Flash Boys: A Wall Street Revolt

by Michael Lewis

  At the same time, he went looking for people: software developers and hardware engineers and network engineers to build the system, the operations people to run it, and the salespeople to explain it to Wall Street. He had no trouble attracting people who knew him—just the opposite. A shockingly large number of people he’d worked with at RBC apparently felt the urge to entrust him with their careers. Several dozen people had hinted that they’d like to join him and do whatever he was doing. He found himself in a series of bizarre conversations, in which he tried to explain why they were better off being paid hundreds of thousands of dollars a year to work at a big Wall Street bank than taking a flier on a new business that had neither a clear plan nor a penny of financing. Still, people followed. Allen Zhang, the Golden Goose himself, got fired for sending RBC’s computer code to himself and instantly turned up at Brad’s front door. Billy Zhao was made redundant after he automated a complicated task so well that the bank no longer needed his help to do it: He came on board, too. But Brad needed people who didn’t know him, and who knew things he did not know. He needed, especially, people with a deep understanding of high-frequency trading and stock exchanges. And the first person he found was Don Bollerman.

  WHAT EVERYONE NOTICED about Don Bollerman—even if they didn’t quite put it this way—was how badly he wanted not to be surprised by his own life. On top of that, he’d grown up in the Bronx and carried with him a resistance to sentiment. He ripped the filters off cigarettes before he smoked them. He weighed a hundred pounds more than he should and ignored entreaties from his colleagues to exercise or take care of himself. “I’m gonna die young anyway,” he’d say. His finer feelings he treated much the way he treated his body, with something approaching disdain. “Much is made of a kind heart,” he said. “I’m more of a feed-yourself-or-die kind of guy.”

  To eliminate the possibility of surprise required not that Don’s life be especially unsurprising but that he control his feelings about whatever surprise it produced. How much he wished to manage these emotions could be seen when they were at their least manageable. On September 11, 2001, Don worked at a small new electronic stock exchange on the twelfth floor of 100 Broadway, five hundred yards from the World Trade Center. He’d arrived at seven that morning. Before the stock market opened, he heard a bump, which sounded as if it had come from upstairs. “What we thought is that it was guys moving heavy equipment,” he said. “Five minutes later it’s snowing office memos.” He and his colleagues went to the window and heard the news on the office TV about the plane hitting one of the towers. “I thought it was an attack right away,” he said, and so he was less shocked than his colleagues by what happened next. They had a direct view of the Twin Towers, across the Trinity Church graveyard, over the top of the American Stock Exchange. The second plane hit. “I felt the heat on my face through the window. You open the barbecue and your face feels like it pulls back—that feeling,” he said. They discussed whether the towers were tall enough to reach them if one fell over. Then the first tower fell. “That’s when we ran for the staircase.” By the time they got to the sixth floor, Don couldn’t see his hands in front of his face. Once outside, in the blizzard, he headed east. He walked alone and matter-of-factly up Third Avenue and then across the bridge over the Harlem River to his apartment in the Bronx, sixteen miles in all. What stuck out in his mind from the day was how, when he arrived in Harlem, some women were waiting outside their homes with fruit juice for him to drink. “That one caught in my throat,” he said. He added quickly, “Actually, I feel like a bit of a pussy, that it got to me that way.”

  The attack, and the ensuing market convulsions, killed off the new electronic stock exchange that employed him. Don, who had thought that the business was probably going to die anyway, went back to NYU to finish his college degree, and then on to a career at the Nasdaq stock exchange. Seven years in, his job was to deal with everything that happened after a trade occurred, but his specific role was less important than his general understanding—both Ronan and Schwall thought that Don Bollerman knew breathtakingly more about the inner workings of the stock exchanges than anyone they had ever met. He’d been privy to just about everything that happened inside Nasdaq, and brought an understanding not just of what had gone wrong but how it might be set right.

  What had gone wrong, in Don’s view, wasn’t all that surprising or complicated. It had to do with human nature, and the power of incentives. The rise of high-frequency trading—and its ability to gain an edge on the rest of the market—had created an opportunity for new exchanges, like BATS and Direct Edge. By giving HFT what it wanted (speed, in relation to the rest of the market; complexity only HFT understood; and payment to brokers for their customers’ orders, so that HFT had something to trade against), the new stock exchanges had stolen market share from the old stock exchanges. Don couldn’t speak for NYSE, but he had watched Nasdaq respond by giving HFT firms what they asked for—and then figuring out how to charge them for it. “It was almost like you couldn’t do anything about it,” he said. “We did all this speed, and I don’t think we fully understood what it was being used for. We just thought, The new rules caused people to have a new experience and then new wants and needs.” Nasdaq had become a public company in 2005, a year after Don had joined it. It had earnings targets to hit; it was incentivized to make decisions, and to make changes in the nature of the exchange, with a focus on their short-term consequences. “It’s hard to be forward-thinking when the whole of corporate America is about the next quarter’s earnings,” said Don. “It went from ‘Is this good for the market?’ to ‘Is this bad for the market?’ And then it slides to: ‘Can we get this through the SEC?’ The demon in this part of the story is expediency.” By late 2011, when Bollerman quit his job (“I felt there was a lack of leadership”), more than two-thirds of Nasdaq’s revenues derived, one way or another, from high-frequency trading firms.

  Don wasn’t shocked or even all that disturbed by what had happened, or, if he was, he disguised his feelings. The facts of Wall Street life were inherently brutal, in his view. There was nothing that he couldn’t imagine someone on Wall Street doing. He was fully aware that the high-frequency traders were preying on investors, and that the exchanges and brokers were being paid to help them to do it. He refused to feel morally outraged or self-righteous about any of it. “I would ask the question, ‘On the savannah, are the hyenas and the vultures the bad guys?’ ” he said. “We have a boom in carcasses on the savannah. So what? It’s not their fault. The opportunity is there.” To Don’s way of thinking, you were never going to change human nature—though you might alter the environment in which it expressed itself. Or maybe that’s just what Don wanted to believe. “He’s kind of like the mob guy who cries every now and then after a hit,” said Brad, who thought that Don was exactly the sort of person he needed. Brad wasn’t in the market for self-righteousness, or for people who defined themselves by their fine moral sentiment. “Disillusion isn’t a useful emotion,” he said. “I need soldiers.” Don was a soldier.

  THEIR NEW EXCHANGE needed a name. They called it the Investors Exchange, which wound up being shortened to IEX.† Its goal was not to exterminate the hyenas and the vultures but, more subtly, to eliminate the opportunity for the kill. To do that, they needed to figure out the ways that the financial ecosystem favored predators over their prey. Enter the Puzzle Masters.

  Back in 2008, when it had first occurred to Brad that the stock market had become a black box whose inner workings eluded ordinary human understanding, he’d gone looking for technologically gifted people who might help him open the box and understand its contents. He’d started with Rob Park; with less precision, he gathered others. One was a twenty-year-old Stanford junior named Dan Aisen, whose résumé Brad discovered in a pile at RBC. The line that leapt out at him was “Winner of the Microsoft College Puzzle Challenge.” Every year, Microsoft sponsored this one-day, ten-hour national brain-twisting marathon. It attracted thousands of young math an
d computer science types. Aisen and three friends had competed, in 2007, against one thousand other teams and had won the whole thing. “It’s kind of a mix of cryptography, ciphers, and Sudoku,” explained Aisen. The solution to each puzzle offered clues to the other puzzles; to be really good at it, a person needed not only technical skill but exceptional pattern recognition. “There’s some element of mechanical work, and some element of ‘aha!’ ” said Aisen. Brad had given Aisen both a job and a nickname, the Puzzle Master, soon shortened, by RBC’s traders, to Puz. Puz was one of the people who had helped him create Thor.

  Puz’s peculiar ability to solve puzzles was suddenly even more relevant. Creating a new stock exchange is a bit like creating a casino: Its creator needs to ensure that the casino cannot in some way be exploitable by the patrons. Or, at worst, he needs to know exactly how his system might be exploited, so that he might monitor the exploitation—as a casino monitors card counting at the blackjack tables. “You are designing a system,” said Puz, “and you don’t want the system to be gameable.” The trouble with the stock market—with all of the public and private exchanges—was that they were fantastically gameable, and had been gamed: first by clever guys in small shops and then by prop traders at the big Wall Street banks. That was the problem, Puz thought. From the point of view of the most sophisticated traders, the stock market wasn’t a mechanism for channeling capital to productive enterprise but a puzzle to be solved. “Investing shouldn’t be about gaming a system,” he said. “It should be about something else.”

  The simplest way to design a stock exchange that could not be gamed was to hire the very people best able to game it, and encourage them to take their best shots. Brad didn’t know any other national puzzle champions, but Puz did. The first person he mentioned was his former Stanford teammate Francis Chung. Francis worked as a trader at a high-frequency trading firm but didn’t like his job. Brad invited him in for a job interview. Francis turned up—and just sat there.

  Brad gazed across a table: The young man was round-faced and shy and sweet-natured but essentially noninteractive.

  “Why are you good at solving puzzles?” Brad asked him. Francis thought about it a moment.

  “I’m not sure how good I am,” said Francis.

  “You just won the national puzzle-solving championship!”

  Francis thought about that some more.

  “Yeah, I guess,” he said.

  Brad had done a lot of these interviews with technologists whose skills he could not judge. He left it to Rob to figure out if they could actually write code. He just wanted to know what kind of people they were. “I’m just looking for the type of people who won’t get along here,” said Brad. “Typically, it’s because the way they describe their experience, and the things they say, are very self-serving. ‘I don’t get enough credit for what I do,’ or ‘I’m overlooked.’ It’s all about me. They’re obsessed with titles and other things that don’t matter. I try to find out how they work with other people. If they don’t know something, what do they do? I look for sponges, learners.” With Francis he had no idea. Every question elicited some choked reply. Desperate to get something, anything, out of him, Brad finally asked, “All right, just tell me: What do you like to do?” Francis thought about it.

  “I like to dance,” he said. Then he went completely silent.

  After Francis had left, Brad hunted down Puz. “Are you sure this is the guy?” he asked.

  “Trust me,” said Puz.

  It took roughly six weeks for Francis to get comfortable enough to speak up. Once he did, he wouldn’t shut up. It was Francis who would eventually take all the rules they created for the exchange and translate them into step-by-step instructions for a computer to follow. Francis alone had the entire logic of the new exchange in his head. Francis fought more than anyone for, as he put it, “making the system so simple there is nothing to game.” And it was Francis whom Bollerman dubbed The Spoiler, because every time the other guys thought they had figured something out, Francis would step in and show them some loophole in their logic. “The level to which the kid will worry a problem is what really separates him,” said Don Bollerman, “without any prior concern for whose theory he’s going to upset—including his own.”

  The only problem with the Puzzle Masters was that neither of them had ever worked inside a stock exchange. Bollerman brought in a guy from Nasdaq, Constantine Sokoloff, who had helped to build the exchange’s matching engine. “The Puzzle Masters needed a guide, and Constantine was that guide,” said Brad. Constantine was also Russian, born and raised in a small town on the Volga River. He had a theory about why so many Russians had wound up inside high-frequency trading. The old Soviet educational system channeled people away from the humanities and into math and science. The old Soviet culture also left its former citizens oddly prepared for Wall Street in the early twenty-first century. The Soviet-controlled economy was horrible and complicated but riddled with loopholes. Everything was scarce; everything was also gettable, if you knew how to get it. “We had this system for seventy years,” said Constantine. “People learn to work around the system. The more you cultivate a class of people who know how to work around the system, the more people you will have who know how to do it well. All of the Soviet Union for seventy years were people who are skilled at working around the system.” The population was thus well suited to exploit megatrends in both computers and the United States financial markets. After the fall of the Berlin Wall, a lot of Russians fled to the United States without a lot of English; one way to make a living without having to converse with the locals was to program their computers. “I know people who never programmed computers but when they get here they say they are computer programmers,” said Constantine. A Russian also tended to be quicker than most to see holes built into the U.S. stock exchanges, even if those holes were unintentional, because he had been raised by parents, in turn raised by their own parents, to game a flawed system.

  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.‡ 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.