Flash Boys: A Wall Street Revolt (28 page)

Up till that point, most of the predation they had uncovered occurred when stock prices moved. A stock went up or down; the high-frequency guys found out before everyone else and took advantage of them. Roughly two-thirds of all stock market trades took place without moving the price of the stock—the trade happened at the seller’s offering price, or the buyer’s bidding price, or in between; afterwards, the bid and offering price remained the same as they had been before. What Brad now saw was how HFT, with the help of the banks, might exploit investors even when the stock price was stable. Say the market for Procter & Gamble’s shares was 80.50–80.52, and the quote was stable—the price wasn’t about to change. The National Best Bid was $80.50, and the National Best Offer was $80.52, and the stock was just sitting there. A seller of 10,000 Procter & Gamble shares appeared on IEX. IEX tried to price the orders that rested on it at the midpoint (the fair price), and so the 10,000 shares were being offered at $80.51. Some high-frequency trader would come into IEX—it was always a high-frequency trader—and chip away at the order: 131 shares here, 189 shares there. But elsewhere in the market, the same HFT was selling the shares—131 shares here, 189 shares there—at $80.52. On the surface, HFT was performing a useful function, building a bridge between buyer and seller. But the bridge was itself absurd. Why didn’t the broker who controlled the buy order simply come to IEX on behalf of his customer and buy, more cheaply, the shares offered?

Back when Rich Gates conducted his experiments, he had managed to get himself robbed inside Wall Street’s dark pools, but only after he had changed the price of the stock (because the dark pools were so slow to move the price of his order resting inside of them). These trades that Brad was now noticing had happened without the market moving at all. He knew exactly why they were happening: The Wall Street banks were failing to send their customers’ orders to the rest of the marketplace. An investor had given a Wall Street bank an order, say, to buy 10,000 shares of P&G. The bank had sent it to its dark pool with instructions for the order to stay there, aggressively priced, at $80.52. The bank was boosting its dark pool stats—and also charging some HFT a fee rather than paying a fee to another exchange—but it was also ignoring whatever else was happening in the market. In a functional market, the investors would simply have met in the middle and traded with each other at a price of $80.51. The price of the stock needn’t have moved a penny. The unnecessary price movement—caused by the screwed-up stock market—also played into HFT’s hands. Because high-frequency traders were always the first to detect any stock price movements, they were able to exploit, with other strategies, ordinary investors’ ignorance of the fact that the market price had changed. The original false note struck by the big Wall Street bank—the act of avoiding making trades outside of its own dark pool—became the prelude to a symphony of scalping.
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“We’re calling this ‘dark pool arbitrage,’ ” said Brad.

IEX had built an exchange to eliminate the possibility of predatory trading—to prevent investors from being treated as prey. In the first two months of its existence, IEX had seen no activity from high-frequency traders except this. It was astonishing, when you stopped to think about it, how aggressively capitalism protected its financial middleman, even when he was totally unnecessary. Almost magically, the banks had generated the need for financial intermediation—to compensate for their own unwillingness to do the job honestly.

Brad opened the floor for questions. For the first few minutes, the investors vied with each other to see who could best control his anger and exhibit the sort of measured behavior investors are famous for.

“Do you think of HFT differently than you did before you opened?” asked one.

That question might have been better answered by Ronan, who had just returned from a tour of the big HFT firms, and now leaned against a wall on the side of the room. Brad had asked Ronan to explain to the investors the technical end of things—how IEX had created its 350-microsecond delay, the magic shoebox, and so on—and to relate the details of his tour. He’d done it. But on the subject of HFT he held himself back. To speak his mind, Ronan needed to feel like himself, which, imprisoned in a gray suit and addressing a semiformal audience, he clearly did not. Put another way: It was just extremely difficult for Ronan to say what he felt without using the word “fuck.” Watching him string together sentences without profanity was like watching someone try to swim across a river without using his arms or his legs. Curiously, he later admitted, he wasn’t worried that the audience would be offended by bad language. “It was because some of them want to be the alpha male cursing in the room,” he said. “When I say ‘fuck,’ they think I’m stealing the show—so when I’m in front of a group I go as straight as I can.”

“I hate them a lot less than before we started,” said Brad. “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.”

A forgiving sentiment. But at that moment the investors in the conference room did not seem in a forgiving mood. “It’s still shocking to me to see how the banks are colluding against us,” one of the investors later said. “It shows
everyone
is a bad actor. And then when you add in that you ask them to route to IEX and they refuse, it’s even worse. Even though I had heard some of it before, I was still incensed. If that was the first time I was hearing it, I think I’d have gone bonkers.”

An investor raised his hand and motioned to some numbers Brad had scribbled on a whiteboard to illustrate how a particular bank had enabled dark pool arbitrage.

“Who is that?” he asked, and not calmly.

An uneasy look crossed Brad’s face. He was now hearing that question more and more. Just that morning, an outraged investor listening to a dry run of his presentation had stopped him to ask: “Which bank is the worst?” “I can’t tell you,” he said, and explained that the agreements the big Wall Street banks signed with IEX forbade IEX from speaking about any bank without its permission.

“Do you know how frustrating it is to sit here and hear this and not know who that broker is?” said another investor.

It wasn’t easy being Brad Katsuyama—to try to effect some practical change without a great deal of fuss, when the change in question was, when you got right down to it, a radical overhaul of a social order. Brad was not by nature a radical. He was simply in possession of radical truths.     

“What we want to do is highlight the good brokers,” said Brad. “We need the brokers who are doing the right thing to get rewarded.” That was the only way around the problem. Brad had asked for the banks’ permission to highlight the virtue of the ones that behaved relatively well, and they had granted it. “Speaking about someone in a positive light does not violate the terms of not speaking about someone in a negative light,” he said.

The audience considered this.

“How many good brokers are there?” asked an investor at length.

“Ten,” said Brad. (IEX had dealings with ninety-four.) The ten included the Royal Bank of Canada, Sanford Bernstein, and a bunch of even smaller outfits. “Three are meaningful,” he added. Morgan Stanley, J.P. Morgan, and Goldman Sachs.

“Why would any broker behave well?”

“The long-term benefit is that when the shit hits the fan, it will quickly become clear who made good decisions and who made bad decisions,” said Brad.

He wondered, often, what it would look like if and when the shit in question hit the fan: The stock market at bottom was rigged. The icon of global capitalism was a fraud. How would enterprising politicians and plaintiffs’ lawyers and state attorneys general respond to that news? The thought of it actually didn’t give him all that much pleasure. Really, he just wanted to fix the problem. At some level, he still didn’t understand why Wall Street banks needed to make his task so difficult.

“Is there a concern from you that the publicity will create even more hostility?” asked another. He wanted to know if telling the world who the good brokers were would make the bad ones worse.

“The bad brokers can’t try harder at being bad,” said Brad. “Some of these brokers are doing everything they can not to do what the client wants them to do.”

An investor wanted to return to the scribbled numbers that illustrated how one particular bank had enabled dark pool arbitrage. “So what do these guys say when you show them that?

“Some of them say, ‘You’re one hundred percent right,’ ” said Brad. “ ‘This shit happens.’ One even said, ‘We used to sit around all the time talking about how to fuck up other people’s dark pools.’ Some of them say, ‘I have no idea what you’re talking about. We have heuristic data bullshit and other mumbo jumbo to determine our routing.’ ”

“That’s a technical term—‘heuristic data bullshit and other mumbo jumbo’?” an investor asked. A few guys laughed.

Technology had collided with Wall Street in a peculiar way. It had been used, as it should have been used, to increase efficiency. But it had also been used to introduce a peculiar sort of market inefficiency. This new inefficiency was not like the inefficiencies that financial markets can easily correct. After a big buyer enters the market and drives up the price of Brent crude oil, for example, it’s healthy and good when speculators jump in and drive up the price of North Texas crude, too. It’s healthy and good when traders see the relationship between the price of crude oil and the price of oil company stocks, and drive these stocks higher. It’s even healthy and good when some clever high-frequency trader divines a necessary statistical relationship between the share prices of Chevron and Exxon, and responds when it gets out of whack. It was neither healthy nor good when public stock exchanges introduced order types and speed advantages that high-frequency traders could use to exploit everyone else. This sort of inefficiency didn’t vanish the moment it was spotted and acted upon. It was like a broken slot machine in the casino that pays off every time. It would keep paying off until someone said something about it; but no one who played the slot machine had any interest in pointing out that it was broken.

Some large amount of what Wall Street had done with technology had been done simply so that 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 that occurred at fractions of a penny at unsafe speeds using order types that no investor could possibly truly understand. That is why Brad Katsuyama’s most distinctive trait—his desire to explain things not so he would be understood but so that others would understand—was so seditious. He attacked the newly automated financial system at its core: the money it made from its incomprehensibility.

Another investor, silent till that point, now raised his hand. “It seems like there’s a first mover risk for someone to behave the right way,” he said. He was right: Even the banks that were behaving relatively well weren’t behaving all that well. A big Wall Street bank that gave IEX an honest shot to execute its customers’ orders would suffer a collapse in its dark pool trading, and in its profits. The bad banks would pounce on the good bank and argue that, because its dark pool was worse than all the others, it shouldn’t be given the orders in the first place. That, Brad told the investors, had been maybe his biggest concern. Would any big Wall Street bank have the ability to see a few years down the road, and summon the nerve to go first? Then he clicked on a slide. On top it read:
December 19, 2013.

YOU COULD NEVER
say for sure exactly what was going on inside one of the big Wall Street banks, but it was a mistake to think of a bank as a coherent entity. They were fractious, and intensely political. Most everyone might be thinking mainly about his year-end bonus, but that didn’t mean there wasn’t one person who wasn’t, and it certainly didn’t mean that everyone inside a big bank shared the same incentives. A dollar in one guy’s pocket was, in some places, a dollar out of another’s. For instance, the guys in the prop group who traded against the firm’s customers in the dark pool would naturally feel a different concern for those customers than the guy whose job it was to sell them stuff would—if for no other reason than that it is harder to rip off a person when you actually need to see him, face to face. That’s why the banks kept the prop traders on different floors from the salespeople, often in entirely different buildings. It wasn’t simply to please the regulators; all involved would prefer that there be no conversation between the two groups. The customer guy was better at his job—and had deniability—if he remained oblivious to whatever the prop guy was up to. The frantic stupidity of Wall Street’s stock order routers and algorithms was simply an extension into the computer of the willful ignorance of its salespeople.

Brad’s job, as he saw it, was to force the argument between the salespeople and the prop people—and to arm the salespeople with a really great argument, which included the distinct possibility that investors in the stock market were about to wake up to what was being done to them, and go to war against the people who were doing it. In most cases, he had no idea if he had succeeded and, as a result, suspected he had not.

Right from the start, the view from inside Goldman Sachs had been less cluttered than the view from inside the other big Wall Street banks. Goldman was unlike the other banks; for instance, the first thing the people he met at the other banks usually did was tell him of the hostility all the other banks felt toward IEX, and of the nefariousness of the other banks’ dark pools. Goldman was aloof, and didn’t appear to care what its competitors were saying or thinking about IEX. In their stock market trading and perhaps in other departments as well, Goldman was undergoing some kind of transition. In February 2013, its head of electronic trading, Greg Tusar, had left to work for Getco, the big high-frequency trading firm. The two partners then assigned to figure out Goldman’s role in the global stock markets—Ron Morgan and Brian Levine—were not high-frequency trading types. They didn’t bear a great deal of responsibility for whatever the high-frequency trading types had done before they took over. Morgan worked in New York and was in charge of sales; Levine, responsible for trading, worked in London. Both were apparently worried about what they had found when they stepped into their new positions. Brad knew this because, oddly, Ron Morgan had called him. “He found us by talking to clients about what they wanted,” said Brad. A week after they first met, Morgan invited Brad back to meet with a group of even more senior executives. “That didn’t happen anywhere else,” Brad said. After he left, he was told that the ensuing discussion had reached “the highest levels of the firm.”