On April Fools’ Day, the S&P 500 hit a new high of 1884. It wasn’t a joke, but it also didn’t provide the biggest entertainment of the day. Trading noticeably slowed on the New York Stock Exchange when a debate on CNBC started to sound more like hockey game commentary than a financial discussion.
“Shame on both of you for falsely accusing literally thousands of people and possibly scaring millions of investors in an effort to promote a business model!”
“I believe the markets are rigged and I also think you’re part of the rigging.”
The one picking the fight was BATS Global Markets president William O’Brien, and IEX’s Brad Katsuyama responded only after O’Brien released a stream of unrelenting goading.
This debate was framed by Michael Lewis, the author who rose to fame with the book, and later film, “Moneyball.” His latest work, “Flash Boys: a Wall Street Revolt,” details how high-frequency traders have rigged the market by exploiting as many small differences as they can before small investors have a chance to even hear about them.
“I believe the markets are rigged.” This conclusion is a strong statement for a trader who makes his living on the markets, but Katsuyama and his brokerage IEX have more than facts to back it up. He has a plan to reform the stock market before it either collapses, becomes heavily regulated or both.
The “rigging” in question is high-frequency trading (HFT). This is done through computers that look for the smallest inconsistency in stock prices and then buy and sell to make up the difference. To make a lot of money at this, one needs high volume and the ability to move with tremendous speed — so fast that even delays caused by the speed of light moving down fiber optic cables are critical.
HFT is now responsible for about half of all stock trades.
Light moves at 186,282 miles per second, or about 180 miles per millisecond. To a high-frequency trader, that’s an eternity, since the price differences they exploit might close up in that time. Every foot of cable is a nanosecond of delay, one-millionth of a second, and that can mean millions of dollars.
“At what point do you say, ‘This is fast enough’?” asks Brent Weisenborn, a former NASDAQ vice president.
According to Katsuyama, we’re way past that point. He was the big hero in “Flash Boys,” and author Lewis never minces words in his praise for Katsuyama.
“His willingness to throw open a window on the American financial world, and to show people what it has become, still takes my breath away,” Lewis wrote of Katsuyama.
To understand the problem and the solution proposed by Katsuyama’s IEX, one needs to understand how trading in stocks is done today. Long gone is the trading floor where traders raised their voices, hands for signing and slips of paper with orders. Stock trading is distributed among individual brokerages all around the world. Buy and sell orders are matched up by the brokers who complete the sales electronically, matching up prices based on the “quotes” for the going price at the moment.
It’s the definition of “moment” that has come to be measured in tiny fractions of a second.
Many surveys have shown that three-quarters of all people also believe that the markets are rigged. According to Gallup, 52 percent of all households currently have some stock, down from a high of 65 percent in 2007. Investor confidence in the fairness of the stock market is low, and that is driving out small investors. But how did this come to be?
The effect on small investors
The problem is explained well in a video on IEX’s website. Most small investors in the market are in mutual funds. These mutual funds manage big blocks of stock that include personal investments and pensions grouped into pools of stock. When they have to sell, they usually have to sell a lot at once. All those trades take some time to arrange, as the computers match up the sale to a potential buyer somewhere else. In the meantime, the market is aware that a big sale is pending, which means that the price is about to fall because supply and demand are temporarily out of whack in some infinitesimal amount.
Small investors need this safety in numbers to protect their assets — something like a capitalist version of organizing. The predators who move on these tiny movements and take their cut of each big sale are much smaller but have incredible equipment and assets at their disposal.
None of this would be a problem for small investors if they had the same access, but they don’t. The speed of light limits the potential advantage to those who are close to the heart of the operation in New York where the price quotes are generated.
Katsuyama saw this in operation when he worked for the Royal Bank of Canada. “It was the perfect place to discover what we discovered,” he said. It was a firm where “choosing to do the right thing was not a hard decision.”
He took his fight on to IEX and has become a hero in both his native Canada and to many on Wall Street. “We’re not against computerized trading – not at all,” he said.
He also pointed out that a well-known HFT firm conducts business on IEX’s platform. “They provide value for our market, but they play by our rules.”
Those rules include a 350 microseconds delay on all trades — enough time for light to go around the world two and a half times. Everyone has the same information before a trade is executed.
IEX is also different from other brokerages in that it is owned and operated by investors, not brokers. “IEX is the first equity trading venue owned exclusively by a consortium of buy-side investors, including mutual funds, hedge funds, and family offices,” according to the brokerage’s website.
They believe this is important because it puts the focus on investing, not trading. “Dedicated to institutionalizing fairness in the markets,” the website continues, “IEX will provide a more balanced marketplace via simplified market structure design and cutting-edge technology.”
In short, Katsuyama wants to reform the market from within by providing a place investors agree is fair. And the market is responding positively.
Will Brad Katsuyama and IEX save the market from itself? As the debate heats up, it’s clear that this topic transfixes Wall Street even more than whether the market is up or down on any given day. That, in and of itself, is a revolution in the works.