Michael 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.
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.
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.