That would have been fine but for the manner in which the best market price was calculated. The new law required a mechanism for taking the measure of the entire market—for creating the National Best Bid and Offer—by compiling all the bids and offers for all U.S. stocks in one place. That place, inside some computer, was called the Securities Information Processor, which, because there is no such thing on Wall Street as too many acronyms, became known as the SIP. The thirteen stock markets piped their prices into the SIP, and the SIP calculated the NBBO. The SIP was the picture of the U.S. stock market most investors saw.
Like a lot of regulations, Reg NMS was well-meaning and sensible. If everyone on Wall Street abided by the rule’s spirit, the rule would have established a new fairness in the U.S. stock market. The rule, however, contained a loophole: It failed to specify the speed of the SIP. To gather and organize the stock prices from all the exchanges took milliseconds. It took milliseconds more to disseminate those calculations. The technology used to perform these calculations was old and slow, and the exchanges apparently had little interest in improving it. There was no rule against high-frequency traders setting up computers inside the exchanges and building their own, much faster, better cared for version of the SIP. That’s exactly what they’d done, so well that there were times when the gap between the high-frequency traders’ view of the market and that of ordinary investors could be twenty-five milliseconds, or twice the time it now took to travel from New York to Chicago and back again.
Reg NMS was intended to create equality of opportunity in the U.S. stock market. Instead it institutionalized a more pernicious inequality. A small class of insiders with the resources to create speed were now allowed to preview the market and trade on what they had seen.
Thus—for example—the SIP might suggest to the ordinary investor in Apple Inc. that the stock was trading at 400–400.01. The investor would then give his broker his order to buy 1,000 shares at the market price, or $400.01. The infinitesimal period of time between the moment the order was submitted and the moment it was executed was gold to the traders with faster connections. How much gold depended on two variables: a) the gap in time between the public SIP and the private ones and b) how much Apple’s stock price bounced around. The bigger the gap in time, the greater the chance that Apple’s stock price would have moved; and the more likely that a fast trader could stick an investor with an old price. That’s why volatility was so valuable to high-frequency traders: It created new prices for fast traders to see first and to exploit. It wouldn’t matter if some people in the market had an early glimpse of Apple’s price if the price of Apple’s shares never moved.
Apple’s stock moved a lot, of course. In a paper published in February 2013, a team of researchers at the University of California, Berkeley, showed that the SIP price of Apple stock and the price seen by traders with faster channels of market information differed 55,000 times in a single day. That meant that there were 55,000 times a day a high-frequency trader could exploit the SIP-generated ignorance of the wider market. Fifty-five thousand times a day, he might buy Apple shares at an outdated price, then turn around and sell them at the new, higher price, exploiting the ignorance of the slower-footed investor on either end of his trades. And that was only the most obvious way a high-frequency trader might use his advance view of the market to make money.
Schwall already knew a lot about the boring nitty-gritty details of Reg NMS, as he had been in charge of implementing the new rule for the whole of Bank of America. He’d seen to the bank’s need to build so-called smart order routers that could figure out which exchange had the official best price of any given stock (the NBBO) and send the customers’ orders to that exchange. By complying with Reg NMS, he now understood, the smart order routers simply marched investors into various traps laid for them by high-frequency traders. “At that point I just got very, very pissed off,” he said. “That they are ripping off the retirement savings of the entire country through systematic fraud and people don’t even realize it. That just drives me up the fucking wall.”
His anger expressed itself in a search for greater detail. When he saw that Reg NMS had been created to correct for the market manipulations of the old NYSE specialists, he wanted to know: How had that corruption come about? He began another search. He discovered that the New York Stock Exchange specialists had been exploiting a loophole in some earlier regulation—which of course just led Schwall to ask: What event had led the SEC to create that regulation? Many hours later he’d clawed his way back to the 1987 stock market crash, which, as it turned out, gave rise to the first, albeit crude, form of high-frequency trading. During the 1987 crash, Wall Street brokers, to avoid having to buy stock, had stopped answering their phones, and small investors were unable to enter their orders into the market. In response, the government regulators had mandated the creation of an electronic Small Order Execution System so that the little guy’s order could be sent into the market with the press of a key on a computer keyboard, without a stockbroker first taking it from him on the phone. Because a computer was able to transmit trades must faster than humans, the system was soon gamed by smart traders, for purposes having nothing to do with the little guy.† At which point Schwall naturally asked: From whence came the regulation that had made brokers feel comfortable not answering their phones in the midst of the 1987 stock market crash?
As it turns out, when you Google “front-running” and “Wall Street” and “scandal,” and you are hell-bent on following the search to its conclusion, the journey cannot be finished in an evening. At five o’clock Monday morning Schwall finally went back inside his house. He slept for two hours, then rose and called Brad to tell him he wasn’t coming to work. Then he set off for a Staten Island branch of the New York Public Library. “There was quite a bit of vengeance on my mind,” he said. As a high school junior Schwall had been New York City’s wrestling champion in the 119-pound division. “He’s the nicest guy in the world most of the time,” said Brad. “But then sometimes he’s not.” A streak of anger ran through him, and exactly where it came from Schwall could not say, but he knew perfectly well what triggered it: injustice. “If I can fix something and fuck these people who are fucking the rest of this country, I’m going to do it,” he said. The trigger for his most recent burst of feeling was Thor, but if you had asked him on Wednesday morning why he was still digging around the Staten Island library instead of going to work, Schwall wouldn’t have thought to mention Thor. Instead he would have said, “I am trying to understand the origins of every form of front-running in the history of the United States.”
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 h
uman 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.
Flash Boys: A Wall Street Revolt Page 10