Flash Boys: A Wall Street Revolt

by Michael Lewis

  But the role in this of the nine big Wall Street banks that controlled 70 percent of all stock market orders was more complicated than the role played by TD Ameritrade. The Wall Street banks controlled not only the orders, and the informational value of those orders, but dark pools in which those orders might be executed. The banks took different approaches to milking the value of their customers’ orders. All of them tended to send the orders first to their own dark pools before routing them out to the wider market. Inside the dark pool, the bank could trade against the orders themselves; or they could sell special access to the dark pool to high-frequency traders. Either way, the value of the customers’ orders was monetized—by the big Wall Street bank, for the big Wall Street bank. If the bank was unable to execute a stock market order in its own dark pool, the bank directed that order first to the exchange that paid the biggest kickback for it—when the kickback was simply the bait for some flash trap.

  If the Puzzle Masters were right, and the design of IEX eliminated the advantage of speed, IEX would reduce the value of investors’ stock market orders to zero. If the orders couldn’t be exploited on this new exchange—if the information they contained was worthless—who would pay for the right to execute them? The big Wall Street banks and online brokers charged by investors with routing stock market orders to IEX would surrender billions of dollars in revenues in the process. And that, as everyone involved understood, wouldn’t happen without a fight.

  One afternoon during the summer of 2013, a few months before the exchange planned to open for business, Brad called a meeting to figure out how to make the big Wall Street banks feel watched. IEX had raised more capital and hired more people and moved to a bigger room, on the thirtieth floor of 7 World Trade Center. There still was no separate place to meet, however, so they gathered in a corner of the big room, where a whiteboard met a window that offered a spectacular view of the 9/11 memorial. Don leaned with his back against the window, along with Ronan, Schwall, and Rob Park, while Brad stood in front of the whiteboard and took a whiteboard marker out of a bin. The twenty or so other employees of IEX remained at their desks in the room, pretending that nothing was happening.

  Then Matt Trudeau appeared and joined in. Matt was the only person in the room who had ever opened a brand-new stock exchange, and so he tended to be included in every business discussion. Oddly enough, among them he was least, by nature, a businessman. He’d entered college to major in painting and then, deciding he lacked the talent to make it as a painter, and thinking he might make it as an academic, had moved into the anthropology department. He didn’t become an anthropologist, either. After college he’d found work adjusting auto insurance claims—a job he judged to be among the world’s most soul-sucking. One day on a lunch break, he noticed a television switched on to CNBC and wondered, “Why are there two separate ticker tapes?” He began to study the stock market. Five years later, in the mid-2000s, he was opening new, American-style stock exchanges in foreign countries for a company with the mystifying name Chi-X Global. (“It was marketing gone awry,” he said. “We spent the first fifteen minutes of every meeting trying to explain our name.”) He’d been one part businessman and one part missionary: He met with officials of various governments, wrote white papers, and sat on panels to extol the virtues of American financial markets. After opening Chi-X Canada, he’d advised firms trying to open stock exchanges in Singapore, Tokyo, Australia, Hong Kong, and London. “Did I think I was doing God’s work?” he said later. “No. But I did think market efficiency was something important for the economy.”

  As he spread the American financial gospel, he couldn’t help but notice a pattern: A new exchange would open, and nothing would happen on it—until the high-frequency traders showed up, stuck their computers beside the exchange’s matching engine, and turned the exchange around. Then he began to hear things—that some of the HFT guys might be shady, that stock exchanges had glitches built into them that HFT could use to exploit ordinary investors. He couldn’t point to specific wrongdoing, but he felt less and less easy about his role in the universe. In 2010, Chi-X promoted him to a big new job, Global Head of Product; but before he took the job he came across an Internet post by Sal Arnuk and Joseph Saluzzi.** The post showed, in fine detail, how data about investors’ orders provided to high-frequency traders by two of the public exchanges, BATS and Nasdaq, helped HFT discern investors’ trading intentions. Most investors, Arnuk and Saluzzi wrote, “have no idea that the private trade information they are entrusting to the market centers is being made public by the exchanges. The exchanges are not making this clear to their clients, but instead are actively broadcasting the information to the HFTs in order to court their order flow.” “It was the first credible evidence of Big Foot,” said Matt. He dug around on his own and saw that the glitches at BATS and Nasdaq that queered the market for the benefit of HFT weren’t flukes but symptoms of a systemic problem, and that “many other little market quirks were there that were potentially being exploited.”

  He was then in an awkward position: that of a public spokesman for the new American-style stock market who doubted the integrity of that market. “I’m at the point where I no longer feel I can authentically defend high-frequency trading,” he said. “I look at us exporting our business model to all these different countries and I think, It’s like exporting a disease.” He was thirty-four years old, and married, with a one-year-old child. Chi-X was paying him more than $400,000 a year. And yet, with no idea what he was going to do to earn a living, he up and quit. “I don’t want to say I’m an idealist,” he said. “But you have a limited amount of time on this planet. I don’t want to be twenty years from now and thinking I hadn’t lived my life in a way I could be proud of.” He kicked around for the better part of a year before he thought to call Ronan, whom he’d met when Ronan came through to run cables for HFT inside his Canadian exchange. In October 2012 they met for coffee at the McDonald’s near Liberty Plaza, and Ronan explained he’d just left RBC to open a new stock exchange. “My first reaction was, I feel so bad for the guy,” said Matt. “He’s just destroyed his future. They’re just doomed. Then, afterwards, I asked myself, ‘What causes a bunch of people making a million a year to quit?’ ” He came back in November and asked Ronan some more questions about this new exchange. In December, Brad hired him.

  Standing in front of the whiteboard, Brad now reviewed the problem at hand: It was unusual for an investor to direct his broker to send his order to one exchange, but that is what investors were preparing to do with IEX. But these investors had no way of determining if the Wall Street brokers followed their instructions and actually sent the orders to IEX. The report investors typically received from their brokers—the Transaction Cost Analysis, or TCA—was useless, so sloppily and inconsistently compiled as to be beyond analysis. Some of it came time-stamped to the second; some, time-stamped in tenths of microseconds. None of it told you which exchange you traded on. As a result, there was no way to determine the context of any transaction, the event immediately before it and the one immediately after. If you didn’t even know the order of the trades in the stock market, you could hardly determine if you had traded at a fair price. “It’s a Pandora’s box of ridiculousness,” said Brad. “Just getting an answer to the question: ‘Where did I trade?’ It isn’t really possible.”

  “What if they [investors] send us their trade orders and we check them to see if they ever got here?” asked Rob Park sensibly.

  “We can’t,” said Don. “It violates our confidentiality agreement with brokers.”

  True. An investor might hand Bank of America an order and ask the Bank of America broker to route it to IEX. The investor might also ask that IEX be permitted to inform him of the outcome. And yet Bank of America might refuse, on principle, to allow IEX to inform the investor that they had followed his instructions—on the grounds that doing so would reveal Bank of America’s secrets!

  “Why can’t we just publish what happened?” aske
d Ronan.

  “It’s the banks’ information,” said Don.

  “We can’t publish what happened to an investor’s trade because what happened to the investor is Goldman Sachs’s information?” Ronan was incredulous—but then he knew less about this than the others.

  “Correct.”

  “What can they do to us if we do it—shut us down?”

  “Probably just a slap on the wrist the first time,” said Don.

  Brad wondered aloud if it was possible to create a mechanism through which investors might be informed, in real time, where their brokers sent their stock market orders. “Like a security camera,” he said. “You don’t care if it’s even turned on. Just the fact that it’s there might alter behavior.”

  “It’s a finger in the eye of the brokerage community,” said Don. He wore a t-shirt that said I Love Aquatic Life, and tossed a rugby ball to himself, but he didn’t feel as comfortable as he wished to appear. All these other guys had worked at big Wall Street banks; none of them had ever had to deal with those banks as a customer. They didn’t know their market power. As Don later put it, “The brokers, if they all decide to hate us, we’re fucked. End of story.” He didn’t put it so bluntly to the others, maybe because he sensed that they all knew it.

  “It’s like saying, ‘I think people are stealing in this office,’ ” said Brad, with growing enthusiasm. “I can run in and run out and run in and run out and keep checking and try to catch someone. Or I can install a camera. It may be plugged in—or not. But there’s still this camera. And whoever is fucking stealing my coffee pots won’t know if it’s on.”

  “We don’t really give a fuck if the investors use it,” added Ronan. “We just want the brokers scared they’ll check.”

  Somewhere in the big room a phone rang, and the sound was as jolting as a car honking in a small town in the middle of the night. The room was an open pit, with no barriers between the people in it, but the young men inside it behaved as if they worked with walls around them. They were, all but one, young men. The exception, Tara McKee, had been a research associate at RBC until Brad found her, in 2009, and asked her to be his personal assistant. (“The first time I met him, I said, ‘I don’t care what I do—I just want to work for him.’ ”) She’d followed him out when he left the bank, even after he tried to talk her out of it, as he couldn’t pay her properly and didn’t think she could tolerate the risk. The cast of technologists Brad had assembled at this new place Tara found even more peculiar than the one he’d put together at RBC. “For geniuses, they are really dumb,” she said. “Some of them are really pampered: They can’t even put together a cardboard box. They don’t think you do something. They think you call somebody.”

  They were also amazingly self-contained. This meeting concerned them all—compelling the big Wall Street banks’ cooperation might mean the difference between success and failure—but they all at least feigned indifference. The etiquette here was a kind of willed incuriosity—even about each other. “Communication with a lot of the guys is not that great,” said Brad. “It’s something we need to work on.” It was funny. To a man, they were puzzle solvers, and yet, to each other, they remained unsolved puzzles.

  Schwall looked over the desks and shouted, “Whose phone is that?”

  “Sorry,” someone said, and the ringing stopped.

  “It’s a nanny,” said Don, of Brad’s security camera idea. “It’s demeaning. It could be a strain on the relationship.”

  “When you get patted down in the airport, do you hate the people who pat you down?” asked Brad.

  “I fuckin’ hate them,” said Don.

  “I say, ‘I’m glad you’re checking my bags, because that means you’re checking other people’s,’ ” said Brad.

  “The problem is that everyone is carrying marijuana through the checkpoint,” said Schwall.

  “If anyone gets fucking angry it’s because they’re guilty,” said Brad hotly.

  “I’m sorry,” said Don. “I’m fat and white and I’m not gonna bomb this airplane. I shouldn’t get extra swabbing.” He’d stopped tossing the rugby ball.

  “Is there some use for this other than policing brokers?” asked Schwall. He was asking, “Can we police them without their realizing it?” The person among them most adept at uncovering the secrets of others believed it was possible for IEX to keep its own affairs secret.

  “No,” said Brad.

  “So it’s a nanny,” said Schwall with a sigh.

  “Broker Nanny,” said Don. “It’s a great name. Shame we can’t patent it.”

  The meeting went quiet. This was just one of a thousand arguments they’d had in designing the exchange. The group was roughly split—between people (Ronan and, to a lesser extent, Brad) who wanted to pick a fight with the biggest Wall Street banks, and people who thought it was insane to pick that fight (Don and, to a lesser extent, Schwall). Rob and Matt hadn’t yet come clean, but for different reasons. After his initial suggestion had been swatted away, Rob had gone silent. “Rob is farthest from the chaos,” said Brad. “He doesn’t meet with brokers. The solutions to the problems they [the Wall Street brokers] create are illogical because they solve a problem that is illogical.”

  Matt Trudeau, also quiet, often tended to step back and observe. “I’ve always felt a little outside the groups of people I hung around with,” he said. He was a natural conciliator as well. He may have quit his job on principle, but he didn’t enjoy conflict, even the internal kind. “I might not be jaded enough,” Matt now said carefully. “But let’s say we launch and we’re wildly successful and we never have to roll this out.”

  That thought was dead on arrival: No one believed they would be wildly successful the moment they launched—least of all Matt. He knew firsthand what happened when a new exchange opened: nothing. Chi-X Canada was now a huge success—20 percent of the Canadian market—but in its first month it had traded 700 shares total. Entire days passed without a single trade on that exchange; and the next few months weren’t much better. And that was what success looked like. IEX didn’t have the luxury of going months without activity. Their new stock exchange didn’t need to be an instant sensation, but it had to host enough trading to illustrate the positive effects of honesty. They needed to be able to prove to investors that an explicitly fair exchange yielded better outcomes for investors than all the other exchanges. To prove the case, they needed data; to generate that data, they needed trades. If the big Wall Street banks colluded to keep trades off IEX, the new exchange would be stillborn. And they all knew it.

  “They’re gonna be pissed,” said Schwall finally.

  “We’re in a fight,” said Brad. “If every client felt like their instructions were being followed, we wouldn’t be having this discussion. It’s not about IEX wanting to go punch some broker in the face for no reason. It’s not about saying, ‘Who is our enemy?’ It’s about saying who we are aligned with. We’re aligned with the investor.”

  “They’re still gonna be pissed,” said Schwall.

  “Are we really in the police business?” asked Don.

  “Maybe we don’t have to have it at all,” added Schwall. “Maybe we just have to create the illusion we have it. We talk to the buy side about having it, and they whisper to their brokers—that might be enough.”

  “But they’ll all know,” said Don. “They know we have to keep the brokers’ junk private. And the broker has to keep the clients’ junk private. And the client can’t opt out.”

  Brad offered one last idea: a chat room in which investors could converse with their brokers as the trade was happening. “Or they can always get their broker on the phone and say, ‘Tell me what the fuck is going on,’ ” he said. “It’s always been a solution.”

  “They’ve never done it,” said Ronan.

  “They’ve never been motivated to do it,” said Matt. True: Investors had never been given a compelling reason to favor one stock exchange over another.

  “You get Danny Mo
ses in a chat room with Goldman,” said Brad, referring to the head trader at Seawolf. “He’ll ask them.”

  “But Danny’s a bit argy-bargy,” said Ronan.

  “Argy-bargy, I like that,” said Don.

  Ronan had been teaching Don Irish epithets, one at a time. “You got wanker. Tosser. Now you got argy-bargy,” said Ronan.

  “You do nothing, and everyone does what they want,” said Brad. “You do something and you can influence behavior. But, by creating the tool, do we incentivize behavior we want to eliminate? By shining the light, do we create a gray zone, just outside the light? Is it like Reg NMS, where you create the very thing you’re trying to get rid of?”

  “Shining a light creates shadows,” said Don. “If you try to create this bright line, you are going to create gray zones on either side.”

  “If we sincerely believe it creates too many blind spots, we might not want to do it,” said Brad.

  “If we bill it as a nanny and she’s drunk on the couch, are we gonna look like assholes?” added Don. “Better not to have a nanny at all. Just leave the kids home alone.”

  “If you can think of any other possible use for this fucker, that would help,” said Schwall, who clung to his hope that they might disguise their actions. That they might be secret cops.

  “I’m less bullish on this than I was before,” said Brad. “I’ll be honest. Because a drunk nanny might not be better than no nanny at all.”

  “How drunk can a nanny get?” asked Ronan idly.

  Brad tossed the marker back into the whiteboard bin. “You can see why the client has been left in the dust,” he said. “The system is designed to leave the client in the dust.” Then he turned to Don. “At Nasdaq did they talk about this?”

  “No,” said Don, leaning back against the window.

  For a moment, Brad looked at Don, and at the view that he only partly concealed. In that moment, he might as well have been, not on the inside of his new exchange looking out, but on the outside looking in. How did they seem to others? To the people out there? Out there, where the twin symbols of American capitalism once loomed, reduced in a few hours to a blizzard of office memos and a ruin. Out there, where idealism was either a ruse or a species of stupidity, and where the people who badly needed them to succeed hadn’t the faintest idea of their existence. But out there a lot of things happened. People built new towers to replace the old ones. People found strength they didn’t know they had. And people were already coming to their aid, and bracing for the war. Out there, anything was possible.