FLASH BOYS March 31st, 2014

OVERVIEW: Illustrating the stories of several individuals including Sergey Aleynikov, a one-time programmer for Goldman Sachs, and , the founder of IEX, : A Revolt focuses on the rise of high frequency trading (HFT). Estimating HFT costs investors between $5-15 billion per year through market abuses, author Michael Lewis claims in the book that the “market is rigged,” which triggered a storm of debate upon release. ------ALGORITHMS ON THE RISE: On October 19th, 1987, the U.S. stock market crashed by 22% in a single day, taking even Wall Street insiders by surprise, now known as Black Monday. Nobody could explain it. Some of the regulatory adjustments that followed the crash facilitated a hastened move from fallible human traders to computer trading. ------BRAD KATSUYAMA: Initially trading stocks for the Royal Bank of Canada in Toronto, Brad Katsuyama moved to New York in the early 2000s to become RBC’s Global Head of Electronic Sales and Trading. Yet after a few years, he began to notice irregularities affecting his work. After 2007, he could no longer buy or sell at the exact stock prices flashing on his trading screen. The market prices changed as he tried to make transactions. The frequency of these price jumps ruled out market news as a cause. Unstable prices made assessing risk more difficult and Katsuyama became hesitant to trade. His team found an explanation. When Katsuyama pressed a button on his computer, it sent his to a few exchanges. Since exchanges are in diverse places, the signal arrived at varied times. The margin was milliseconds, but other participants – high-frequency traders – picked up his order and beat him to other exchanges. ------THE NEED FOR SPEED: Ronan Ryan lacked Wall Street contacts that might open doors to a great job and settled for a position at a big telecom company. Although never particularly interested in technology, once he put his mind to it, he became a sought-after expert. At Radianz, he helped firms transmit signals at NOTABLE QUOTE ever-increasing speeds. He became a witness to a mad war for speed. Trading firms tried to lessen the distance – even by a few feet – that a cable travelled from their data centers to the end destination, “The world clings to its old mental the stock exchanges. The exchanges offer “co-location,” letting traders place their computers in the picture of the stock market because it’s exchange for a fee. When the traders couldn’t move their computer connections any closer, they comforting; because it’s so hard to draw demanded the latest materials or changed switches to gain microsecond increases in signal speed. a picture of what has replaced it; and What seemed random to Ryan made sense to Katsuyama, who recruited Ryan for his banking team. Ryan took a significant pay cut to join RBC as head of high-frequency trading strategies. The title bore because the few people able to draw it almost no relation to his actual job, which was to explain to Katsuyama in technical terms what was for you have no interest in doing so.” happening in the markets. As Katsuyama learned all he could about high-frequency trading , he came to understand the rules of the rigged HFT game, its impact on the markets and its grip on the brokers and exchanges. As Lewis explains, Katsuyama ultimately decided to fight HFT and its ability to cut off fair trading. In turn, he hoped to enlighten and educate other investors and to put enough pressure on the system to change it. ------REGULATION LOOPHOLES: Before John Schwall joined Katsuyama’s team, he was a product manager at Bank of America. Deeply attentive to detail, Schwall ran the nitty-gritty specifications that trading programs required. When he learned that some market participants were, in effect, “front-running” others, he needed to find out why that was possible, or lawful. His research led him to some well-meaning legislation: Regulation National Market System, or Reg NMS for short. It required brokers to buy at the exchange that offered the lowest prices. Determining the lowest price required US exchanges to submit data to the Securities Information Processor, which calculated the National Best Bid and Offer (NBBO). This created a trading delay. HFT experts could calculate the NBBO much faster, and thus profit from a sneak preview of the market. The larger the time gap between the official NBBO and a privately calculated one, the more high-frequency traders made. The more price fluctuations a stock went through, the more opportunities high-frequency traders had to exploit those fluctuations. The regulation made market behavior easier for high-frequency traders to predict, because brokers had less flexibility in how they placed orders. Reg NMS inadvertently created a loophole high-frequency traders could exploit. Schwab saw that whatever regulators did to improve market behavior, some people still found a way to turn the new rules to their advantage. ------BATTLING HFT ILLITERACY: Katsuyama encountered widespread ignorance about the workings of HFT. Some HFT supporters, including SEC employees, claimed that HFT “provided liquidity” in the market – since, by 2008, high-frequency trades made up about 65% of all trades. In Katsuyama’s view, however, high-frequency traders hijacked trades that would have taken place without it. Once they knew a buyer and a seller were in place, they profited from the trade without assuming any risk. HFT did not create liquidity, but rather undermined it. Traders like Katsuyama – who did provide liquidity – were less likely to assume the risk of trading if they could not rely on market information. Further, high-frequency traders benefited from volatile, fragmented markets. “The price volatility within each trading day in the US stock market between 2010 and 2013 was nearly 40% higher than in the most volatile days of the dot-com bubble.” HFT also contributed to fragmentation by “[encouraging] new exchanges to open.” ------THE INVESTOR’S EXCHANGE: In a gutsy move, Katsuyama and his team decided to leave their secure jobs at RBC to open their own exchange, the Investors Exchange (IEX). They hoped it would fix the loopholes that HF traders exploited and would allow fair trading. To avoid “predatory trading,” IEX took several steps, including: • A 350-Microseconds Delay – IEX intentionally extends the time it takes for a traders’ signal to reach its matching engine, thus negating any speed advantage. • No Co-Location – IEX does not allow any firm to put computers near its matching engine. • No Kickbacks Or Rebates – IEX charges everyone the same fee based on share volume. • Limited Types Of Orders – Some exchanges offer various order types catering to HFT. For example, a high-frequency trader could hide an order until someone else entered the same order, making the high-frequency trader first in line. IEX’s order types do not give faster traders an advantage. • Owned By Investors Only – To avoid a conflict of interest or any hint of a conflict, only investors (such as pension funds, mutual funds and hedge funds) – not bankers or brokers – own IEX. Even the exchange’s founders have to work through a broker to trade on the exchange. ------WHAT HAPPENS IN THE , STAYS IN THE DARK POOL: A couple of months after IEX opened on October 25th, 2013, Katsuyama had learned some valuable lessons. Other stock exchanges and big Wall Street banks did not welcome IEX. It received negative – and untruthful – word-of-mouth feedback. Opponents even threatened some IEX employees. When big investors, such as mutual fund managers, told their banks to manage their business via IEX, those banks bent over backward to avoid giving IEX any business at all. A program that graphically showed IEX’s trading statistics helped Katsuyama interpret market behavior. He learned that some big banks were “pinging” IEX for shares. They would, for example, order 100 shares to see whether IEX had a matching seller. This was a way to get information without publicizing a high demand that might affect the share price to their disadvantage. Curiously, even if IEX did have a matching trade partner, the banks still wouldn’t trade on IEX. Katsuyama saw that the banks were trading in their own barely regulated exchanges, called “dark pools.” The law did not require banks to publish data on how the pools operated. This provided banks with opportunities to put investors at a disadvantage. Pinging IEX gave banks a double advantage: They gained a facade that made it look as if they had tried to trade on IEX. And, they could make IEX’s stats look bad: Investors read large average trade volumes as an indicator of a good exchange. By ignoring offers outside their dark pools, these banks also gave HF traders – who paid for access – an opportunity to exploit orders. Katsuyama saw that the exchanges, banks and brokers all benefited from existing inefficiencies. Fixing the market would take far more than offering a fair exchange. Katsuyama invited major investors, such as pension funds and mutual funds, to share his findings, and he praised the banks and brokers that refused to participate in unfair behavior. influential Goldman Sachs managers saw IEX as a crucial milestone in financial history. In December 2013, the bank began sending many trades to IEX. This change of strategy and support was a ray of hope for Katsuyama. He saw that what he started could end up changing the market for good.