Flash Boys: A Wall Street Revolt
Michael Lewis

Ended: Oct. 17, 2016

Worried that it needed to do more to promote diversity, RBC invited Brad along with a bunch of other nonwhite people to a meeting to discuss the issue. Going around the table, people took turns responding to a request to “talk about your experience of being a minority at RBC.” When Brad’s turn came he said, “To be honest, the only time I’ve ever felt like a minority is this exact moment. If you really want to encourage diversity you shouldn’t make people feel like a minority.” Then he left. The group continued to meet without him.
The RBC trading floor had what the staff liked to refer to as a “no-asshole rule”; if someone came in the door looking for a job and sounding like a typical Wall Street asshole, they wouldn’t hire him, no matter how much money he said he could make the firm.
The best way to manage people, he thought, was to convince 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. These thoughts came naturally to him: They just seemed obvious.
“Jeremy was emotional, erratic, and loud—everything the Canadians were not,” says one former senior RBC executive. “To me, Toronto is like a foreign country,” said Frommer later. “The people there are not the same culture as us. They take a very cerebral approach to Wall Street. It was just such a different world. It was a hard adjustment for me. If you were a hitter, you couldn’t swing your dick around the way you could in the old days.”
For reasons Brad did not fully grasp, RBC insisted that he move with his entire U.S. stock trading department from their offices near the World Trade Center site into Carlin’s building in Midtown. This bothered him a lot. He got the distinct impression that people in Canada had decided that electronic trading was the future, even if they didn’t understand why or even what it meant.
There they found a Chinese programmer named Allen Zhang, who, it turned out, had written the computer code for the doomed dark pool. “I couldn’t tell who was good and who was not from just talking to them, but Rob could,” said Brad. “And it became clear that Allen was the Goose.” Or, at any rate, the only part of the Goose that might be turned to gold. Allen, Brad noticed, had no interest in conforming to the norms of corporate life. He preferred to work on his own, in the middle of the night, and refused to ever take off his baseball cap, which he wore pulled down low over his eyes, giving him the appearance of a getaway driver badly in need of sleep. Allen was also incomprehensible: What was just possibly English came tumbling out of him so quickly and indistinctly that his words tended to freeze the listener in his tracks. As Brad put it, “Whenever Allen said anything, I’d turn to Rob and say, ‘What the fuck did he just say?’
The first thing that struck Ronan about a lot of the big investors he met was their insecurity. “People in this industry don’t want to admit they don’t know something,” he said. “Almost never do they say, ‘No, I don’t know. Tell me.’ I’d say, ‘Do you know what co-location is?’ And they’d say, ‘Oh yeah, I know about co-location.’ Then I’d say, ‘You know, HFT now puts their servers in the same building with the exchange, as close as possible to the exchange’s matching engine, so they get market data before everyone else.’ And people are like, ‘What the fuck??!! That’s got to be illegal!’ We met with hundreds of people. And no one knew about it.” He was also surprised to find how wedded they were to the big Wall Street banks, even when those banks failed them. “In HFT there was no loyalty whatsoever,” he said. Over and over again, investors would tell Ronan and Brad how outraged they were that the big Wall Street firms that handled their stock market orders had failed to protect them from this new predator. Yet they were willing to give RBC only a small percentage of their trades to execute. “This was the biggest confusion to me about Wall Street,” said Ronan. “ ‘Wait, you’re telling me you can’t pay us because you need to pay all these other people who are trying to screw you?’
Vincent Daniel, the head strategist at Seawolf, put it another way. He took a long look at this unlikely pair—a Canadian Asian guy from this bank no one cared about, and this Irish guy who was doing a fair impression of a Dublin handyman—who had 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 fuck me.”
Investors paid Wall Street banks for all sorts of reasons: for research, to keep them sweet, to get private access to corporate executives, or simply because they had always done so. The way that they paid them was to give them their trades to execute—that is, they believed they needed to allocate some very large percentage of their trades to the big Wall Street banks simply to maintain existing relations with them.
Ronan landed back in New York on Tuesday, January 3, 2012, turned on his BlackBerry, and watched the new messages flood in. The first was from Brad, announcing his resignation from the Royal Bank of Canada. As Ronan later recalled the moment, “The next ten messages said, ‘Holy shit, Brad Katsuyama just fucking resigned.’
“I have a question about Brad: Have you figured out why he’s playing Robin Hood?” Brad’s first answer to that question was the thing he’d told himself: The stock market had become grotesquely unjust, and badly needed to be changed, and he’d come to see that, if he didn’t do it, no one else would. “That didn’t sit well,” he recalled. “They’d just say, ‘That sounds like complete bullshit.’ The first couple of times it happened, it really bothered me.” Then he got over it. If this new stock exchange flourished, its founders stood to make money—maybe a lot of money. He wasn’t a monk; he simply didn’t feel any need to make great sums of money. But he noticed, weirdly, that when he stressed how much money he himself might make from the new stock exchange, potential investors in his new business warmed to him—and so he started to stress how much money he might make. “We had a saying that seemed to appease everyone when they asked why we are doing this,” he said. “We are long-term greedy. That worked very well. . . . It always got a better response out of them than my first answer.”
He spent six months running around New York faking greed he didn’t really feel, to put money people at ease. It was maddening: He couldn’t get the people who should give him money to do so, and he couldn’t take the money from the people who wanted to give it to him. Just about all of the big Wall Street banks either asked him outright if they might buy a stake in his exchange or wanted at least to be considered as possible investors. But if he took their money, his stock exchange would lose both its independence and its credibility with investors. His friends and family in Toronto also all wanted to invest in his new company.
Just about all of the big Wall Street banks either asked him outright if they might buy a stake in his exchange or wanted at least to be considered as possible investors. But if he took their money, his stock exchange would lose both its independence and its credibility with investors.
What he needed was for the big stock market investors who had said they wanted him to quit RBC to fix the stock market—that is, the mutual funds, pension funds, and hedge funds—to put their money where their mouth was. They offered all sorts of excuses why they couldn’t help: They weren’t designed to invest in start-ups; the investment managers thought it was a great idea, but the compliance arm simply wasn’t equipped to evaluate Brad; and so on.
What had gone wrong, in Don’s view, wasn’t all that surprising or complicated. It had to do with human nature, and the power of incentives. The rise of high-frequency trading—and its ability to gain an edge on the rest of the market—had created an opportunity for new exchanges, like BATS and Direct Edge. By giving HFT what it wanted (speed, in relation to the rest of the market; complexity only HFT understood; and payment to brokers for their customers’ orders, so that HFT had something to trade against), the new stock exchanges had stolen market share from the old stock exchanges. Don couldn’t speak for NYSE, but he had watched Nasdaq respond by giving HFT firms what they asked for—and then figuring out how to charge them for
By late 2011, when Bollerman quit his job (“I felt there was a lack of leadership”), more than two-thirds of Nasdaq’s revenues derived, one way or another, from high-frequency trading firms.
He refused to feel morally outraged or self-righteous about any of it. “I would ask the question, ‘On the savannah, are the hyenas and the vultures the bad guys?’ ” he said. “We have a boom in carcasses on the savannah. So what? It’s not their fault. The opportunity is there.” To Don’s way of thinking, you were never going to change human nature—though you might alter the environment in which it expressed itself. Or maybe that’s just what Don wanted to believe. “He’s kind of like the mob guy who cries every now and then after a hit,” said Brad, who thought that Don was exactly the sort of person he needed.
“I’m just looking for the type of people who won’t get along here,” said Brad. “Typically, it’s because the way they describe their experience, and the things they say, are very self-serving. ‘I don’t get enough credit for what I do,’ or ‘I’m overlooked.’ It’s all about me. They’re obsessed with titles and other things that don’t matter. I try to find out how they work with other people. If they don’t know something, what do they do? I look for sponges, learners.”
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 the exchanges were able to react. Say, for instance, the market for P&G shares is 80–80.01, and buyers and sellers sit on both sides on all of the exchanges. A big seller comes in on the NYSE and knocks the price down to 79.98–79.99. High-frequency traders buy on NYSE at $79.99 and sell on all the other markets at $80, before the market officially changes. This happened all day, every day, and generated more billions of dollars a year than the other strategies combined.
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.
One of his favorite books was actually called Complexity, by M. Mitchell Waldrop. His favorite paper to pass out was “How Complex Systems Fail,” an eighteen-bullet-point summary by Richard I. Cook, now a professor of health care systems safety in Sweden. (Bullet Point #6: Catastrophe is always just around the corner.)
“People think that complex is an advanced state of complicated,” said Zoran. “It’s not. A car key is simple. A car is complicated. A car in traffic is complex.”
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.
Brad’s biggest weakness, as a strategist, was his inability to imagine just how badly others might behave. He had expected that the big banks would resist sending orders to IEX. He hadn’t imagined they would use their customers’ stock market orders to actively try at their customers’ expense to sabotage an exchange created to help their customers. “You want to create a system where behaving correctly would be rewarded,” he concluded. “And the system has been doing the opposite. It’s rational for a broker to behave badly.”
“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.”
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.
But it was more than that. At forty-eight and forty-three, respectively, Morgan and Levine were, by Wall Street standards, old guys. Morgan had been made a Goldman partner back in 2004, Levine in 2006. Both confided to friends that IEX presented them with a choice, at what might be a pivotal financial historical moment. An investor who knew Ron Morgan said, “Ronnie’s saying to himself, ‘You work for twenty-five years in the business, how often do you have a chance to make a difference?’ ” Brian Levine himself said, “I think it’s a business decision. I also think it’s a moral decision. I think this is the shot we have. And I think Brad is the right guy. It’s the best odds we have to fix the problem.”
A big Wall Street bank’s biggest advantage was its access to vast amounts of cheap risk capital and, with that, its ability to survive the ups and downs of a risky business. That meant little when the business wasn’t risky and didn’t require much capital. High-frequency traders went home every night with no position in the stock market. They traded in the market the way card counters in a casino played blackjack: They played only when they had an edge. That’s why they were able to trade for five years without losing money on a single day.
The big moves occurred first in the futures market in Chicago, before sweeping into the markets for individual stocks. If you were able to detect these moves, and warn your computers in New Jersey of price movements in Chicago, you could simply withdraw your bids for individual stocks before the market fully realized that it had fallen.
One enterprising U.S. brokerage firm, Interactive Brokers, announced that, unlike its competitors, it did not sell retail stock market orders to high-frequency traders, and even installed a button that enabled investors to route their orders directly to IEX, the stock market created by Brad Katsuyama and his team, who would protect them.
The trouble is that high-frequency traders don’t make anything like half of all trades on IEX. They make 17 percent of the trades. When you prevent high-frequency traders from preying on investors, their activity shrinks from more than half of all trading to less than one-fifth. Leave to one side the question of why a former financial market regulator appears to think it fine and dandy to use the prestige he acquired in government service to muddy the picture of the financial marketplace. In a fair marketplace there are many fewer collisions between high-frequency traders and ordinary investors than there are on the U.S. stock exchanges as currently designed.