window that offered a spectacular view of the 9/11 memorial. Don leaned with his back against the window, along with Ronan, Schwall, and Rob Park, while Brad stood in front of the whiteboard and took a whiteboard marker out of a bin. The twenty or so other employees of IEX remained at their desks in the room, pretending that nothing was happening.

Then Matt Trudeau appeared and joined in. Matt was the only person in the room who had ever opened a brand-new stock exchange, and so he tended to be included in every business discussion. Oddly enough, among them he was least, by nature, a businessman. He’d entered college to major in painting and then, deciding he lacked the talent to make it as a painter, and thinking he might make it as an academic, had moved into the anthropology department. He didn’t become an anthropologist, either. After college he’d found work adjusting auto insurance claims—a job he judged to be among the world’s most soul-sucking. One day on a lunch break, he noticed a television switched on to CNBC and wondered, “Why are there two separate ticker tapes?” He began to study the stock market. Five years later, in the mid-2000s, he was opening new, American-style stock exchanges in foreign countries for a company with the mystifying name Chi-X Global. (“It was marketing gone awry,” he said. “We spent the first fifteen minutes of every meeting trying to explain our name.”) He’d been one part businessman and one part missionary: He met with officials of various governments, wrote white papers, and sat on panels to extol the virtues of American financial markets. After opening Chi-X Canada, he’d advised firms trying to open stock exchanges in Singapore, Tokyo, Australia, Hong Kong, and London. “Did I think I was doing God’s work?” he said later. “No. But I did think market efficiency was something important for the economy.”

As he spread the American financial gospel, he couldn’t help but notice a pattern: A new exchange would open, and nothing would happen on it—until the high-frequency traders showed up, stuck their computers beside the exchange’s matching engine, and turned the exchange around. Then he began to hear things—that some of the HFT guys might be shady, that stock exchanges had glitches built into them that HFT could use to exploit ordinary investors. He couldn’t point to specific wrongdoing, but he felt less and less easy about his role in the universe. In 2010, Chi-X promoted him to a big new job, Global Head of Product; but before he took the job he came across an Internet post by Sal Arnuk and Joseph Saluzzi.
**
The post showed, in fine detail, how data about investors’ orders provided to high-frequency traders by two of the public exchanges, BATS and Nasdaq, helped HFT discern investors’ trading intentions. Most investors, Arnuk and Saluzzi wrote, “have no idea that the private trade information they are entrusting to the market centers is being made public by the exchanges. The exchanges are not making this clear to their clients, but instead are actively broadcasting the information to the HFTs in order to court their order flow.” “It was the first credible evidence of Big Foot,” said Matt. He dug around on his own and saw that the glitches at BATS and Nasdaq that queered the market for the benefit of HFT weren’t flukes but symptoms of a systemic problem, and that “many other little market quirks were there that were potentially being exploited.”

He was then in an awkward position: that of a public spokesman for the new American-style stock market who doubted the integrity of that market. “I’m at the point where I no longer feel I can authentically defend high-frequency trading,” he said. “I look at us exporting our business model to all these different countries and I think,
It’s like exporting a disease
.” He was thirty-four years old, and married, with a one-year-old child. Chi-X was paying him more than $400,000 a year. And yet, with no idea what he was going to do to earn a living, he up and quit. “I don’t want to say I’m an idealist,” he said. “But you have a limited amount of time on this planet. I don’t want to be twenty years from now and thinking I hadn’t lived my life in a way I could be proud of.” He kicked around for the better part of a year before he thought to call Ronan, whom he’d met when Ronan came through to run cables for HFT inside his Canadian exchange. In October 2012 they met for coffee at the McDonald’s near Liberty Plaza, and Ronan explained he’d just left RBC to open a new stock exchange. “My first reaction was,
I feel so bad for the guy
,” said Matt. “
He’s just destroyed his future. They’re just doomed
. Then, afterwards, I asked myself, ‘What causes a bunch of people making a million a year to quit?’ ” He came back in November and asked Ronan some more questions about this new exchange. In December, Brad hired him.

Standing in front of the whiteboard, Brad now reviewed the problem at hand: It was unusual for an investor to direct his broker to send his order to one exchange, but that is what investors were preparing to do with IEX. But these investors had no way of determining if the Wall Street brokers followed their instructions and actually sent the orders to IEX. The report investors typically received from their brokers—the Transaction Cost Analysis, or TCA—was useless, so sloppily and inconsistently compiled as to be beyond analysis. Some of it came time-stamped to the second; some, time-stamped in tenths of microseconds. None of it told you which exchange you traded on. As a result, there was no way to determine the context of any transaction, the event immediately before it and the one immediately after. If you didn’t even know the order of the trades in the stock market, you could hardly determine if you had traded at a fair price. “It’s a Pandora’s box of ridiculousness,” said Brad. “Just getting an answer to the question: ‘Where did I trade?’ It isn’t really possible.”