Flash Boys: A Wall Street Revolt (14 page)

In spirit Scalpers Inc. was less a market enabler than a weird sort of market burden. Financial intermediation is a tax on capital; it’s the toll paid by both the people who have it and the people who put it to productive use. Reduce the tax and the rest of the economy benefits. Technology should have led to a reduction in this tax; the ability of investors to find each other without the help of some human broker might have eliminated the tax altogether. Instead this new beast rose up in the middle of the market and the tax increased—by billions of dollars. Or had it? To measure the cost to the economy of Scalpers Inc., you needed to know how much money it made. That was not possible. The new intermediaries were too good at keeping their profits secret.
¶
Secrecy might have been the signature trait of the entities who now sat at the middle of the stock market: You had to guess what they were making from what they spent to make it. Investors who eyeballed the situation did not find reason for hope. “There used to be this guy called Vinny who worked on the floor of the stock exchange,” said one big investor who had observed the market for a long time. “After the markets closed Vinny would get into his Cadillac and drive out to his big house in Long Island. Now there is the guy called Vladimir who gets into his jet and flies to his estate in Aspen for the weekend. I used to worry a little about Vinny. Now I worry a lot about Vladimir.”

Apart from taking some large sum of money out of the market, and without taking risk or adding anything of use to that market, Scalpers Inc. had other, less intended consequences. Scalpers Inc. inserted itself into the middle of the stock market not just as an unnecessary middleman but as a middleman with incentives to introduce dysfunction into the stock market. Scalpers Inc. was incentivized, for instance, to make the market as volatile as possible. The value of its ability to buy Microsoft from you at $30 a share and to hold the shares for a few microseconds—knowing that, even if the Microsoft share price began to fall, it could turn around and sell the shares at $30.01—was determined by how likely it was that Microsoft’s share price, in those magical microseconds, would rise in price. The more volatile Microsoft’s share price, the higher Microsoft’s stock price might move during those microseconds, and the more Scalpers Inc. would be able to scalp. One might argue that intermediaries have always profited from market volatility, but that is not really true. The old specialists on the New York Stock exchange, for instance, because they were somewhat obliged to buy in a falling market and to sell in a rising one, often found that their worst days were the most volatile days. They thrived in times of relative stability.

Another incentive of Scalpers Inc. is to fragment the marketplace: The more sites at which the same stocks changed hands, the more opportunities to front-run investors from one site to another. The bosses at Scalpers Inc. would thus encourage new exchanges to open, and would also encourage them to place themselves at some distance from each other. Scalpers Inc. also had a very clear desire to maximize the difference between the speed of their private view of the market and the view afforded the wider public market. The more time that Scalpers Inc. could sit with some investor’s stock market order, the greater the chance that the price might move in the interim. Thus an earnest employee of Scalpers Inc. would look for ways either to slow down the public’s information or to speed up his own.

The final new incentive introduced by Scalpers Inc. was perhaps the most bizarre. The easiest way for Scalpers Inc. to extract the information it needed to front-run other investors was to trade with them. At times it was possible to extract the necessary information without having to commit to a trade. That’s what the “flash order” scandal had been about: high-frequency traders being allowed by the exchanges to see other people’s orders before anyone else, without any obligation to trade against them. But for the most part, if you wanted to find out what some big investor was about to do, you needed to do a little bit of it with him. For instance, to find out that, say, T. Rowe Price wanted to buy 5 million shares of Google Inc., you needed to sell some Google to T. Rowe Price. That initial market contact between any investor and Scalpers Inc. was like the bait in a trap—a loss leader. For Scalpers Inc., the goal was to spend as little as possible to acquire the necessary information—to make those initial trades, the bait, as small as possible.

To an astonishing degree, since the implementation of Reg NMS, the U.S. financial markets had evolved to serve the narrow interests of Scalpers Inc. Since the mid-2000s, the average trade size in the U.S. stock market had plummeted, the markets had fragmented, and the gap in time between the public view of the markets and the view of high-frequency traders had widened. The rise of high-frequency trading had been accompanied also by a rise in stock market volatility—over and above the turmoil caused by the 2008 financial crisis. The price volatility within each trading day in the U.S. stock market between 2010 and 2013 was nearly 40 percent higher than the volatility between 2004 and 2006, for instance. There were days in 2011 in which volatility was higher than in the most volatile days of the dot-com bubble.

The financial crisis brought with it a great deal of stock market volatility; perhaps people just assumed that there was supposed to be an unusual amount of drama in the stock market evermore. But then the financial crisis abated and the drama remained. There was no good explanation for this, but Brad now had a glimmer of one. It had to do with the way a front-runner operates. A front-runner sells you a hundred shares of some stock to discover that you are a buyer and then turns around and buys everything else in sight, causing the stock to pop higher (or the opposite, if you happen to be a seller). The Royal Bank of Canada had tested the effects on stock market volatility of using Thor, which stymied front-runners, rather than the standard order routers used by Wall Street, which did not. The sequential cost-effective router responded to the kickbacks and fees of the various exchanges and went to those exchanges first that paid them the most to do so. The spray router—which, as its name suggests, just sprayed the market and took whatever stock was available, or tried to—did not make any effort to compel a stock market order to arrive at the different exchanges simultaneously. Every router, when it bought stock, tended to drive the price of that stock a bit higher. But when the stock had settled—say, ten seconds later—it settled differently with each router. The sequential cost-effective router caused the share price to remain higher than the spray router did, and the spray router caused it to move higher than Thor did. “I have no scientific evidence,” said Brad. “This is purely a theory. But with Thor the HFT firms are trying to cover their losses.
I’m short when I don’t want to be, so I need to buy to cover, quickly.
” The other two routers enabled HFT to front-run, so they wound up being long the stock. “[With] the other two, HFT is in a position to trade around a winning position,” said Brad, “and they can do whatever they can do to force the stock even higher.” (Or lower, if the investor who triggered the activity is a seller.) They had, in those privileged microseconds, the reckless abandon of gamblers playing with house money.

The new choppiness in the public U.S. stock markets was spreading to other financial markets, as they, too, embraced high-frequency traders. It was what investors most noticed: They were less and less able to buy and sell big chunks of stock in a gulp. Their frustration with the public stock exchanges had led the big Wall Street banks to create private exchanges: dark pools. By the middle of 2011, roughly 30 percent of all stock market trades occurred off the public exchanges, most of them in dark pools. The appeal of these dark pools—said the Wall Street banks—was that investors could expose their big stock market orders without fear that those orders would be exploited.

WHAT BOTHERED RICH
Gates, at least at first, was the tone of the pitch he was hearing from the big Wall Street banks. All through 2008 and 2009 they would come to his office and tell him why he needed their algorithms to defend himself in the stock market.
This algo is like a tiger that lurks in the woods and waits for the prey and then jumps on it.
Or:
This algo is like an anaconda in a tree
. The algos had names like Ambush and Nighthawk and Raider and Dark Attack and Sumo. Citi had one called Dagger, Deutsche Bank had Slicer, and Credit Suisse had one named Guerrilla, which came, in the bank’s flip-chart presentation, with a menacing drawing of Che Guevara wearing a beret and scowling. What the hell was that about? Their very names made Rich Gates wary; he also didn’t like how loudly the brokers selling them told him they’d come to protect him. Protect him from what? Why did he need protection? From whom did he need to be protected? “I’m immediately skeptical of people saying they are looking out for my interests,” Gates said. “Especially on Wall Street.”

Gates ran a mutual fund, TFS Capital, that he had created in 1997 with friends from the University of Virginia. He liked to think of himself as a hick, but in truth he was a keenly analytical math geek in the perfectly pleasant Philadelphia suburb of West Chester. He managed nearly $2 billion belonging to 35,000 small investors but still positioned himself, even in his own mind, as an industry outsider. He believed that mutual funds were less often exercises in smart money management than in creepy marketing, and that many of the people who ran mutual funds should be doing something else with their lives. Back in 2007, to make this point, he dug out of a stack of league tables America’s worst-performing mutual fund: the Phoenix Market Neutral Fund. Over the prior decade, Gates’s firm had earned its investors returns of 10 percent per year. Over that same period, the Phoenix Market Neutral Fund had
lost
.09 percent a year for its investors—the investors would have been better off hopping over the fence of the president of the Phoenix Market Neutral Fund’s home and burying the money in his backyard. Gates wrote a letter to the Phoenix president saying, in effect,
You are so obviously inept at managing money that you could do your investors a favor by turning over all of your assets to me and letting me run them for you
. The president failed to reply.

The machismo of Wall Street’s algorithms, combined with what struck Gates as a lot of nonsensical talk about the need for trading speed, stirred his naturally suspicious mind. “I just noticed a lot of bullshit,” he said. He and his colleagues devised a test to see if there was anything in this new stock market to fear. The test, specifically, would show him if, when he entered an order into one of Wall Street’s dark pools, he wound up getting ripped off by some unseen predator. He started by identifying stocks that didn’t trade very often. Chipotle Mexican Grill, for instance. He sent in an order to a single Wall Street dark pool to buy that stock at the “mid-market” price. Say, for example, that the shares of Chipotle Mexican Grill were trading at 100–100.10. Gates would submit his bid to buy a thousand shares of Chipotle at $100.05. There it would normally just sit until some other investor came along and lowered his price from $100.10 to $100.05. Gates didn’t wait for that to happen. Instead, a few seconds later, he sent a second order to one of the public exchanges, to
sell
Chipotle at $100.01.

What should have happened next was that his order in the dark pool should have been filled at $100.01, the official new best price in the market. He should have been able to buy from himself the shares he was selling at $100.01. But that’s not what happened. Instead, before he could blink his eye, he had made two trades. He had bought Chipotle from someone inside the Wall Street dark pool at $100.05 and sold it to someone else on the public exchange for $100.01. He’d lost 4 cents by, in effect, trading with himself. Only he hadn’t traded with himself; some third party had obviously used the sell order he had sent to the public exchange to exploit the buy order he had sent to the dark pool.

Gates and his colleagues wound up making hundreds of such tests, with their own money, in several Wall Street dark pools. In the first half of 2010 there was only one Wall Street firm in whose dark pool the test came back positive: Goldman Sachs. In the Goldman dark pool, Sigma X, he got ripped off a bit more than half the time he ran the test. As Gates traded in lightly traded stocks, and high-frequency trading firms were overwhelmingly interested in heavily traded ones, these tests would have been vastly more likely to generate false negatives than false positives. Still, he was a bit surprised that Goldman, and only Goldman, seemed to be running a pool that allowed someone else to front-run his orders to the public stock exchanges. He called his broker at Goldman. “He said it wasn’t fair,” said Gates, “because it wasn’t just them. He said, ‘It’s happening all over. It’s not just us.’ ”

Gates was dutifully shocked. “When I first saw the results of these tests, I thought: This obviously is not right. As far as he could tell, no one seemed much to care that 35,000 small investors could be so exposed to predation inside Wall Street’s most prominent bank. “I’m amazed that people don’t ask the questions,” he said. “That they don’t dig deeper. If some schmuck in West Chester, PA, can figure it out, I’ve got to believe other people did, too.” Outraged, Gates called a reporter he knew at the
Wall Street Journal
. The reporter came to see Gates’s tests and seemed interested, but two months later there was still no piece in the
Journal
—and Gates sensed that there might never be. (Among other things, the reporter was uncomfortable mentioning Goldman Sachs by name.) At which point Gates noticed that the Dodd-Frank Wall Street Reform and Customer Protection Act, soon to be passed, contained a whistle-blower provision. “I’m like, ‘Holy crap, I’m trying to out this anyway. If I can get paid, too—great.’ ”

The people who worked in the SEC’s Division of Trading and Markets were actually great—nothing like what the public imagined. They were smart and asked good questions and even spotted small mistakes in Gates’s presentation, which he appreciated—though, as with Brad Katsuyama, they gave him no idea how they might respond to the information he’d given them. They wondered, shrewdly, exactly who was ripping off investors in Goldman’s dark pool. “They wanted to know if Goldman Sachs’s prop group was on the other side of the trade,” said Gates. He had no answer for that. “They don’t tell you who took the other side of the trade,” he said. All he knew was that he’d been ripped off, in exactly the way you might expect to be ripped off, when you can’t see the market trading in real time and others can.