Flash Boys: A Wall Street Revolt (26 page)

A few weeks later, both Nasdaq and the New York Stock Exchange announced that they had widened the pipe that carried information between the HFT computers and each exchange’s matching engine. The price for the new pipe was $40,000 a month, up from the $25,000 a month the HFT firms had been paying for the old, smaller pipe. The increase in speed was
two microseconds
. Brad understood that the reason for this was not that the market was better off if HFT had information two microseconds faster than before, but that the high-frequency traders were all terrified of being slower than their peers, and the exchanges had figured out how to milk this anxiety. In a stock market now defined by its technology accidents, nothing actually happened by accident: There was a reason for even the oddest events. For instance, one day, investors woke up to discover that they’d bought shares in some company for $30.0001. Why? How was it possible to pay ten-thousandths of a penny for anything? Easy: High-frequency traders had asked for an order type that enabled them to tack digits on the right side of the decimal, so that they might jump the queue in front of people trying to pay $30.00. The reason for change was seldom explained; change just happened. “The fact that it is such an opaque industry should be alarming,” Brad said. “The fact that the people who make the most money want the least clarity possible—that should be alarming, too.”

Everything he had done with his new exchange was aimed at making it more transparent, and forcing Wall Street to follow. The sixteen investors understood IEX’s basic commercial strategy: to open as a private stock market and convert to a public exchange once their trading volume justified incurring the millions of dollars in regulatory fees they would have to pay. Although technically a dark pool, IEX had done something no Wall Street dark pool had ever done: It had published its rules. Investors could see, for the first time, what order types were allowed on the exchange, and if any traders had been given special access. IEX, as a dark pool, would thus try to set a new standard of transparency—and perhaps shame others into following its example. Or perhaps not. “I would have thought one dark pool would have come forward after us and published their own rules,” Brad now told the investors. “
Someone
must have nothing to hide. My prediction was six or seven out of the forty-four would have done it. None. Zero. There are now forty-five markets. On forty-four of them no one has any idea how they trade. Has it not dawned on anyone that it might actually be a good idea to tell people how the market works? People can look back on the financial crisis and say, ‘How can you give a mortgage loan with no documentation? It’s preposterous.’ But banks did it. And now trillions of dollars of trades are being executed on markets where no one has any idea of how it works, because there is no documentation. Does that sound familiar?”

Now he explained just how badly the market wanted to remain in the shadows—and just how badly the people at the heart of it wanted IEX to fail. Even before IEX opened, brokers from the big Wall Street banks went to work trying to undermine them. One investor called to inform Brad that a representative of Bank of America had just told him that IEX was owned by high-frequency trading firms. On the morning IEX opened, a manager at an investment firm called ING sent out a mass email that looked as if it had been written on her behalf by someone inside one of the big Wall Street banks: “With the pending launch of IEX, we request that all ING Equity Trading executions be excluded from executing on the IEX venue. . . . I am still challenged by the conflict of interest inherent in their business model. As a result I request to opt out of trading with the IEX venue.”

The employees of IEX had risked their careers to attack the conflicts of interest in the stock market. They had refused the easy capital from the big Wall Street banks—to avoid conflicts of interest. To avoid conflicts of interest, the investors who had backed IEX had structured their investments so that they themselves did not personally profit from sending trades onto the exchange: Profits from their investment flowed through to the people whose money they managed. These investors had further insisted on having a stake of less than 5 percent in the exchange, to avoid having even the appearance of control over it. Before IEX launched, Brad had rebuffed an overture from IntercontinentalExchange (known as ICE), the new owners of the New York Stock Exchange, to buy IEX for hundreds of millions of dollars—and walked away from the chance to get rich quick. To align their interests with the broader market’s, IEX planned to lower their fees as their volumes rose—for everyone who used the exchange. And on the day IEX opened for trading, this manager at ING—who had earlier refused to meet with them so that they might explain the exchange to her—was spreading a rumor that IEX had a conflict of interest.
**

But then all sorts of bizarre behavior had attended IEX’s arrival in the U.S. stock market. Ronan had gone to a private trade conference—no media, lots of Wall Street big shots. It was the first time he had been invited to the exclusive event, and he intended to lie low. He was outside in the hallway on his way to the bathroom when someone said, “You know, they’re in there talking about IEX.” Ronan returned to the conference room and listened to the heads of several big public U.S. stock exchanges on a panel. All agreed that IEX would only contribute to the biggest problem in the U.S. stock market: its fragmentation. The market already had thirteen public exchanges and forty-four private ones: Who needed another? When it came time for audience participation, Ronan found a microphone. “Hi, I’m Ronan, and I think I went to go take a piss at the wrong time,” he said, and then gave a little speech. “We’re not like you guys,” he concluded. “Or anyone else in the market. We’re an army of one.” He thought he was being calm and measured, but the crowd, by its standards, went wild—which is to say they actually clapped. “Jesus, I thought you were about to throw a punch,” some guy said afterward.

The stock exchanges didn’t like IEX for obvious reasons, the big Wall Street banks for less obvious ones. But the more the big banks sensed that Brad was being regarded by big investors as an arbiter of Wall Street behavior, the more carefully they confronted him. Instead of voicing their own objections to him directly, they would voice objections they claimed to have heard from other big banks. The guy from Deutsche Bank would say that the guy from Citigroup was upset that IEX was telling investors how to tell the banks to route to IEX—that sort of thing. “When I visited, they were all cordial,” said Brad. “It made me feel that the plan was to starve us out.” But without seeming to do so. The day before they’d opened for trading, a guy from Bank of America called Brad and said,
Hey, buddy, what’s going on? I’d appreciate it if you’d say we’re being supportive.
Bank of America had been the first to receive the documents they needed to connect to the exchange and, on opening day, were still dragging their feet in establishing a connection. Brad declined to help Bank of America out of its jam. “Shame is a huge tactic we have to deploy,” he said.

Nine weeks after IEX launched, it was already pretty clear that the banks were not following their customers’ instructions to send their orders to the new exchange. A few of the investors in the room knew this; the rest now learned. “When we told them we wanted to route to IEX,” one said, “they said, ‘Why would you want that? We can’t do that!’ The phrase ‘squealing pigs’ comes to mind.” After the first six weeks of IEX’s life, UBS, the big Swiss bank, inadvertently disclosed to one big investor that it hadn’t routed a single order onto IEX—despite explicit instructions 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 followed his instructions “at most ten 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 the $300-a-month connection fee.

Of all the banks that dragged their feet after their customers asked them to send their stock market orders to IEX, Goldman Sachs had offered the best excuse: They were afraid to tell their computer system to do anything it hadn’t done before. In August 2013, the Goldman automated trading system generated a bunch of crazy and embarrassing trades that lost Goldman hundreds of millions of dollars (until the public exchanges agreed, amazingly, to cancel them). Goldman wanted to avoid giving new instructions to its trading machines until it figured out why they had ceased to follow the old ones. There was something about the way Goldman had treated Brad when he visited their offices—listening to what he had to say, bouncing him up the chain of command rather than out the door—that led him to believe their excuse. He sensed that they were taking him seriously. After his first meeting with their stock market people, for instance, Goldman’s analysts had told the firm’s clients that they should be more wary of investing in Nasdaq Inc.

The other banks—Morgan Stanley and J.P. Morgan were the exceptions—were mostly passive-aggressive, but there were occasions when they became simply aggressive. Employees of Credit Suisse spread rumors that IEX wasn’t actually independent but owned by the Royal Bank of Canada—and so just a tool of a big bank. One night, in a Manhattan bar, an IEX employee bumped into a senior manager at Credit Suisse. “After you guys fail, come to me and I’ll give you a job,” he said. “Wait, no, everyone hates your fucking guts, so I won’t.” In the middle of their first day of trading, one of IEX’s employees got a call from a senior executive of Bank of America, who said that one of his colleagues had “ties to the Irish Mafia,” and “you don’t want to piss those guys off.” The IEX employee went to Brad, who just said, “He’s full of shit.” The IEX employee was less sure, and followed the call with a text.

IEX employee: Should I be concerned?

Bank of America employee: Yes.

IEX employee: Are you serious?

Bank of America employee: Jk [Just kidding].

IEX employee: Haven’t noticed any Irish guys following me.

Bank of America employee: Be careful next time you get in your car.

IEX employee: Good thing I don’t own a car.

Bank of America employee: Well, maybe your gf’s car.

Brad also heard what the big Wall Street banks were already saying to investors to dissuade them from sending orders to IEX:
It’s too slow
. For years, the banks had been selling the speed and aggression of their trading algos, along with the idea that, for an investor, slower always meant worse. They seemed to have persuaded themselves that the new speed of the markets actually helped their clients. They’d even dreamed up a technical-sounding name for an absence of speed: “duration risk.” (“If you make it sound official, people will believe that it’s something you really need to care about,” Brad explained.) The 350-microsecond delay IEX had introduced to foil the stock market predator was roughly one-thousandth of the blink of an eye. But investors for years had been led to believe that one-thousandth of the blink of an eye might matter to them, and that it was extremely important for their orders to move as fast and aggressively as possible.
Guerrilla! Raider!
This emphasis on speed was absurd: No matter how fast the investor moved, he would never outrun the high-frequency traders. Speeding up his stock market order merely reduced the time it took for him to arrive in HFT’s various traps. “But how do you prove that a millisecond is irrelevant?” Brad asked.

He threw the problem to the Puzzle Masters. The team had expanded to include Larry Yu, whom Brad thought of as the guy with the box of Rubik’s cubes under his desk. (The standard 3x3-inch cube he could solve in under thirty seconds, and so he kept it oiled with WD-40 to make it spin faster. His cube box held more challenging ones: a 4x4-incher, a 5x5-incher, a giant irregularly shaped one, and so on.) Yu generated two charts, which Brad projected onto the screen for the investors.

To
see
anything in the stock market, you have to stop trying to see it with your eyes and instead attempt to imagine it as it might appear to a computer, if a computer had eyes. The first chart showed the investors how trading on all public U.S. stock exchanges in the most actively traded stock of a single company (Bank of America Corp) appeared to the human eye over a period of ten minutes, in one-second increments. The activity appears constant, even frantic. In virtually every second, something occurs: a trade or, more commonly, a new buy or sell order. The second chart illustrated the same activity on all public U.S. stock exchanges as it appeared to a computer, over the course of a single
second
, in millisecond increments. All the market activity within a single second was so concentrated—within a mere 1.78 milliseconds—that on the graph it resembled an obelisk rising from a desert. In 98.22 percent of all milliseconds, nothing at all happened in the U.S. stock market. To a computer, the market in even the world’s most actively traded stock was an uneventful, almost sleepy place. “Yes, your eyeballs think the markets are going fast,” Brad said. “They aren’t really going that fast.” The likelihood an investor would miss out on something important in a third of a millisecond was close to zero, even in the world’s most actively traded stock. “I knew it was bullshit to worry about milliseconds,” said Brad, “because if milliseconds were relevant, every investor would be in New Jersey.”

“What’s the spike represent?” asked one of the investors, pointing to the obelisk.

“That’s one of your orders touching down,” said Brad.

A few investors shifted in their seats. It was growing clear to them, if it wasn’t already so, that, if the stock market was the party, they were the punch bowl. They were unlikely to miss any action as the result of a delay of one-third of a millisecond. They were the reason for all the action! “Every time a trade happens at the exchange, it creates a signal,” said Brad. “In the fifty milliseconds running up to it—total silence. Then there is an event. Then there is this massive reaction. Then a reaction to that reaction. The HFT algos on the other side are predicting what you’ll do next based on what you just did.” The activity peaked roughly 350 microseconds after an investor’s order triggered the feeding frenzy, or the time it took for HFT to send its orders from the stock exchange on which the investor had touched down to all of the others. “Your eye will never pick up what is really happening,” said Brad. “You don’t see shit. Even if you’re a fucking cyborg you don’t see it. But if there was no value to reacting, why would anyone react at all?” The arrival of the prey awakened the predator, who deployed his strategies—rebate arbitrage, latency arbitrage, slow market arbitrage. Brad didn’t need to dwell on these; he’d already walked each of the investors through his earlier discoveries. It was his new findings that he wanted them to focus on.
††