Flash Boys: A Wall Street Revolt (13 page)

Several days later he’d worked his way back to the late 1800s. The entire history of Wall Street was the story of scandals, it now seemed to him, linked together tail to trunk like circus elephants. Every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice. “No matter what the regulators did, some other intermediary found a way to react, so there would be another form of front-running,” he said. When he was done in the Staten Island library he returned to work, as if there was nothing unusual at all about the product manager having turned himself into a private eye. He’d learned several important things, he told his colleagues. First, there was nothing new about the behavior they were at war with: The U.S. financial markets had always been either corrupt or about to be corrupted. Second, there was zero chance that the problem would be solved by financial regulators; or, rather, the regulators might solve the narrow problem of front-running in the stock market by high-frequency traders, but whatever they did to solve the problem would create yet another opportunity for financial intermediaries to make money at the expense of investors.

Schwall’s final point was more aspiration than insight. For the first time in Wall Street history, the technology existed that eliminated entirely the need for financial intermediaries. Buyers and sellers in the U.S. stock market were now able to connect with each other without any need of a third party. “The way that the technology had evolved gave me the conviction that we had a unique opportunity to solve the problem,” he said. “There was no longer any need for any human intervention.” If they were going to somehow eliminate the Wall Street middlemen who had flourished for centuries, they needed to enlarge the frame of the picture they were creating. “I was so concerned that we were talking about what we were doing as a solution to high-frequency trading,” he said. “It was bigger than that. The goal had to be to eliminate
any
unnecessary intermediation.”

BRAD FOUND IT
odd that his product manager had set off to investigate the history of Wall Street scandal—it was a bit like an offensive lineman choosing to skip practice to infiltrate the opposing team’s locker room. But Schwall’s side career as a private eye, at least at first, struck him as a harmless digression, of a piece with Schwall’s tendency in meetings to go off on tangents. “Once he gets on one of these bents it’s better just to let him go,” said Brad. “That’s just him working eighteen-hour days instead of fourteen-hour days.”

Besides, they now had far bigger problems. By the middle of 2011, Thor’s limitations were visible. “We had this meteoric rise in our business the first year and then it flatlines,” said Brad. In an open market, when customers were offered a new and better product, they ditched their old product for it. Wall Street banks weren’t subject to the usual open market forces. 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. RBC’s clients were now routinely calling to say, “Hey, we love using Thor, but there is only so much business we can do with you because we have to pay Goldman Sachs and Morgan Stanley.”

The Royal Bank of Canada was running away with the title of Wall Street’s most popular broker by peddling a tool whose only purpose was to protect investors from the rest of Wall Street. The investors refused to draw the obvious conclusion that they should have a lot less to do with the rest of Wall Street. RBC had become the number-one-rated stockbroker in America and yet was still only the ninth best paid: They would never attract more than a tiny fraction of America’s stock market trades, and that fraction would never be enough to change the system. A guy Ronan knew at the big high-frequency trading shop Citadel called him one day and put the matter in a nutshell:
I know what you’re doing. It’s genius. And there’s nothing we can do about it. But you are only two percent of the market.

On top of that, the big Wall Street banks, seeing RBC’s success, were seeking to undermine it or at least to pretend to replicate it. “The tech people at other firms are calling me and saying, ‘I want to do Thor. How does Thor work?’ ” recalled Allen Zhang. The business people at the banks were now calling Ronan and Rob and offering them multiples of what they earned at RBC to leave. The whole of Wall Street had been in something like a two-year hiring freeze, and yet these big banks were suggesting to Ronan—who had spent the past fifteen years unable to get his foot in the door of any bank—that they’d pay him as much as $1.5 million to join them. Headhunters called Brad and told him that, if he was willing to leave RBC for a competitor, the opening bid was $3 million a year, guaranteed. Just to keep his team in place, Brad arranged for RBC to create a pool of money and set it aside: If the guys hung around for three years, they would be handed the money and would wind up being paid something closer to their market value. RBC agreed to do it, probably because Brad did not ask for a piece of the action himself and continued to work for far less than he could have made elsewhere.

The bank’s marketing department proposed to Brad, as a way to get some media attention for Thor, that he apply for a
Wall Street Journal
Technology Innovation Award. Brad had never heard of the
Wall Street Journal
’s Technology Innovation Awards, but he thought that he might use the
Wall Street Journal
to tell the world just how corrupt the U.S. stock market had become. His bosses at RBC, when they got wind of his plans, wanted him to attend a lot of meetings—to discuss what he might say to the
Wall Street Journal
. They worried about their relationships with other Wall Street banks and with the public exchanges. “They didn’t want to ruffle anyone’s feathers,” says Brad. “There was not a lot I couldn’t say in a small closed forum, but they didn’t want me saying it openly.” He soon realized that, while RBC would allow him to apply for awards, it would not let him describe publicly what Thor had inadvertently exposed: the manner in which HFT firms front-ran ordinary investors; the conflict of interest that brokers had when they were being paid by the exchanges to route orders; the conflict of interest the exchanges had when they were being paid a billion dollars a year by HFT firms for faster access to market data; the implications of an exchange paying brokers to “take” liquidity; that Wall Street had found a way to bill investors without showing them the bill. “I had about eight things I wanted to say to the
Journal
,” said Brad. “By the time I got through all these meetings, there was nothing to say. I was only allowed to say one of them—that we had found a way to route orders so they arrived at the exchanges simultaneously.”

That was the problem with being RBC nice: It rendered you incapable of going to war with nasty. Before Brad said anything at all to the
Wall Street Journal
, RBC’s upper management felt they needed to inform the U.S. regulators of what little he planned to say. They asked Brad to prepare a report on Thor for the SEC and then flew themselves down from Canada to join him in a big meeting with the SEC’s Division of Trading and Markets staff. “It was more about not wanting them to be embarrassed about not knowing about Thor than it was us thinking they were going to do something about it,” Brad said. He had no idea what a meeting at the SEC was supposed to be like and prepared as if he were testifying before Congress. As he read straight from the document he had written, the people around the table listened, stoned-faced. “I was scared shitless,” he said. When he was finished, an SEC staffer said,
What you are doing is not fair to high-frequency traders. You’re not letting them get out of the way.

Excuse me?
said Brad.

The SEC staffer argued that it was unfair that high-frequency traders couldn’t post phony bids and offers on the exchanges to extract information from actual investors without running the risk of having to stand by them. It was unfair that Thor forced them to honor the markets they claimed to be making. Brad just looked at the guy: He was a young Indian quant.

Then a second staffer, a much older guy, raised his hand and said,
If they don’t want to be on the offer they shouldn’t be there at all.

A lively argument ensued, with the younger SEC staffers taking the side of high-frequency trading and the older half taking Brad’s point. “There was no clear consensus,” said Brad. “But it gave me a sense that they weren’t going to be doing anything anytime soon.”
‡
After the meeting, RBC conducted a study, never released publicly, in which they found that more than two hundred SEC staffers since 2007 had left their government jobs to work for high-frequency trading firms or the firms that lobbied Washington on their behalf. Some of these people had played central roles in deciding how, or even whether, to regulate high-frequency trading. For instance, in June 2010, the associate director of the SEC’s Division of Trading and Markets, Elizabeth King, had quit the SEC to work for Getco. The SEC, like the public stock exchanges, had a kind of equity stake in the future revenues of high-frequency traders.

The argument in favor of high-frequency traders had beaten the argument against them to the U.S. regulators. It ran as follows: Natural investors in stocks, the people who supply capital to companies, can’t find each other. The buyers and sellers of any given stock don’t show up in the market at the same time, so they needed an intermediary to bridge the gap, to buy from the seller and to sell to the buyer. The fully computerized market moved too fast for a human to intercede in it, and so the high-frequency traders had stepped in to do the job. Their importance could be inferred from their activity: In 2005 a quarter of all trades in the public stock markets were made by HFT firms; by 2008 that number had risen to 65 percent. Their new market dominance—so the argument went—was a sign of progress, not just necessary but good for investors. Back when human beings sat in the middle of the stock market, the spreads between the bids and the offers of any given stock were a sixteenth of a percentage point. Now that computers did the job, the spread, at least in the more actively traded stocks, was typically a penny, or one-hundredth of 1 percent. That, said the supporters of high-frequency trading, was evidence that more HFT meant more liquidity.

The arguments against the high-frequency traders hadn’t spread nearly so quickly—at any rate, Brad didn’t hear them from the SEC. A distinction cried out to be made, between “trading activity” and “liquidity.” A new trader could leap into a market and trade frantically inside it without adding anything of value to it. Imagine, for instance, that someone passed a rule, in the U.S. stock market as it is currently configured, that
required
every stock market trade to be front-run by a firm called Scalpers Inc. Under this rule, each time you went to buy 1,000 shares of Microsoft, Scalpers Inc. would be informed, whereupon it would set off to buy 1,000 shares of Microsoft offered in the market and, without taking the risk of owning the stock for even an instant, sell it to you at a higher price. Scalpers Inc. is prohibited from taking the slightest market risk; when it buys, it has the seller firmly in hand; when it sells, it has the buyer in hand; and at the end of every trading day, it will have no position at all in the stock market. Scalpers Inc. trades for the sole purpose of interfering with trading that would have happened without it. In buying from every seller and selling to every buyer, it winds up: a) doubling the trades in the marketplace and b) being exactly 50 percent of that booming volume. It adds nothing to the market but at the same time might be mistaken for the central player in that market.

This state of affairs, as it happens, resembles the United States stock market after the passage of Reg NMS. From 2006 to 2008, high-frequency traders’ share of total U.S. stock market trading doubled, from 26 percent to 52 percent—and it has never fallen below 50 percent since then. The total number of trades made in the stock market also spiked dramatically, from roughly 10 million per day in 2006 to just over 20 million per day in 2009.

“Liquidity” was one of those words Wall Street people threw around when they wanted the conversation to end, and for brains to go dead, and for all questioning to cease. A lot of people used it as a synonym for “activity” or “volume of trading,” but it obviously needed to mean more than that, as activity could be manufactured in a market simply by adding more front-runners to it. To get at a useful understanding of liquidity and the likely effects of high-frequency trading on it, one might better begin by studying the effect on investors’ willingness to trade once they sense that they are being front-run by this new front-running entity. Brad himself had felt the effect: When the market as displayed on his screens became illusory, he became less willing to take risk in that market—to provide liquidity. He could only assume that every other risk-taking intermediary—every other useful market participant—must have felt exactly the same way.

The argument for HFT was that it provided liquidity, but what did this mean? “HFT firms go home flat every night,” said Brad. “They don’t take positions. They are bridging an amount of time between buyers and sellers that’s so small that no one even knows it exists.” After the market was computerized and decimalized, in 2000, spreads in the market had narrowed—that much was true. Part of that narrowing would have happened anyway, with the automation of the stock market, which made it easier to trade stocks priced in decimals rather than in fractions. Part of that narrowing was an illusion: What appeared to be the spread was not actually the spread. The minute you went to buy or sell at the stated market price, the price moved. What Scalpers Inc. did was to hide an entirely new sort of activity behind the mask of an old mental model—in which the guy who “makes markets” is necessarily taking market risk and providing “liquidity.” But Scalpers Inc. took no market risk.
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