Flash Boys: A Wall Street Revolt (21 page)

The role of the Puzzle Masters was to ensure that the new stock exchange did not contain aspects of a puzzle. That it had no problem inside its gears that could be “solved.” To begin, they listed the features of the existing stock exchanges and picked them apart. Aspects of the existing stock exchanges obviously incentivized bad behavior. Rebates, for instance: The maker-taker system of fees and kickbacks used by all of the exchanges was simply a method for paying the big Wall Street banks to screw the investors whose interests they were meant to guard. The rebates were the bait in the high-frequency traders’ flash traps. The moving parts of the traps were order types. Order types—like “market” and “limit”—exist so that the person who submits the order to buy or sell stock retains some control over his order after it has entered the marketplace.
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They are an acknowledgment that the investor cannot be physically present on the exchange to micromanage his situation. Order types also exist, less obviously, so that the person who is buying or selling stock can embed, in a single simple instruction, a lot of other, smaller instructions.

The old order types were simple and straightforward and mainly sensible. The new order types that accompanied the explosion of high-frequency trading were nothing like them, either in detail or spirit. When, in the summer of 2012, the Puzzle Masters gathered with Brad and Don and Ronan and Rob and Schwall in a room to think about them, there were maybe one hundred fifty different order types. What purpose did each serve? How might each be used? The New York Stock Exchange had created an order type that ensured that the trader who used it would trade only if the order on the other side of his was smaller than his own order; the purpose seemed to be to prevent a high-frequency trader from buying a small number of shares from an investor who was about to crush the market with a huge sale. Direct Edge created an order type that, for even more complicated reasons, allowed the high-frequency trading firm to withdraw 50 percent of its order the instant someone tried to act on it. All of the exchanges offered something called a Post-Only order. A Post-Only order to buy 100 shares of Procter & Gamble at $80 a share says, “I want to buy a hundred shares of Procter & Gamble at eighty dollars a share, but only if I am on the passive side of the trade, where I can collect a rebate from the exchange.” As if that weren’t squirrely enough, the Post-Only order type now had many even more dubious permutations. The Hide Not Slide order, for instance. With a Hide Not Slide order, a high-frequency trader—for who else could or would use such a thing?—would say, for example, “I want to buy a hundred shares of P&G at a limit of eighty dollars and three cents a share, Post-Only, Hide Not Slide.”

One of the joys of the Puzzle Masters was their ability to figure out what on earth that meant. The descriptions of single order types filed with the SEC often went on for twenty pages, and were in themselves puzzles—written in a language barely resembling English and seemingly designed to bewilder anyone who dared to read them. “I considered myself a somewhat expert on market structure,” said Brad. “But I needed a Puzzle Master with me to fully understand what the fuck any of it means.”

A Hide Not Slide order—it was just one of maybe fifty such problems the Puzzle Masters solved—worked as follows: The trader said he was willing to buy the shares at a price ($80.03)
above
the current offering price ($80.02), but only if he was on the passive side of the trade, where he would be paid a rebate. He did this not because he wanted to buy the shares. He did this in case an actual buyer of stock—a real investor, channeling capital to productive enterprise—came along and bought all the shares offered at $80.02. The high-frequency trader’s Hide Not Slide order then established him as first in line to purchase P&G shares if a subsequent investor came into the market to sell those shares. This was the case even if the investor who had bought the shares at $80.02 expressed further demand for them at the higher price. A Hide Not Slide order was a way for a high-frequency trader to cut in line, ahead of the people who’d created the line in the first place, and take the kickbacks paid to whoever happened to be at the front of the line.

The Puzzle Masters spent days working through the many order types. All of them had one thing in common: They were designed to create an edge for HFT at the expense of investors. “We’d always ask, ‘What is the point of that order, if you want to trade?’ ” said Brad. “Most of the order types were designed to
not
trade, or at least to discourage trading. [With] every rock we turned over, we found a disadvantage for the person who was actually there to trade.” Their purpose was to hardwire into the exchange’s brain the interests of high-frequency traders—at the expense of everyone who wasn’t a high-frequency trader. And the high-frequency traders wanted to obtain information, as cheaply and risklessly as possible, about the behavior and intentions of stock market investors. That is why, though they made only half of all trades in the U.S. stock market, they submitted more than 99 percent of the orders: Their orders were a tool for divining information about ordinary investors. “The Puzzle Masters showed me the length the exchanges were willing to go to—to satisfy a goal that wasn’t theirs,” said Brad.

The Puzzle Masters might not have thought of it this way at first, but in trying to design their exchange so that investors who came to it would remain safe from high-frequency traders, they were also divining the ways in which high-frequency traders stalked their prey. As they worked through the order types, they created a taxonomy of predatory behavior in the stock market. Broadly speaking, it appeared as if there were three activities that led to a vast amount of grotesquely unfair trading. The first they called “electronic front-running”—seeing an investor trying to do something in one place and racing him to the next. (What had happened to Brad, when he traded at RBC.) The second they called “rebate arbitrage”—using the new complexity to game the seizing of whatever kickbacks the exchange offered without actually providing the liquidity that the kickback was presumably meant to entice. 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 exchanges 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.

All three predatory strategies depended on speed, and to speed the Puzzle Masters turned their attention, once they were done with the order types. They were trying to create a safe place, where every dollar stood the same chance. How to do that, when a handful of people in the market would always be faster than everyone else? They couldn’t very well prohibit high-frequency traders from trading on the exchange—an exchange needed to offer fair access to all broker-dealers. And, anyway, it wasn’t high-frequency trading in itself that was pernicious; it was its predations. It wasn’t necessary to eliminate high-frequency traders; all that was needed was to eliminate the unfair advantages they had, gained by speed and complexity. Rob Park put it best: “Let’s say you know something before everyone else. You are in a privileged state. Eliminating the position of privilege is impossible—some people always will get the information first. Some people will always get it last. You can’t stop it. What you can control is how many moves they can make to monetize it.”

The obvious starting point was to prohibit high-frequency traders from doing what they had done on all the other exchanges—co-locating inside them, and getting the information about whatever happened on those exchanges before everyone else.
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That helped, but it did not entirely solve the problem: High-frequency traders would always be faster at processing the information they acquired from any exchange, and they would always be faster than anyone else to exploit that information on other exchanges. This new exchange would be required both to execute trades on itself and to route, to the other exchanges, the orders it was unable to execute. The Puzzle Masters wanted to encourage big orders, and larger-sized trades, so that honest investors with a lot of stock to sell might collide with honest investors who had a lot of stock to buy, without the intercession of HFT. If some big pension fund came to IEX to buy a million shares of P&G and found only 100,000 for sale there, it would be exposed to some high-frequency trader figuring out that its demand for P&G shares was unsatisfied. The Puzzle Masters wanted to be sure that they could beat any HFT firm to the supply of P&G stock on the other exchanges.

They entertained all sorts of ideas about how to solve the speed problem. “We had professors coming through here constantly,” said Brad. For instance, one professor suggested a “randomized delay.” Every order submitted to the new stock exchange would be assigned, at random, some time lag before it entered the market. The market information some high-frequency trader obtained with his 100-share sell order, the sole intention of which was to uncover the existence of a big buyer, might thus move so slowly that it would prove of no use to him. An order would become, like a lottery ticket, a matter of chance. The Puzzle Masters instantly spotted the problem: Any decent HFT firm would simply buy huge numbers of lottery tickets—to increase its chances of being the 100-share sell order that collided with the massive buy order. “Someone will just flood the market with orders,” said Francis. “You end up massively increasing quote traffic for every move.”

It was Brad who had the crude first idea:
Everyone is fighting to get in as close to the exchange as possible. Why not push them as far away as possible?
Put ourselves at a distance, but don’t let anyone else be there.
In designing the exchange, they needed to consider what the regulators would tolerate; they couldn’t just do whatever they wanted. Brad kept a close eye on what the regulators already had approved, and paid special attention when the New York Stock Exchange won the SEC’s approval for the strange thing they had done in Mahwah. They’d built this 400,000-square-foot fortress in the middle of nowhere, and they planned to sell, to high-frequency traders, access to their matching engine. But the moment they announced their plans, high-frequency trading firms began to buy up land surrounding the fort—so that they might be near the NYSE matching engine, without paying the NYSE for the privilege. In response, the NYSE somehow persuaded the SEC to let them make a rule for themselves: Any banks or brokers or HFT firms that did not buy (expensive) space inside the fort would be allowed to connect to the NYSE in one of two places: Newark, New Jersey, or Manhattan. The time required to move a signal from those places to Mahwah undermined HFT strategies; and so the banks and brokers and HFT firms were all forced to buy space inside the fort from the NYSE. Brad thought:
Why not create the distance that undermines HFT’s strategies, without selling high-frequency traders the right to put their computers in the same building?
“There was a precedent: They’d let NYSE do it,” Brad said. “Unless the regulators said, ‘You must allow co-location,’ ” they’d have to let IEX forbid it.

The idea was to establish the IEX computer that matched buyers and sellers (the matching engine) at some meaningful distance from the place traders connected to IEX (called the “point of presence”), and to require anyone who wanted to trade to connect to the exchange at that point of presence. If you placed every participant in the market far enough away from the exchange, you could eliminate most, and maybe all, of the advantages created by speed. Their matching engine, they already knew, would be located in Weehawken, New Jersey (they’d been offered cheap space in a data center). The only question was: Where to put the point of presence? “Let’s put it in Nebraska,” someone said, but they all knew it would be harder to get the already reluctant Wall Street banks to connect to their market if the banks had to send people to Omaha to do it. Actually, though, it wasn’t necessary for anyone to move to Nebraska. The delay needed only to be long enough for IEX, once it had executed some part of a customer’s buy order, to beat HFT in a race to any other shares available in the marketplace at the same price—that is, to prevent electronic front-running. It needed to be long enough, also, for IEX, each time a share price moved on any exchange, to process the change, and to move the prices of any orders resting on it, so that they didn’t get picked off—in the way, say, that Rich Gates had been picked off, when he ran his tests to determine if he was being ripped off inside the dark pools run by the big Wall Street banks. (That is, to prevent “slow market arbitrage.”) The necessary delay turned out to be 320 microseconds; that was the time it took them, in the worst case, to send a signal to the exchange farthest from them, the NYSE in Mahwah. Just to be sure, they rounded it up to 350 microseconds.

The new stock exchange also cut off the food source for all identifiable predators. Brad, when he was a trader, had been cheated because his orders had arrived first at BATS, where HFT guys had picked up his signal and raced him to the other exchanges. The fiber routes through New Jersey that Ronan handpicked were chosen so that an order sent from IEX to the other exchanges arrived at them all at precisely the same time. (He thus achieved with hardware what Thor had achieved with software.) Rich Gates had gotten himself picked off in the Wall Street dark pools because the dark pools had not moved fast enough to re-price his order. The slow movement of the dark pools’ prices had made it possible for a high-frequency trader (or the Wall Street banks’ own traders) to exploit the orders inside it—legally. To prevent the same thing from happening on their new exchange, IEX needed to be extremely fast—much faster than any other exchange. (At the same time that they were slowing down everyone who traded on their exchange, they were speeding themselves up.) To “see” the prices on the other stock exchanges, IEX didn’t use the SIP or some phony improvement on the SIP but instead created their own private, HFT-like pictures of the entire stock market. Ronan had scoured New Jersey for paths from their computers in Weehawken to all the other exchanges; there turned out to be thousands of them. “We used the fastest subterranean routes,” said Ronan. “All the fiber we used was created by HFT for HFT. One hundred percent of it.” The 350-microsecond delay worked like a head start in a footrace. It ensured that IEX would be faster to see and react to the wider market than even the fastest high-frequency trader, thus preventing investors’ orders from being abused by changes in that market. In the bargain, it prevented high-frequency traders—who would inevitably try to put their computers nearer than everyone else’s to IEX’s in Weehawken—from submitting their orders onto IEX more quickly than everyone else.