In some cases, these startups were bought up by bigger technology firms—like Google, Cisco, Microsoft, and others—who were using the growing startup ecosystem almost as a replacement for R&D. Cisco, for example, was a serial acquirer of companies that once upon a time would have gone public and joined the Nasdaq ecosystem. The same is now true of Google, Apple, Microsoft, and many other large technology companies. In addition, many firms launched large venture capital arms of their own, adding bigger and bigger pools of available money to the technology ecosystem.
The advent of these well-capitalized, privately funded teenage companies—like Uber, Lyft, Stripe, Airbnb, and many others—created a conundrum. Employees in those firms naturally had much of their own wealth tied up in relatively illiquid stock options. It’s one thing for an employee to hold those options for a few years before they become liquid with an IPO. But now, that time horizon was getting longer and longer. Inevitably, people needed access to their money—to buy houses, pay medical bills, or send kids to college. If they couldn’t count on the company going public, they needed ways to cash in those options in some other kind of a liquidity event.
Initially, certain law firms in Silicon Valley would facilitate trading of pre-IPO private-company shares of stock, but as the need increased, so did the opportunity for a new “second market” or “private market”—a venue to facilitate trading in those options. Two new companies, SharesPost and SecondMarket, formed to serve this need. For Nasdaq, this was a call to arms: If a new, semiprivate trading market was forming in startup options, why should we cede the business to upstarts? It was a natural extension of our strengths, and soon we decided to get in on the game as well.
In 2013, using Gift Council funding, we developed Nasdaq Private Markets in collaboration with SharesPost, a new venture designed to bring some order, efficiency, and liquidity to the trading of stock in private growth companies. It also proved to be an important way to develop and deepen our network of relationships with new talent in the Bay Area’s significant stable of young companies. A couple of years later, we bought SecondMarket and consolidated this new trading venue around Nasdaq’s brand.
It is often said that innovation happens on the boundaries of the establishment, where new ideas can take root without being squashed by the conventional order of things. As an incumbent player in the financial ecosystem, Nasdaq needed to cultivate an awareness of what was going on outside our ecosystem that might be disruptive in the future. And once we had identified those technologies, we needed to figure out how to bring them inside our walls, so to speak, and embrace them, showing a pathway to their adoption without overly compromising existing technological infrastructure.
In this spirit, Brad Peterson, Nasdaq’s CIO, started a series of internal conversations among a few leaders about new disruptive technologies that might be coming down the road. During one off-site strategy session in May 2014, we did a session on quantum computing and an interesting new technology called cryptocurrency—including something called Bitcoin, which few people had heard of back then.
As we explored the ins and outs of this exotic new financial instrument, it was hard to ascertain its significance for Nasdaq, if any. It just didn’t seem to have any immediate relevance. But at a certain point, we realized that the jewel of Bitcoin wasn’t its use as a currency; it was the technology that underlies it—blockchain. Blockchain is the unique database technology upon which many cryptocurrencies depend.
Blockchain is a powerful, decentralized, distributed ledger system that is highly secure. For a company like Nasdaq, it’s a technology that is right in our wheelhouse—after all, we are experts at facilitating trading and transactions, and blockchain is aimed at transforming the way we conduct digital transactions. Brad and I and much of the executive team spent hours discussing this technology—how it worked, how it might be used, how it would change financial markets, and how Nasdaq might pioneer that endeavor. We became early experts on blockchain and its application potential.
Transactions technology in the public market is so well established that it was hard to imagine trying to take this entirely foreign technology and throw it immediately into the mix with the existing networks of banks, clearinghouses, and exchanges. But what if we were to start from scratch in a market that we controlled, one that was not already burdened with so much existing legacy technology? Nasdaq Private Markets began to look like the perfect opportunity to test out this interesting new technology.
In 2015, we launched a service on NPM using blockchain technology that was able to execute, settle, and clear a given trade and then move the money in ten minutes—a fraction of the time it takes in other markets. If you make a trade today in the public equity markets, it takes two days to settle and clear. Rarely has there been a more dramatic example of the future staring us in the face. There is a lot of work to be done to integrate this technology into our financial systems, but I genuinely believe it has tremendous promise. Blockchain is not yet ready for the microsecond, superfast world of equity trading. I believe its real strength, at least for the immediate future, is in settlement and clearing—on the back end of trading, so to speak. That’s where its initial impact is likely to be felt. I was thrilled to have Nasdaq be early to market with an application demonstrating its potential. As an established player, Nasdaq needed to embrace the technology, affirm its relevance, and show the evolutionary path to its adoption in the industry. Blockchain has great potential, though the scale of its impact is yet to be seen.
Flash Boys and the Need for Speed
Toward the end of my time at Nasdaq, we received some pointed reminders that stock markets must continue to guard against complacency, and be on the lookout for new forms of inefficiency and new avenues for innovation. In 2014, a particularly public (though overblown) alarm was sounded: According to a new book by best-selling author Michael Lewis, an army of unscrupulous “high frequency traders” (HFTs) were operating in the microsecond gaps between buyers and sellers and profiting from their superior speed at the expense of investors. Furthermore, he claimed, these “flash boys” were enabled by the established Wall Street players.
To understand the HFT phenomenon and separate the facts from the hype, it’s important to understand that the search for speed in financial markets is hardly novel. From the fastest horse to the telegraph to the rotary phone to a quick-dialing handset to satellite dishes to fiber optics to point-to-point microwave to the quickest algorithm, traders have always used technology to gain information advantages and outpace competitors. The Rothschilds famously used carrier pigeons in the early nineteenth century to gain an information advantage that would allow them to profit in London’s financial markets. And when I was at ASC in the mid-1990s, one of my business lines was selling new wireless communications equipment that would allow individuals standing on the exchange floor to quickly send information up to a trading booth, giving them a brief time advantage over those relying on the less-than-athletic runners.
Later, I was fortunate to be part of a collection of outsiders—motivated by high ideals and armed with ones and zeros—who stormed the castle of old-style, floor-based Wall Street trading, breached the walls, and remade the place in their image. We eradicated inefficiencies and expedited trading, eventually breaking apart what the Wall Street Journal in 2003 had bluntly described as a “monopoly” on the part of NYSE, which had “failed to adapt to a world of new technology that allows for faster… electronic trades.”
Within a few years of my arrival at Nasdaq, much of the Wall Street infrastructure had radically changed, swept aside by the electronic wave of the future. My own motives in being part of the revolution were more about effective business practices than high ideals. But I certainly shared the Journal’s perspective that we were doing the global markets a great service by breaking the hold of floor-based specialists, with their thirty-second time advantage. We changed it to microseconds, and dramatically reduced the friction and inefficiencies of the previous mar
ket-making system.
In many respects, we succeeded beyond what I could ever have imagined. In so many ways—ease of access, price of service, capacity for speed, quality of execution, diversity of products, dynamics of competition, transparency of fees—stock exchanges today serve their function far better than they ever have in history. But conquerors inevitably have a tendency to get complacent. And today’s revolutionaries have a tendency to become tomorrow’s establishment.
As the markets became more and more electronic, the need for speed moved into the virtual domain with an increasing emphasis on lightning-fast trades made in milliseconds, and even microseconds. Indeed, part of the evolution of markets in my early days at Nasdaq centered on an issue called price-time trading. Simply put, it means that if several orders arrive to an exchange at the exact same price, there naturally has to be some way of deciding which order to execute first. What’s the best method for deciding that question? The fair way—and the way the market currently works—is to privilege the order that arrives first. First in, first out. In such a world, speed matters—when price is equal, time is the most democratic differentiator. With that market reality came the need for speed—giving rise to a new kind of high frequency trading operation that bought and sold stocks in the blink of an eye, profiting on microdifferences in the price between two markets or exchanges, measured in pennies, or less. The physical trading floor had been replaced with a virtual “floor”—a series of exchanges competing to offer the best price, and superfast trading operations exploiting the differences between them.
At our data-center headquarters in Secaucus, New Jersey, where the hardware of this virtual world resided, we were developing a new type of business. We decided to sell real estate in our data center. This wasn’t just about offering customers greater execution speed; it was also about reliability. If you wanted to ensure continuous, reliable service—avoid nasty interruptions and costly downtime—it’s much safer to have a computer in the Nasdaq data center than to rely on some data connection from many miles away. We offered the safe and secure connection of a Local Area Network (LAN) rather than the unpredictability of a Wide Area Network (WAN). The service was available to everyone—big banks, investment banks, HFTs, brokers and dealers, and new trading outfits. In fact, HFTs were a minority of customers. And the critical part was that no one had a speed advantage. Some customers tried. They asked us if their computers could be a few feet closer to the matching engine servers—just as back in the day, traders on the NYSE floor wanted to be a few feet closer to the trading posts. But we built a unique “coil” that slowed down closer connections, making sure there was no time advantage to be gained by the particular positioning of any company’s computers. It was a new, cloud-based business, like Amazon Web Services or Microsoft Azure. In fact, many new trading outfits found this was the quickest and most inexpensive way to start initial operations. As with just about everything we did at Nasdaq, we did it all under the close supervision of the SEC.
After the publication of Michael Lewis’s Flash Boys in the spring of 2014, the furor in the financial media was intense and immediate. Once again, Wall Street was under attack. Lewis has a unique ability to spin an enticing narrative, and he loves to tell lionizing stories of outsider warriors fighting for an enigmatic truth against a blind or corrupt establishment. In this case, the role of “outsider” was played by a small group of individuals looking to understand the role of HFT in markets and build an alternative exchange. The role of “corrupt establishment” was played by all of us who worked at the major banks, exchanges, and trading firms.
Lewis made little mention of how markets had evolved and improved over the previous decades, thanks to the efforts of many of those people he was criticizing. No compliments were forthcoming for the efforts that so many made in the previous era to open up markets, democratize access, reduce costs, and create more efficient markets. Considering that Lewis had talked to almost no significant figures in the industry before publication, you can imagine how my colleagues and I felt about his analysis, or lack thereof.
I understand that Flash Boys was not meant to be a fully researched report, weighing the pros and cons of how contemporary financial markets are structured, but many took it as exactly that. In the wake of the financial crisis, it’s all too easy to convince the average American of hyperbolic statements like “the stock market is rigged” and “Wall Street is corrupt.” I know it’s fashionable to look at Wall Street and proclaim, “There be the demons of greed!” In a post–financial crisis world, such claims appeal to our society’s natural suspicions.
Of course, if by greed you mean the motivation to be smarter, work harder, compete better, and make money doing it, well, that’s not hard to find on Wall Street. But when it comes to protecting and analyzing markets, I don’t believe that is the primary issue of concern. The more important question is: Are the players on Wall Street following the rules established by the SEC? And if so, do those rules and regulations need to be updated to protect investors? And finally, do American equity markets compare favorably to alternative markets in the world, and to the financial markets in our own history?
For the most part, Lewis said little directly about Nasdaq in Flash Boys, which isn’t surprising given that he spoke to no one at the exchange except a former employee who had been terminated a few years before. But he did make a dramatically false claim nonetheless—stating that fully two-thirds of our entire revenue was driven by HFT. I have absolutely no idea where he might have generated such a number, but it is certainly untrue. Again, he never checked that number with us. In fact, after the publication of Flash Boys there was such concern about that number that many investors worried Nasdaq transactions revenue might collapse if the HFT industry was regulated differently. We did an internal analysis and concluded that the actual number was well under 10 percent.
Perhaps the most egregious oversight in Flash Boys was Lewis’s portrayal of the role of the SEC. They come off as minor players in his book, absentee landlords always looking the other way. I found this characterization not only inaccurate but misleading. I could hardly make a change to a line of code in Nasdaq’s order-matching computers without approval by the SEC. Our entire business model as an exchange was overseen in great detail. And much of this oversight is not something that happens away from public scrutiny. Significant rule changes at the SEC go through a painstakingly thorough, transparent, and public process. It is carefully orchestrated and open for comment. Smaller rule changes may not have the same level of public scrutiny, but again, every little change that Nasdaq makes in relationship to its exchange is being carefully reviewed and approved by the agency.
Is the SEC perfect? No, of course not. But they are hardly without teeth. They are the cops on the beat, the referees on the field, making sure the rules are enforced and followed, and updating them as needed. In the world portrayed in Flash Boys, it often seemed like the SEC was hardly involved—a mistaken impression that may have served the story of rogue foxes rummaging through the henhouse—but it simply is not the case. The SEC is a towering presence throughout the equities industry. But Lewis bypassed this point in favor of making the banks and exchanges the villains.
The book ignored the SEC, but the SEC did not ignore the book. “The markets are not rigged,” declared SEC Chairwoman Mary Jo White to a House panel in 2014, soon after the publication of Flash Boys. “The U.S. markets are the strongest and most reliable in the world.” I agree with her assessment. That does not deny that there is room for improvement. White herself spent considerable effort beefing up the SEC’s oversight of HFT firms and their practices.
I would add one thought to White’s statement. I also think that today’s market is stronger and more robust than any in history. Behind the drama of Flash Boys is an unspoken idea that perhaps things were better off before computers came to Wall Street. I think such an impression is wishful thinking.
In the last decades, almost all of the transaction cost ha
s been eliminated from trading in equity markets. One study found that institutional costs for large cap trading fell by more than 20 percent in just the years between 2010 and 2015.1 Lewis complains that this trend of falling costs has slowed, but that is not surprising. Encroaching upon the small percentage of costs that remain is inevitably going to be more difficult. There is always going to be some friction cost to trading.
With such facts at hand, I don’t romanticize Wall Street’s past. I try to be frank and fair-minded about its present, and I hope that it will continue to evolve in a better direction in the future. No doubt that evolution will involve some bumps and bruises along the way. But that does not mean apocalypse is imminent. One gets the impression, in the pages of Flash Boys, that our current system is on the brink of implosion under the nefarious behavior of the HFT industry, and that massive instability in the market is just around the corner. None of this is true, nor have these warnings played out as he suggested they would. Since the publication of the book, markets are more resilient than ever. What has indeed proved to be true is that progress in the real world is not about moving from black to white, from bad to good, from corrupt to perfect, but rather, from one system with problems to a much better system that solves old problems and usually creates some new ones as well.
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