Trusted Advisor

The Trust Matters Blog: Trust and Culture

Michael Lewis, Wall Street, and Trust

Outsourcer?Right after Michael Lewis’s 60-Minutes appearance to promote his new book Flash Boys I wrote a blogpost about it.

The next day I received a phone call from a retail stock broker. His tone was somewhere between kindly uncle and exasperated old-timer, but his message was clear:

“That Lewis guy’s obviously got an axe to grind,” said the caller. “He lost big-time in the market and he’s trying to get even with people. And that Katsuyama guy he writes about, he’s just a spoiled baby, trying to make an even bigger buck than he was lucky to get paid in the first place. The whole thing is just a bunch of hype designed to sell books, and you’re getting suckered into it.”

If you know anything about the book (and if you don’t, here’s a good start), you know that’s a crock. In any case, my caller exhibited three traits:

  1. He’s convinced the world is of the dog-eat-dog variety,
  2. He’s convinced that everyone else believes the same thing,
  3. The default strategy therefore is do unto others before they do unto you.

My caller does not believe in people with different value systems. Let’s call such people “unicorns” Canadians.  (Did I mention Katsuyama is Canadian?)

Now, I suggest the odds of making my caller more trusting and  trustworthy through more regulations are roughly zero. The odds of making him trustworthy  through incentives, can be only slightly better (and I can’t even imagine the incentives).

The only way he’s ever likely to behave in a trusting and trustworthy manner is if he gets beat in a level playing field market by those who are capable of trusting and being trusted.

The Showdown on CNBC

The next day, Lewis and the book’s hero Brad Katsuyama appeared in a very confrontational spot on CNBC  with Bill O’Brien, President of BATS. BATS is an exchange that the book accused of being at the heart of misleading investors and supporting high frequency trading in a legal form of “front-running.”

O’Brien wasted no time throwing the first punch, leading off with:

O’Brien: Shame on you, Michael and Brad, shame on you both for falsely accusing literally thousands of people and possibly scaring millions of investors in an effort to promote a business model. It’s a very, very old tactic to try to build a business on the planks of fear, mistrust and accusation; this is certainly taking that to a new level. It reflects either an unwillingness – a continued lack of understanding about how this market operates or just unwillingness to acknowledge it, because you’re trying to launch a new business and you want to get volume for your platform…

Katsuyama: If you’re going to launch these accusations, let me ask – what market data do you use to price trades?

O’Brien:  We use direct feeds.

Katsuyama: No, you don’t. [You use SIP feeds]

O’Brien: Yes, we do [use direct feeds]

The very next day, the Wall Street Journal reported:

BATS Global Markets Inc., under pressure from the New York Attorney General’s office, corrected statements made by a senior executive during a televised interview this week about how its exchanges work…the exchange operator said two of its exchanges, EDGA and EGX, use a slower feed, known as the Securities Information Processor, to price trades.

This is what is known, in my circles as – technical term – being caught in a flat-out lie.

In any case, Mr. O’Brien exhibited the same three traits as my retail-level caller:

  1. He’s convinced the world is of the dog-eat-dog variety,
  2. He’s convinced that everyone else believes the same thing,
  3. The default strategy therefore is do unto others before they do unto you. Which of course is just what he tried to do.

O’Brien does not believe in people who believe in honesty or fair dealing; in other words, he does not believe in unicorns or Canadians – even when staring one in the face (did I mention that Katsuyama is Canadian?).

The odds of making O’Brien and his ilk more trustworthy through better regulations are roughly zero. The odds of making him trustworthy  through incentives, only slightly better (and I still can’t even imagine the incentives).

The only way he’s likely to behave in a trusting and trustworthy manner is if he gets beat in a level playing field market by those who are capable of trusting and being trusted.

And that is precisely what Brad Katsuyama is setting out to do in the development of a new exchange, IEX. Not a regulatory answer; not a new incentives answer; an answer based on the hope that enough customers in the market will actually choose to do business with an exchange that is unconflicted, that is transparent about its data, that offers only easy-to-understand offers, and that enforces a level playing field.

Will it work?  Stay tuned. There are some interesting positive signs, including even from (hold your breath) Goldman Sachs.

Trust on Wall Street

Having focused solely on trust in business for over 15 years now, several things are apparent to me.

1. The Mother Theresa Paradox is Real. The less trust exists in an industry, the less interested are the industry players in reforming it. It is the already-trust-conscious industries (and companies) who are convinced of trust’s value, and who are interested in improving it. This despite the fact that trust is an overwhelmingly powerful competitive advantage for anyone who can see it. Katsuyama’s new exchange will be a great test of that proposition.

By anybody’s measure (e.g. Edelman’s Trust Barometer), financial services are at the bottom of the trust list. Low hanging fruit, for anyone willing to think their way out of the low-trust box.

2. You Can’t Get Trust with Cheese.  The rats-and-cheese model of behavioral change through incentives doesn’t work with trust, because incentives are personal and trust is relational. Unless you can make incentives team-based and long term, they fail. Even then, they can and will be gamed by very smart rats. See next item.

3. Regulation Is a Vicious Circle. Wall Street pays much more than regulators, and many regulators go to work in the industry they regulate. Regulators have small budgets. But even if that were untrue, you can’t regulate morality. In fact, the more you make “ethics” the target of regulatory efforts, the less it becomes about morality and the more it becomes just compliance.

4. The Needed Values are Clear. They’ve been obvious for some time. They are:

  1. a focus on the client first for the sake of the client
  2. a belief in collaboration
  3. a focus on relationships, not transactions
  4. a default to transparency

These are key to trust. They are clearly in short supply on Wall Street.

So, how to increase ethics on Wall Street? Two answers:

One is, cheer on Brad Katsuyama’s noble capitalist market experiment in honesty, transparency and customer focus.

The other? Instead of Occupy Wall Street, how about – Outsource Wall Street! To Canada!

Within months, I suspect, we’d see lower transaction costs, less risk of flash crashes, higher liquidity, higher legitimate volume, and a reduction in the total size of the industry with no loss of value added.

All it takes is the willingness to operate based on values other than dog-eat-dog.

 

Trust Hero: Brad Katsuyama, on CBS 60 Minutes

Illustration: Truth and LieMichael Lewis’s new book Flash Boys goes on sale at Amazon this morning, March 31. The headline, as he put it in Sunday’s exquisitely timed CBS 60 Minutes – “The stock market is rigged.”  And it’s rigged in favor of high-frequency traders.

Complaints about high frequency trading are not new. What is new, to nearly all of us, is the story of an unlikely trust hero that Lewis profiles, and the amazing response to HFT that he is developing.

Brad Katsuyama, a Canadian employee of Royal Bank of Canada, ran the New York trading desk for RBC. He noticed that the trading action was as if someone was constantly front-running him, causing him higher prices to fill orders, and thus higher costs to his customers. He soon found the problem was endemic in the industry.

He teamed up with an Irish fiber networks expert. The two of them and their team figured out how it all worked. Firms like Spread Networks had figured out how to lay enough fiber cable to allow just milliseconds of advantage – enough to notice an order from someone like RBC, then quickly get in front of that order at other exchanges, and buy-then-sell the same stock before the victim’s trade, running on slower networks, could get filled.

It is, as Lewis says, “legalized front-running.” And it was clearly worth billions.

Trust Motives

Now comes the trust part. Katsuyama and his team figured out how to beat the front-runners by spreading their orders to all arrive at the same time at different exchanges.  But he wasn’t done yet. He wanted to change the rigged market. Why? “Because it just didn’t feel right. Customers of pension funds and retirement funds are getting bait-and-switched every day.”

Katsuyama quit his million-plus job and set out to found a new exchange. What motivated him – the chance to earn multiple millions more, in good capitalist fashion? No. In his words, “It felt like a sense of obligation; we’ve found a problem affecting millions of people, blindly losing money they don’t even know they’re entitled to.”

They founded IEX, a competitive exchange; using 60 kilometers of cable to disadvantage the HFTs, they beat them at their own game. The exchange is off to a good start, though with lots of powerful enemies.

Selling Trust 

Katsuyama himself is a bit giddy. “To think that trust itself is actually a differentiator in a services business – it’s kind of a crazy idea.”

Of course, it is anything but crazy. As Michael Lewis says, “When someone walks in the door who is actually trustworthy, he has enormous power. And this is about trying to restore trust to the financial markets.”

Exactly. As anyone who’s been reading this blog for years knows, trust sells. Trust scales. Trust creates value. Trust is an enormous competitive advantage.

If you can drag untrustworthy practices out into the sunlight, customers overwhelmingly prefer trustworthy practices. Key investors like David Einhorn agree; Einhorn figures IEX is a winner.

More power to Katsuyama and to IEX. It’s good to have someone you can trust on Wall Street. I would not bet against him.