Flash Boys: A Wall Street Revolt

by Michael Lewis

  That is but the most obvious of many examples of routing stupidity. The customer (you, or someone investing on your behalf) is typically entirely oblivious to the inner workings of both algorithms and routers: Even if he demanded to know how his order was routed, and his broker told him, he would never be sure what was said was true, as he has no sufficiently detailed record of what shares traded and when they traded.

  The brokers’ routers, like bad poker players, all had a conspicuous tell. The tell might be a glitch in their machines rather than a twitch of their facial muscles, but it was just as valuable to the HFT guys on the other side of the table.

  Once Brad had explained all of this to Ronan, he didn’t need to explain it again. “It was, ‘Oh shit, some of the things I overheard now make more sense,’ ” said Ronan.

  With Ronan’s help, the RBC team designed their own fiber network and turned Thor into a product that could be sold to investors. The sales pitch was absurdly simple: There is a new predator in the financial markets. Here is how he operates, and we have a weapon you can use to defend yourself against him. The argument about whether RBC should leap into bed with high-frequency traders ended. Brad’s new problem was spreading the word of what he now knew to the U.S. investing public. Seeing how shocked people were by what Ronan had to say, and how interested they were in it, and no longer needing Ronan to persuade his bosses that something strange and new was afoot, Brad decided to set Ronan loose on Wall Street’s biggest customers. “Brad calls me in and says, ‘What if we stop calling you Head of High-Frequency Trading Strategy and make you Head of Electronic Trading Strategy?,’ ” said Ronan, who had no idea what either title actually meant. “I called my wife and said, ‘I think they just promoted me.’ ”

  A few days later, Ronan went with Brad to his first Wall Street meeting. “Right before the meeting, Brad says, ‘What are you going to say? What have you prepared?’ I hadn’t prepared anything, so I said, ‘I’ll just wing it.’ ” He now had a pretty good idea why Brad had given him a new job title. “My role was to walk around and say to clients, ‘Don’t you understand you’re being fucked?’ ” The man on the other end of this first extemporaneous presentation—the president of a $9 billion hedge fund—recalls the encounter this way: “I know I have a three-hundred-million-dollar problem on a nine-billion-dollar hedge fund.” (That is, he knows that the cost of not being able to trade at the stated market prices is costing him $300 million a year.) “But I don’t know exactly what the problem is. As he’s talking, I’m saying to myself, RBC doesn’t even know what they are doing. And who are these guys? They aren’t traders. They’re not salesguys. And they’re not quants. So what are they? And then they say they have a solution to the world’s problems. And you’re like: ‘What? How on earth can I even trust you?’ And then they totally explain my problem.” Between them, Brad and Ronan told this hedge fund manager all they had learned. They explained, in short, how the informational value of everything this man did with money was being auctioned by brokers and exchanges to high-frequency trading firms so that they might exploit him. That was why he had a $300 million problem on a $9 billion fund.

  After Brad and Ronan had left his office, the president of this big hedge fund, who had never before thought of himself as prey, reconsidered the financial markets. He sat at his desk watching both his personal online brokerage account and his $1,800-a-month Bloomberg terminal. In his private brokerage account he set out to buy an exchange-traded fund (ETF) comprised of Chinese construction companies. Over several hours he watched the price of the fund on his Bloomberg terminal. It was midnight in China, nothing was happening, and the ETF’s price didn’t budge. He then clicked the Buy button on his online brokerage account screen, and the price on the Bloomberg screen jumped. Most people who used online brokerage accounts didn’t have Bloomberg terminals that enabled them to monitor the market in something close to real time. Most investors never would know what happened in the market after they pressed the Buy button. “I hadn’t even hit Execute,” says the hedge fund president. “I hadn’t done anything but put in a ticker symbol and a quantity to buy. And the market popped.” Then, after he had bought his ETF at a higher price than originally listed, the hedge fund president received a confirmation saying that the trade had been executed by Citadel Derivatives. Citadel was one of the biggest high-frequency trading firms. “And I wondered, Why is my online broker sending my trades to Citadel?”

  Brad had observed and encouraged a lot of Wall Street careers, but, as he said, “I’d never seen anyone’s star rise as quickly as Ronan’s did. He just took off.” Ronan, for his part, couldn’t quite believe how ordinary the people on Wall Street were. “It’s a whole industry of bullshit,” he said. The first thing that struck Ronan about a lot of the big investors he met was their insecurity. “People in this industry don’t want to admit they don’t know something,” he said. “Almost never do they say, ‘No, I don’t know. Tell me.’ I’d say, ‘Do you know what co-location is?’ And they’d say, ‘Oh yeah, I know about co-location.’ Then I’d say, ‘You know, HFT now puts their servers in the same building with the exchange, as close as possible to the exchange’s matching engine, so they get market data before everyone else.’ And people are like, ‘What the fuck??!! That’s got to be illegal!’ We met with hundreds of people. And no one knew about it.” He was also surprised to find how wedded they were to the big Wall Street banks, even when those banks failed them. “In HFT there was no loyalty whatsoever,” he said. Over and over again, investors would tell Ronan and Brad how outraged they were that the big Wall Street firms that handled their stock market orders had failed to protect them from this new predator. Yet they were willing to give RBC only a small percentage of their trades to execute. “This was the biggest confusion to me about Wall Street,” said Ronan. “ ‘Wait, you’re telling me you can’t pay us because you need to pay all these other people who are trying to screw you?’ ”

  Maybe because Ronan was so unlike a Wall Street person, he was granted special access and was able to get inside the heads of the Wall Street people to whom he spoke. “After that first meeting, I told him there was no point in us even being in the same meeting,” said Brad. “We needed to divide and conquer.”

  By the end of 2010, Brad and Ronan between them met with roughly five hundred professional stock market investors who controlled, among them, many trillions of dollars in assets. They never created a PowerPoint; they never did anything more formal than sit down and tell people everything they knew in plain English. Brad soon realized that the most sophisticated investors didn’t know what was going on in their own market. Not the big mutual funds, Fidelity and Vanguard. Not the big money management firms like T. Rowe Price and Janus Capital. Not even the most sophisticated hedge funds. The legendary investor David Einhorn, for instance, was shocked; so was Dan Loeb, another prominent hedge fund manager. Bill Ackman ran a famous hedge fund, Pershing Square, that often made bids for large chunks of companies. In the two years before Brad turned up in his office to explain what was happening, Ackman had started to suspect that people might be using the information about his trades to trade ahead of him. “I felt that there was a leak every time,” says Ackman. “I thought maybe it was the prime broker. It wasn’t the kind of leak that I thought.” A salesman Brad hired at RBC from Merrill Lynch to help him market Thor recalls one big investor calling to say, “You know, I thought I knew what I did for a living but apparently not, because I had no idea this was going on.”

  Then came the so-called flash crash. At 2:45 on May 6, 2010, for no obvious reason, the market fell six hundred points in a few minutes. A few minutes later, like a drunk trying to pretend he hadn’t just knocked over the fishbowl and killed the pet goldfish, it bounced right back up to where it was before. If you weren’t watching closely you could have missed the entire event—unless, of course, you had placed orders in the market to buy or sell certain stocks. Shares of Procter & Gamble, for instance, traded as low as a penny and
as high as $100,000. Twenty thousand different trades happened at stock prices more than 60 percent removed from the prices of those stocks just moments before. Five months later, the SEC published a report blaming the entire fiasco on a single large sell order, of stock market futures contracts, mistakenly placed on an exchange in Chicago by an obscure Kansas City mutual fund.

  That explanation could only be true by accident, because the stock market regulators did not possess the information they needed to understand the stock markets. The unit of trading was now the microsecond, but the records kept by the exchanges were by the second. There were one million microseconds in a second. It was as if, back in the 1920s, the only stock market data available was a crude aggregation of all trades made during the decade. You could see that at some point in that era there had been a stock market crash. You could see nothing about the events on and around October 29, 1929. The first thing Brad noticed as he read the SEC report on the flash crash was its old-fashioned sense of time. “I did a search of the report for the word ‘minute,’ ” said Brad. “I got eighty-seven hits. I then searched for ‘second’ and got sixty-three hits. I then searched for ‘millisecond’ and got four hits—none of them actually relevant. Finally, I searched for ‘microsecond’ and got zero hits.” He read the report once and then never looked at it again. “Once you get a sense of the speed with which things are happening, you realize that explanations like this—someone hitting a button—are not right,” he said. “You want to see a single time-stamped sheet of every trade. To see what followed from what. Not only does it not exist, it can’t exist, as currently configured.”

  No one could say for sure what caused the flash crash—for the same reason no one could prove that high-frequency traders were front-running the orders of ordinary investors. The data didn’t exist. But Brad sensed that the investment community was not persuaded by the SEC’s explanation and by the assurances of the stock exchanges that all was well inside them. A lot of them asked the same question he was asking himself: Isn’t there a much deeper question of how this one snowball caused a deadly avalanche? He watched the most sophisticated investors respond after Duncan Niederauer, the CEO of the New York Stock Exchange, embarked on a goodwill tour, the purpose of which seemed to be to explain why the New York Stock Exchange had nothing to do with the flash crash. “That’s when a light went off,” said Danny Moses, of Seawolf Capital, a hedge fund that specialized in stock market investments. He had heard Brad and Ronan’s pitch. “Niederauer was saying, ‘Hey, have confidence in us. It wasn’t us.’ Wait a minute: I never thought it was you. Why should I be concerned that it was you? It was like your kid walks into your house and says to you, ‘Dad, I didn’t dent your car.’ Wait, there’s a dent in my car?”

  After the flash crash, Brad no longer bothered to call investors to set up meetings. His phone rang off the hook. “What the flash crash did,” said Brad, “was it opened the buy side’s willingness to understand what was going on. Because their bosses started asking questions. Which meant that our telling the truth, and explaining it to them, fit perfectly.”

  A few months later, in September 2010, another strange, albeit more obscure, market event occurred, this time in the Chicago suburbs. A sleepy stock exchange called the CBSX, which traded just a tiny fraction of total stock market volume, announced that it was going to invert the usual system of fees and kickbacks. It was now going to pay people to “take” liquidity and charge people to “make” it. Once again, this struck Brad as bizarre: Who would make markets on exchanges if they had to pay to do it? But then the CBSX exploded with activity. Over the next several weeks, for example, it handled a third of the total volume of the shares traded in Sirius, the satellite radio company. Brad knew that Sirius was a favorite stock of HFT firms—but he couldn’t understand why it was suddenly trading in huge volume in Chicago. Obviously, when they saw they could be paid to “take” on the CBSX, the big Wall Street brokers all responded by reprogramming their routers so that their customers’ orders were sent to the CBSX. But who was on the other side of their trades, paying more than ever had been paid for the privilege?

  That’s when Ronan told Brad about a new company called Spread Networks. Spread Networks, as it turned out, had tried to hire Ronan to sell its precious line to high-frequency traders. They’d walked Ronan through their astonishing tunneling project and their business plans. “I told them they were fucking bananas,” said Ronan. “They said they were going to sell two hundred of these things. I came up with a list of twenty-eight firms who would potentially buy the line. Plus they were charging ten point six million dollars up front for five years’ worth of service, and they wanted to pay me twelve grand for each one I sold. Which is just an insult. You might as well ask me to blow you while I’m doing it.”

  Ronan mentioned this unpleasant experience to Brad, who naturally said, “You’re telling me this now?” Ronan explained that he hadn’t been able to mention Spread before because he had signed a non-disclosure agreement with the company. The agreement had expired that day, and so now he was free to disclose not only what Spread had done but for whom they had done it: not just HFT firms like Knight and Citadel but also the big Wall Street banks—Morgan Stanley, Goldman Sachs, and others. “You couldn’t prove what these guys were doing was a big deal, because they were so guarded about how much money they were making,” said Brad. “But you could see how big a deal it was by how much they spent. And now the banks were involved. I thought, Oh shit, this isn’t just HFT shops. This is industry-wide. It’s systemic.”

  Ronan offered an explanation for what had just happened on the CBSX: Spread Networks had flipped its switch and turned itself on just two weeks earlier. CBSX then inverted its pricing. By inverting its pricing—by paying brokers to execute customers’ trades for which they would normally be charged a fee—the exchange enticed the brokers to send their customers’ orders to the CBSX so that they might be front-run back to New Jersey by high-frequency traders using Spread Networks. The information that high-frequency traders gleaned from trading with investors in Chicago they could use back in the markets in New Jersey. It was now very much worth it to them to pay the CBSX to “make” liquidity. It was exactly the game they had played on BATS, of enticing brokers to reveal their customers’ intentions so that they might exploit them elsewhere. But racing a customer order from Weehawken to other points in New Jersey was hard compared to racing it from Chicago on Spread’s new line.

  Spread was another piece of what was becoming a fantastically elaborate puzzle. The team Brad was assembling at RBC didn’t have all the pieces to the puzzle—not yet—but they had more of them than anyone else willing to talk openly on the subject. The reactions of investors to what they already knew they considered as simply more pieces of the puzzle. Every now and then—perhaps 5 percent of the time—Brad or Ronan met some investor who didn’t care to know about the puzzle, someone who didn’t want to hear their story. Whenever Brad returned from one of these meetings, he’d discover that the person to whom he had just spoken depended, one way or another, on the revenues flowing to high-frequency traders. Every now and again—maybe another 5 percent of the time—they met with an investor who was completely terrified. “They knew so little, and they’d be so scared inside their own firms that they’d rather the meeting never happened,” said Brad. But most of the hundreds of big-time investors with whom Brad and Ronan spoke had the same reaction as T. Rowe Price’s Mike Gitlin: They knew something was very wrong, but they didn’t know what, and now that they knew they were outraged. “Brad was the honest broker,” said Gitlin. “I don’t know how many knew it, but he was the only guy who would say it. He was saying, ‘I’m here and I’m watching it and we’re a party to it and the whole thing is rigged.’ He exposed people who were bad actors, and a lot of people in this industry are afraid to do that. He was saying, ‘This is just offensive.’ ” Vincent Daniel, the head strategist at Seawolf, put it another way. He took a long look at this unlikely pair—a
Canadian Asian guy from this bank no one cared about, and this Irish guy who was doing a fair impression of a Dublin handyman—who had just told him the most incredible true story he had ever heard, and said, “Your biggest competitive advantage is that you don’t want to fuck me.”

  Trust on Wall Street was still—just—possible. The big investors who trusted Brad began to share whatever information they could get their hands on from their other brokers—information Brad was never meant to see. For instance, several demanded to know from their other Wall Street brokers what percentage of the trades executed on their behalf were executed inside the brokers’ dark pools. These dark pools contained the murkiest financial incentives in the new stock market. Goldman Sachs and Credit Suisse ran the most prominent dark pools. But every brokerage firm strongly encouraged investors who wanted to buy or sell big chunks of stock to do so in that firm’s dark pool. In theory, the brokers were meant to find the best price for their customers. If the customer wanted to buy shares in Chevron, and the best price happened to be on the New York Stock Exchange, the broker was not supposed to stick the customer with a worse price inside their dark pool. But the dark pools were opaque. Their rules were not published. No outsider could see what went on inside them. It was entirely possible that a broker’s own traders were trading against the customers in the dark pool: There were no rules against it. And while the brokers often protested that there were no conflicts of interest inside their dark pools, all the dark pools exhibited the same strange property: A huge percentage of the customer orders sent into a dark pool were executed inside the pool. Brad knew this because a handful of the world’s biggest stock market investors had shared their information with him—so that he might help them figure out what was going on.

  It was hard to explain. A broker was expected to find the best possible price in the market for his customer. The Goldman Sachs dark pool—to take one example—was less than 2 percent of the entire stock market. So why did nearly 50 percent of the customer orders routed into Goldman’s dark pool end up being executed inside that pool—rather than out in the wider market? Most of the brokers’ dark pools constituted less than 1 percent of the entire market, and yet somehow those brokers found the best price for their customers between 15 and 60 percent of the time. (So-called rates of internalization varied from broker to broker.) And because the dark pool was not required to say exactly when it had executed a trade, and the broker did not typically tell his investors where it had executed a trade, much less the market conditions at the moment of execution, the customer lived in darkness. Even a giant investor like T. Rowe Price simply had to take it on faith that Goldman Sachs or Merrill Lynch had acted in its interest, despite the obvious financial incentives not to do so. As Mike Gitlin said, “It’s just very hard to prove that any broker-dealer is routing the trades to someplace other than the place that is best for you. You couldn’t SEE what any given broker was doing.” If an investor as large as T. Rowe Price, which acted on behalf of millions of small investors, was unable to obtain from its stockbrokers the information it needed to determine if the brokers had acted in their interest, what chance did the little guy have?