Flash Boys: A Wall Street Revolt (11 page)

Spread was another piece of what was becoming a fantastically elaborate puzzle. The team Brad was assembling at RBC didn’t have all the pieces to the puzzle—not yet—but they had more of them than anyone else willing to talk openly on the subject. The reactions of investors to what they already knew they considered as simply more pieces of the puzzle. Every now and then—perhaps 5 percent of the time—Brad or Ronan met some investor who didn’t care to know about the puzzle, someone who didn’t want to hear their story. Whenever Brad returned from one of these meetings, he’d discover that the person to whom he had just spoken depended, one way or another, on the revenues flowing to high-frequency traders. Every now and again—maybe another 5 percent of the time—they met with an investor who was completely terrified. “They knew so little, and they’d be so scared inside their own firms that they’d rather the meeting never happened,” said Brad. But most of the hundreds of big-time investors with whom Brad and Ronan spoke had the same reaction as T. Rowe Price’s Mike Gitlin: They knew something was very wrong, but they didn’t know what, and now that they knew they were outraged. “Brad was the honest broker,” said Gitlin. “I don’t know how many knew it, but he was the only guy who would say it. He was saying, ‘I’m here and I’m watching it and we’re a party to it and the whole thing is rigged.’ He exposed people who were bad actors, and a lot of people in this industry are afraid to do that. He was saying, ‘This is just offensive.’ ” 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.”

Trust on Wall Street was still—just—possible. The big investors who trusted Brad began to share whatever information they could get their hands on from their other brokers—information Brad was never meant to see. For instance, several demanded to know from their other Wall Street brokers what percentage of the trades executed on their behalf were executed inside the brokers’ dark pools. These dark pools contained the murkiest financial incentives in the new stock market. Goldman Sachs and Credit Suisse ran the most prominent dark pools. But every brokerage firm strongly encouraged investors who wanted to buy or sell big chunks of stock to do so in that firm’s dark pool. In theory, the brokers were meant to find the best price for their customers. If the customer wanted to buy shares in Chevron, and the best price happened to be on the New York Stock Exchange, the broker was not supposed to stick the customer with a worse price inside their dark pool. But the dark pools were opaque. Their rules were not published. No outsider could see what went on inside them. It was entirely possible that a broker’s own traders were trading against the customers in the dark pool: There were no rules against it. And while the brokers often protested that there were no conflicts of interest inside their dark pools, all the dark pools exhibited the same strange property: A huge percentage of the customer orders sent into a dark pool were executed inside the pool. Brad knew this because a handful of the world’s biggest stock market investors had shared their information with him—so that he might help them figure out what was going on.

It was hard to explain. A broker was expected to find the best possible price in the market for his customer. The Goldman Sachs dark pool—to take one example—was less than 2 percent of the entire stock market. So why did nearly 50 percent of the customer orders routed into Goldman’s dark pool end up being executed inside that pool—rather than out in the wider market? Most of the brokers’ dark pools constituted less than 1 percent of the entire market, and yet somehow those brokers found the best price for their customers between 15 and 60 percent of the time. (So-called rates of internalization varied from broker to broker.) And because the dark pool was not required to say exactly when it had executed a trade, and the broker did not typically tell his investors where it had executed a trade, much less the market conditions at the moment of execution, the customer lived in darkness. Even a giant investor like T. Rowe Price simply had to take it on faith that Goldman Sachs or Merrill Lynch had acted in its interest, despite the obvious financial incentives
not
to do so. As Mike Gitlin said, “It’s just very hard to prove that any broker-dealer is routing the trades to someplace other than the place that is best for you. You couldn’t SEE what any given broker was doing.” If an investor as large as T. Rowe Price, which acted on behalf of millions of small investors, was unable to obtain from its stockbrokers the information it needed to determine if the brokers had acted in their interest, what chance did the little guy have?

In this environment, the effect of trying to help investors see what was happening to their money was revolutionary. The Royal Bank of Canada had never been anything more than the most trivial player in the U.S. stock market. At the end of 2010, Brad saw a report from Greenwich Associates, the firm used by Wall Street banks to evaluate their standing in relation to their peers. Greenwich Associates interviews the investors who use Wall Street’s services and privately reports their findings to the Wall Street firms. In 2009, RBC had—at number 19—been far down Greenwich Associates’ stock market rankings. At the end of 2010, after only six months of Thor, RBC was ranked number 1. Greenwich Associates called RBC to ask what on earth was going on within the bank. In the history of their rankings, they said, they had never seen a firm jump more than three spots.

At the same time, this movement spawned by Brad Katsuyama’s unhappiness with Wall Street was starting to feel less like a business than a cause. Brad was no radical. As he put it, “There’s a difference between choosing a crusade and having it thrust on you.” He’d never really thought all that much about how he fit into the bigger picture, and certainly never considered himself a character upon a stage. He’d never run for student council. He’d never had anything to do with politics. “It’s always seemed to me that the things you need to do to influence change had to do with glad-handing,” he said. “It just felt so phony.” This didn’t feel phony. This felt like a situation in which a person, through his immediate actions, might change the world. After all, he was now educating the world’s biggest money managers about the inner workings of the stock market, which strongly suggested to him that no one else on Wall Street was willing to teach them how their investment dollars were being abused. The more he understood the inner workings of the financial system, the better he might inform the investors, big and small, who were being abused by that system. And the more pressure they might bring to bear on the system to change.

The deep problem with the system was a kind of moral inertia. So long as it served the narrow self-interests of everyone inside it, no one on the inside would ever seek to change it, no matter how corrupt or sinister it became—though even to use words like “corrupt” and “sinister” made serious people uncomfortable, and so Brad avoided them. Maybe his biggest concern, when he spoke to investors, was that he’d be seen as just another nut with a conspiracy theory. One of the compliments that made him happiest was when a big investor said, “Thank God, finally there’s someone who knows something about high-frequency trading who isn’t an Area 51 guy.” Because he wasn’t a radical, it took him a while to figure out that fate and circumstance had created for him a dramatic role, which he was obliged to play. One night he actually turned to Ashley, now his wife, and said, “It feels like I’m an expert in something that badly needs to be changed. I think there’s only a few people in the world who can do anything about this. If I don’t do something right now—me, Brad Katsuyama—there’s no one to call.”

CHAPTER FOUR

TRACKING THE PREDATOR

B
y the end of 2010 they’d built a marketable weapon. The weapon promised to defend investors in the U.S. stock market from what appeared to be a new kind of market predator. About that predator they knew surprisingly little. Apart from Ronan, Brad knew no one from inside the world of high-frequency trading. He had only a vague idea of that world’s reach, or its political influence. From Ronan he knew that the HFT firms enjoyed special relationships with the public stock exchanges, but he knew nothing about their dealings with the big Wall Street banks tasked with guarding the interests of investors. Then again, many of the people who worked inside the Wall Street banks seemed to have only the faintest idea of what those banks were up to. If you worked for a big Wall Street bank, the easiest way to find out what other banks were up to was to seek out their employees who were looking for new jobs and interview them. In the wake of the financial crisis, the too-big-to-fail end of Wall Street was in turmoil, and Brad was able to talk to people who, just a few years before, would never have considered working for the Royal Bank of Canada. By the time he was finished picking their collective brains, he had spoken to more than a hundred employees at too-big-to-fail banks but hired only about thirty-five of them. “They all wanted jobs,” he said. “It’s not that they wouldn’t tell me. It’s that they didn’t know how their own electronic systems worked.”

The thread running through all these people, even the ones he didn’t hire, was their fear and distrust of the system. John Schwall was a curious case in point. Schwall’s father had been a firefighter on Staten Island, like his father before him. “Every male on my father’s side is a fireman,” Schwall said. “I wanted to do something more.” More meant getting a master’s in engineering from the Stevens Institute of Technology, in Hoboken, New Jersey. In the late 1990s he took a job at Banc of America Securities,
*
where he rose to a position with an important-sounding title: Head of New Products. His job description was more glamorous than his job. John Schwall was the guy behind the scenes who handled the boring details, like managing relations between the traders on the floor and the tech geeks who built stuff for them, or ensuring that the bank complied with new stock market regulations. He routinely ranked in the top 1 percent of all employees in Banc of America’s reviews of its personnel, but his status in a Wall Street bank was akin to head butler to a British upper-class family. To the grunts in the back office he might have seemed like a big shot, but to the traders who made the money he did not.

Whatever frustration this caused him he buried. Given an excuse to feel loyalty for his company, he seized it. September 11, 2001, for instance. Schwall’s desk was in the North Tower of the World Trade Center, on the eighty-first floor. By sheer fluke he had been late to work that morning—the only day in 2001 he would report late to work—and he’d watched the first plane hit, thirteen floors above his desk, from the window of a distant bus. Several of his colleagues died that day, and so had some Staten Island firemen he’d known. Schwall seldom spoke of the event, but privately he believed that, had he been at his desk when the plane hit, his instinct would have been to go up the stairs rather than down them. The guilt he felt for not having been on hand to help somehow became, in his mind, a debt he owed to his colleagues and to his employer. Which is to say that Schwall wanted to feel toward a Wall Street bank what a fireman is meant to feel toward his company. “I thought I’d be at Banc of America forever,” he said.

Then came the financial crisis, and, in 2008, the acquisition, by Bank of America, of a collapsing Merrill Lynch. What happened next upended Schwall’s worldview. Merrill Lynch had been among the most prolific creators of the very worst subprime mortgage bonds. Had they been left to the mercy of the market—had Bank of America not saved them—the Merrill Lynch people would have been tossed out on the street. Instead, right before their acquisition, they awarded themselves massive bonuses that Bank of America wound up having to pay. “It was incredibly unfair,” said Schwall. “It was incredibly unjust. My stock in this company I helped to build for nine years goes into the shitter, and these assholes pay themselves record bonuses. It was a fucking crime.” Even more incredibly, the Merrill Lynch people ended up in charge of Bank of America’s equity division and set about firing most of the people in it. A lot of those people had been good, loyal employees of the bank. “Wall Street is corrupt, I decided,” said Schwall afterwards. “There is no corporate loyalty to employees.”

Schwall was one of the few Banc of America people who kept his job: Merrill Lynch had no one to replace him. He hid his true feelings, but he no longer trusted his employer. And he sensed, for the first time in his career, that his employer did not trust him. One day he sent himself an email from his personal account to his work account—he was helping out some friends who had been fired by the bank and who wanted to start a small brokerage firm. His boss called him to ask him about it.
What the hell are they doing monitoring my incoming emails?
Schwall wondered.

His ability to monitor his superiors exceeded their ability to monitor him, and he began to do it. “There was a lot of unspoken animosity,” he said. He noticed the explosion of trading activity inside of Merrill Lynch’s dark pool fueled by high-frequency traders. He saw that Merrill Lynch created a new revenue line, to account for the money paid to them by high-frequency trading firms for access to the Merrill Lynch dark pool. He noticed that the guy who had built the Merrill Lynch electronic trading platform was one of the highest-paid people in all of Merrill Lynch—and he’d nevertheless quit to create a company that would cater to HFT firms. He noticed letters sent on bank letterhead to the Securities and Exchange Commission arguing against further stock market regulation. He saved one in which the bank’s lawyers wrote that “despite numerous changes in recent years in both market structure and participant behavior, the equity market is functioning well today.” One day he heard a rumor that the Merrill people had assigned an analyst to produce a report to prove that Merrill’s stock market customers were better off because of whatever happened inside Merrill’s dark pool. There was apparently some controversy around this report. Schwall filed that rumor away for later use.