In this environment, the effect of trying to help investors see what was happening to their money was revolutionary. The Royal Bank of Canada had never been anything more than the most trivial player in the U.S. stock market. At the end of 2010, Brad saw a report from Greenwich Associates, the firm used by Wall Street banks to evaluate their standing in relation to their peers. Greenwich Associates interviews the investors who use Wall Street’s services and privately reports their findings to the Wall Street firms. In 2009, RBC had—at number 19—been far down Greenwich Associates’ stock market rankings. At the end of 2010, after only six months of Thor, RBC was ranked number 1. Greenwich Associates called RBC to ask what on earth was going on within the bank. In the history of their rankings, they said, they had never seen a firm jump more than three spots.
At the same time, this movement spawned by Brad Katsuyama’s unhappiness with Wall Street was starting to feel less like a business than a cause. Brad was no radical. As he put it, “There’s a difference between choosing a crusade and having it thrust on you.” He’d never really thought all that much about how he fit into the bigger picture, and certainly never considered himself a character upon a stage. He’d never run for student council. He’d never had anything to do with politics. “It’s always seemed to me that the things you need to do to influence change had to do with glad-handing,” he said. “It just felt so phony.” This didn’t feel phony. This felt like a situation in which a person, through his immediate actions, might change the world. After all, he was now educating the world’s biggest money managers about the inner workings of the stock market, which strongly suggested to him that no one else on Wall Street was willing to teach them how their investment dollars were being abused. The more he understood the inner workings of the financial system, the better he might inform the investors, big and small, who were being abused by that system. And the more pressure they might bring to bear on the system to change.
The deep problem with the system was a kind of moral inertia. So long as it served the narrow self-interests of everyone inside it, no one on the inside would ever seek to change it, no matter how corrupt or sinister it became—though even to use words like “corrupt” and “sinister” made serious people uncomfortable, and so Brad avoided them. Maybe his biggest concern, when he spoke to investors, was that he’d be seen as just another nut with a conspiracy theory. One of the compliments that made him happiest was when a big investor said, “Thank God, finally there’s someone who knows something about high-frequency trading who isn’t an Area 51 guy.” Because he wasn’t a radical, it took him a while to figure out that fate and circumstance had created for him a dramatic role, which he was obliged to play. One night he actually turned to Ashley, now his wife, and said, “It feels like I’m an expert in something that badly needs to be changed. I think there’s only a few people in the world who can do anything about this. If I don’t do something right now—me, Brad Katsuyama—there’s no one to call.”
CHAPTER FOUR
TRACKING THE PREDATOR
By the end of 2010 they’d built a marketable weapon. The weapon promised to defend investors in the U.S. stock market from what appeared to be a new kind of market predator. About that predator they knew surprisingly little. Apart from Ronan, Brad knew no one from inside the world of high-frequency trading. He had only a vague idea of that world’s reach, or its political influence. From Ronan he knew that the HFT firms enjoyed special relationships with the public stock exchanges, but he knew nothing about their dealings with the big Wall Street banks tasked with guarding the interests of investors. Then again, many of the people who worked inside the Wall Street banks seemed to have only the faintest idea of what those banks were up to. If you worked for a big Wall Street bank, the easiest way to find out what other banks were up to was to seek out their employees who were looking for new jobs and interview them. In the wake of the financial crisis, the too-big-to-fail end of Wall Street was in turmoil, and Brad was able to talk to people who, just a few years before, would never have considered working for the Royal Bank of Canada. By the time he was finished picking their collective brains, he had spoken to more than a hundred employees at too-big-to-fail banks but hired only about thirty-five of them. “They all wanted jobs,” he said. “It’s not that they wouldn’t tell me. It’s that they didn’t know how their own electronic systems worked.”
The thread running through all these people, even the ones he didn’t hire, was their fear and distrust of the system. John Schwall was a curious case in point. Schwall’s father had been a firefighter on Staten Island, like his father before him. “Every male on my father’s side is a fireman,” Schwall said. “I wanted to do something more.” More meant getting a master’s in engineering from the Stevens Institute of Technology, in Hoboken, New Jersey. In the late 1990s he took a job at Banc of America Securities,* where he rose to a position with an important-sounding title: Head of New Products. His job description was more glamorous than his job. John Schwall was the guy behind the scenes who handled the boring details, like managing relations between the traders on the floor and the tech geeks who built stuff for them, or ensuring that the bank complied with new stock market regulations. He routinely ranked in the top 1 percent of all employees in Banc of America’s reviews of its personnel, but his status in a Wall Street bank was akin to head butler to a British upper-class family. To the grunts in the back office he might have seemed like a big shot, but to the traders who made the money he did not.
Whatever frustration this caused him he buried. Given an excuse to feel loyalty for his company, he seized it. September 11, 2001, for instance. Schwall’s desk was in the North Tower of the World Trade Center, on the eighty-first floor. By sheer fluke he had been late to work that morning—the only day in 2001 he would report late to work—and he’d watched the first plane hit, thirteen floors above his desk, from the window of a distant bus. Several of his colleagues died that day, and so had some Staten Island firemen he’d known. Schwall seldom spoke of the event, but privately he believed that, had he been at his desk when the plane hit, his instinct would have been to go up the stairs rather than down them. The guilt he felt for not having been on hand to help somehow became, in his mind, a debt he owed to his colleagues and to his employer. Which is to say that Schwall wanted to feel toward a Wall Street bank what a fireman is meant to feel toward his company. “I thought I’d be at Banc of America forever,” he said.
Then came the financial crisis, and, in 2008, the acquisition, by Bank of America, of a collapsing Merrill Lynch. What happened next upended Schwall’s worldview. Merrill Lynch had been among the most prolific creators of the very worst subprime mortgage bonds. Had they been left to the mercy of the market—had Bank of America not saved them—the Merrill Lynch people would have been tossed out on the street. Instead, right before their acquisition, they awarded themselves massive bonuses that Bank of America wound up having to pay. “It was incredibly unfair,” said Schwall. “It was incredibly unjust. My stock in this company I helped to build for nine years goes into the shitter, and these assholes pay themselves record bonuses. It was a fucking crime.” Even more incredibly, the Merrill Lynch people ended up in charge of Bank of America’s equity division and set about firing most of the people in it. A lot of those people had been good, loyal employees of the bank. “Wall Street is corrupt, I decided,” said Schwall afterwards. “There is no corporate loyalty to employees.”
Schwall was one of the few Banc of America people who kept his job: Merrill Lynch had no one to replace him. He hid his true feelings, but he no longer trusted his employer. And he sensed, for the first time in his career, that his employer did not trust him. One day he sent himself an email from his personal account to his work account—he was helping out some friends who had been fired by the bank and who wanted to start a small brokerage firm. His boss called him to ask him about it. What the hell are they doing monitoring my incoming emails? Schwall wondered.
His ability to m
onitor his superiors exceeded their ability to monitor him, and he began to do it. “There was a lot of unspoken animosity,” he said. He noticed the explosion of trading activity inside of Merrill Lynch’s dark pool fueled by high-frequency traders. He saw that Merrill Lynch created a new revenue line, to account for the money paid to them by high-frequency trading firms for access to the Merrill Lynch dark pool. He noticed that the guy who had built the Merrill Lynch electronic trading platform was one of the highest-paid people in all of Merrill Lynch—and he’d nevertheless quit to create a company that would cater to HFT firms. He noticed letters sent on bank letterhead to the Securities and Exchange Commission arguing against further stock market regulation. He saved one in which the bank’s lawyers wrote that “despite numerous changes in recent years in both market structure and participant behavior, the equity market is functioning well today.” One day he heard a rumor that the Merrill people had assigned an analyst to produce a report to prove that Merrill’s stock market customers were better off because of whatever happened inside Merrill’s dark pool. There was apparently some controversy around this report. Schwall filed that rumor away for later use.
Schwall wanted to think of himself as a guy who lived by a few simple principles, a good soldier. After the financial crisis he was more like the Resentful Butler. He had a taste for asking complicated questions, and for tracking the answers into whatever rabbit hole they might lead him. He had, in short, an obsessive streak.
It wasn’t until after he’d hired Schwall away from Bank of America to work for RBC that Brad noticed this side of Schwall. He should have seen it before, simply from Schwall’s chosen role on Wall Street: product manager. A product manager, to be any good, had to be obsessive. The role had been spawned by the widespread belief that traders didn’t know how to talk to computer geeks and that computer geeks did not respond rationally to big, hairy traders hollering at them. A product manager stood between the two groups, to sort out which of the things the traders wanted that were the most important and how best to build them. For instance, an RBC stock market trader might demand a button on his screen that said “Thor,” which he could hit when he wanted Thor to execute his order to buy stock. To design that button might require twenty pages of mind-numbingly detailed specifications. That’s where Schwall came in. “He goes into details that no one else will go into, because for some reason that’s what he likes to do,” said Brad.
The first hint that Schwall’s obsession with detail might take a sharp turn into some private cul-de-sac came in company meetings. “He’d go off on complete tangents,” said Brad. “Semi-related but outer space–type stuff.” Another way Brad saw how Schwall’s mind worked was in a fight that Schwall picked not long after he started working at RBC. The bank had declined an offer to serve as a lead sponsor for a charity called Wings Over Wall Street. Wings Over Wall Street raised money to combat amyotrophic lateral sclerosis (ALS)—Lou Gehrig’s disease. In response, and without explaining why, Schwall blasted a system-wide email explaining the importance of ALS research and encouraging all RBC employees to get behind Wings Over Wall Street. The RBC executives who had made the original decision understandably saw this rogue email as a political act intended to undermine their authority. For no apparent reason, Schwall had alienated a bunch of important people who had the power to fire him.
Brad now found himself between his new, extremely valuable employee and a top RBC executive who wanted his scalp. When pressed, Schwall finally explained to Brad that his mother had just died of ALS. “And he hadn’t thought to mention it,” said Brad. “He’d spent years trying to figure out how to help his mother. The fact his mother died of the disease would have won the argument, and he never mentions it. He said it would have been underhanded and unprincipled.” Schwall’s problem wasn’t an uncharming taste for corporate politics but a charming ineptitude at playing them, Brad decided. (“Anyone who was politically astute never would have done this.”) He nevertheless stumbled into politics often enough and played them badly enough that Brad finally came up with a name for the resulting mess: a Schwalling. “A Schwalling is when he does something unintentionally idiotic that makes him look stupid,” said Brad.
All Schwall would say is, “I just sort of get crazy from time to time.” He’d become obsessed with something, and his obsessions sent him on a trip to a place from which the journey’s origin could no longer be glimpsed. The result was a lot of activity without an obvious motive.
Thor had triggered Schwall’s private process. Thor, and what it implied about the U.S. financial system, became Schwall’s greatest obsession. Before Brad explained to him how Thor worked and why, Schwall hadn’t thought twice about the U.S. stock markets. After he met Brad, he was certain that the market at the heart of capitalism was rigged. “As soon as you realize this,” he said, “as soon as you realize that you are not able to execute your orders because someone else is able to identify what you are trying to do and race ahead of you to the other exchanges, it’s over,” he said. “It changes your mind.” He stewed on the situation; the longer he stewed, the angrier he became. “It really just pissed me off,” he said. “That people set out this way to make money from everyone else’s retirement account. I knew who was being screwed, people like my mom and pop, and I became hell-bent on figuring out who was doing the screwing.” He reconsidered what he’d seen at Merrill Lynch after they had taken over Bank of America’s stock trading department. He hunted down the analyst who had done the controversial analysis of Merrill’s dark pool, for instance. The analyst told him that he had found that the dark pool was actually costing the customers (while profiting Merrill Lynch), but that management did not want to hear it. “They kept on telling him to change his report,” said Schwall. “He was basically told that he had to find a different way to do it to get the answer they needed.”
Early one Monday morning, in the summer of 2011, Brad had a call from Schwall. “He said, ‘Hey, I’m not coming in today,’ ” recalls Brad. “And I said, ‘What’s going on?’ He just said, ‘Trust me.’ Then he disappeared.”
The previous night Schwall had gone out into his backyard, with nothing but a cigar, a chair, and his iPad. “I had the belief that some people were perpetuating a fraud. When you think HFT, what do you think? You think nothing. You don’t have a person. You don’t have a face. You think a computer. But there are specific people behind this.” He’d started by Googling “front-running” and “Wall Street” and “scandal.” What he was looking for, at first, was the cause of the problem Thor had solved: How was it legal for a handful of insiders to operate at faster speeds than the rest of the market and, in effect, steal from investors? He soon had his answer: Regulation National Market System. Passed by the SEC in 2005 but not implemented until 2007, Reg NMS, as it became known, required brokers to find the best market prices for the investors they represented. The regulation had been inspired by charges of front-running made in 2004 against two dozen specialists on the floor of the old New York Stock Exchange—a charge the specialists settled by paying a $241 million fine.
Up till then the various brokers who handled investors’ stock market orders had been held to the loose standard of “best execution.” What that meant in practice was subject to interpretation. If you wanted to buy 10,000 shares of Microsoft at $30 a share, and the broker went into the market and saw that there were only 100 shares offered at $30, he might choose not to buy those hundred shares and wait until more sellers turned up. He had the discretion not to spook the market, and to play your hand on your behalf as smartly as he could. After the brokers abused the trust implicit in that discretion once too often, the government took the discretion away. Reg NMS replaced the loose notion of best execution with the tight legal one of “best price.” To define best price, Reg NMS relied on the concept of the National Best Bid and Offer, known as the NBBO. If an investor wished to buy 10,000 shares of Microsoft, and 100 shares were offered on the BATS exchange at $30 a share, while the full 10,000
listed on the other twelve exchanges were offered at $30.01, his broker was required to purchase the 100 shares on Bats at $30 before moving on to the other exchanges. “It mandated routing to more exchanges than you might otherwise have to go to,” said Schwall. “And so it created more opportunities for people to front-run you.” The regulation also made it far easier for high-frequency traders to predict where brokers would send their customers’ orders, as they must send them first to the exchange that offered the best market price.
Flash Boys: A Wall Street Revolt Page 9
