Flash Boys: A Wall Street Revolt

by Michael Lewis

  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.§ 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.

  To create the 350-microsecond delay, they needed to keep the new exchange roughly thirty-eight miles from the place the brokers were allowed to connect to the exchange. That was a problem. Having cut one very good deal to put the exchange in Weehawken, they were offered another: to establish the point of presence in a data center in Secaucus, New Jersey. The two data centers were less than ten miles apart, and already populated by other stock exchanges and all the high-frequency traders. (“We’re going into the lion’s den,” said Ronan.) A bright idea came from a new employee, James Cape, who had just joined them from an HFT firm: Coil the fiber. Instead of running straight fiber between the two places, coil thirty-eight miles of fiber and stick it in a compartment the size of a shoebox to simulate the effects of the distance. And that’s what they did. The information flowing between IEX and all the players on it would thus go round and round, in thousands of tiny circles, inside the magic shoebox. From the high-frequency traders’ point of view, it was as if they’d been banished to West Babylon, New York.

  Creating fairness was remarkably simple. They would not sell to any one trader or investor the right to put his computers next to the exchange, or special access to data from the exchange. They would pay no kickbacks to brokers or banks that sent orders; instead, they’d charge both sides of any trade the same amount: nine one-hundredths of a cent per share (known as 9 “mils”). They’d allow just three order types: market, limit, and Mid-Point Peg, which meant that the investor’s order rested in between the current bid and offer of any stock. If the shares of Procter & Gamble were quoted in the wider market at 80–80.02 (you can buy at $80.02 or sell at $80), a Mid-Point Peg order would trade only at $80.01. “It’s kind of like the fair price,” said Brad.

  Finally, to ensure that their own incentives remained as closely aligned as they could be with those of stock market investors, the new exchange did not allow anyone who could trade directly on it to own any piece of it: Its owners were all ordinary investors who needed first to hand their orders to brokers.

  The design of the new stock exchange was such that it would yield all sorts of new information about the inner workings of the U.S. stock market—and, indeed, the entire financial system. For instance, it did not ban but welcomed high-frequency traders who wished to trade on it. If high-frequency traders performed a valuable service in the financial markets, they should still do so, after their unfair advantages had been eliminated. Once the new stock exchange opened for business, IEX would be able to see how much of what HFT did was useful simply by watching what, if anything, high-frequency traders did on the new exchange, where predation was not possible. The Puzzle Masters’ only question was whether, in their design, they had accounted for every possible form of market predation. That was the one thing even they did not know: whether they had missed something.

  THE HIDDEN PASSAGES and trapdoors that riddled the exchanges enabled a handful of players to exploit everyone else; the latter didn’t understand that the game had been designed precisely for the former. As Brad put it, “It’s like you run this casino, and you need to get players in to attract other players. You invite a few players in to start a game of Texas Hold’em by telling them that the deck doesn’t have any jacks or queens in it, and that you won’t tell the other people who come to play with them. How do you get people into the casino? You pay the brokers to bring them there.” By the summer of 2013, the world’s financial markets were designed to maximize the number of collisions between ordinary investors and high-frequency traders—at the expense of ordinary investors, and for the benefit of high-frequency traders, exchanges, Wall Street banks, and online brokerage firms. Around those collisions an entire ecosystem had arisen.

  Brad had heard many firsthand accounts about the nature of that ecosystem. One came from a man named Chris Nagy, who, until 2012, had been responsible for selling the order flow for TD Ameritrade. Every year, people from banks and high-frequency trading firms would fly to Omaha, where TD Ameritrade was based, and negotiate with Nagy. “Most of the deals tend to be handshake deals,” Nagy said. “You go out to a steak dinner. ‘We’ll pay you two cents a share. Everything is good.’ ” The negotiations were always done face-to-face, because no one involved wanted to leave a paper trail. “The payment for the order flow is as off-the-record as possible,” said Nagy. “They never have an email or even a phone call. You had to fly down to meet with us.” For its part, TD Ameritrade was required to publish how much per share they were making from the practice but not the total amounts, which were buried on its income statements on a line labeled “Other Revenue.” “So you can see the income, but you can’t see the deals.”

  In his years selling order flow, Nagy noticed a couple of things—and he related them both to Brad and his team when he came to visit them to find out why he kept hearing about this strange new thing called IEX. The first was that the market complexity created by Reg NMS—the rapid growth in the number of stock markets, and in high-frequency trading—raised the value of a stock market customer’s order. “It caused the value of our flow to triple, a least,” Nagy said. The other thing he couldn’t help but notice was that not all of the online brokers appreciated the value of what they were selling. TD Ameritrade was able to sell the right to execute its customers’ orders to high-frequency trading firms for hundreds of millions a year. The bigger Charles Schwab, whose order flow was even more valuable than TD Ameritrade’s, had sold its flow to UBS back in 2005, in
an eight-year deal, for only $285 million. (UBS charged the high-frequency trading firm Citadel some undisclosed sum to execute Schwab’s trades.) “Schwab left at least a billion dollars on the table,” Nagy said. A lot of the people selling their customers’ orders, it seemed to Nagy, had no idea of the value of the information the orders contained. Even he was unsure; the only way to know would be to find out how much money high-frequency traders were making by trading against slow-footed individual investors. “I’ve tried over the years [to find out how much money was being made by high-frequency trading],” Nagy said. “The market makers are always reluctant to share their performance.” What Nagy did know was that the simple retail stock market order was, from the point of view of high-frequency traders, easy kill. “Whose order flow is the most valuable?” he said. “Yours and mine. We don’t have black boxes. We don’t have algos. Our quotes are late to the market—a full second behind.”¶

  High-frequency traders sought to trade as often as possible with ordinary investors, who had slower connections. They were able to do so because the investors themselves had only the faintest clue of what was happening to them, and also because the investors, even big, sophisticated ones, had no ability to control their own orders. When, say, Fidelity Investments sent a big stock market order to Bank of America, Bank of America treated that order as its own—and behaved as if it, not Fidelity, owned the information associated with that order. The same was true when an individual investor bought stock through an online broker. The moment he pressed the Buy icon on his screen, the business was out of his hands, and the information about his intentions belonged, in effect, to E*Trade, or TD Ameritrade or Schwab.