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Trust Hero: Brad Katsuyama, on CBS 60 Minutes

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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.

The Tyranny of Low Cost Strategies and the Gospel of Walmart

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High Frequency Trading is in the news again. HFT is highly computerized stock trading, which secures faster execution for bigger computers located physically closer to the stock exchange. It now amounts to over half the daily flow on the stock exchanges.  Critics argue it amounts to legalized front-running, is unethical, and should be illegal.

The issue was raised starkly in a July 24 2009 CNBC interview  wherein a critic of HFT (Joe Saluzzi) accuses a proponent (Irene Aldridge) of defending unethical behavior. Aldridge’s reply:

“How dare you accuse us being unethical! We are the ones cutting margins, you are the ones being unethical.”

Ms. Aldridge’s response captures perfectly the moral flip-flop that business has achieved in the past few decades. Never mind whether HFT amounts to front-running, involves collusive behavior by the exchanges, or is unfair to retail investors, says Ms. Aldridge – the moral high ground, the Ethical Trump Card, is Low Cost. In the name of lower prices, even fractions of pennies, all is justified.

The Gospel of Walmart

Let’s leave Wall Street for Main Street. We all know the Walmart story – low prices all the time. But as a Fast Company article wrote, back in 2007:

The giant retailer’s low prices often come with a high cost. Wal-Mart’s relentless pressure can crush the companies it does business with and force them to send jobs overseas. Are we shopping our way straight to the unemployment line?

If revenue were GDP, Walmart would be the world’s 25th largest economy. That is pretty big market power.

Walmart’s benefits are clear: lower prices, all the time, for millions of consumers. But along with those costs come trade-offs. The reduction of brand power. The exporting of jobs. The reduction of pay and benefits for workers in the name of lower costs to consumers.

More insidiously, what we get in the Walmart deal is lowest-common-denominator consuming. We get buyers who aren’t presented with quality alternatives, can’t recognize them if they are presented, and are trained to view low price as the primary Pavlovian trigger for purchasing.

That’s how we get tramplings at 5AM holiday store openings; that’s how the US produces twice the garbage per capita of Sweden; and I suspect (though can’t prove it) it helps us move toward becoming a nation of hoarders.

Is it all worth it?

The Tyranny of Low-Cost Strategies: Linking Wall Street and Main Street

What links high frequency trading to Walmart?  There is a common ancestor in the family tree of business thinking.

In the 1970s, thinking about business strategy took an abrupt turn – from CUS to COM.  That is, from being about the company’s relationship to its customers, to being about the company’s relationship to its competitors. (If you’re interested, the leading thinkers were Bruce Henderson, Michael Porter, and the Boston Consulting Group).

By 1980, the conversion was complete: anytime anyone said “strategy,” you knew it meant “competitive strategy.”

One of the most powerful points Porter made in his classic Competitive Strategy was that there were two successful generic strategies, and the first of them was Low Cost Producer. He who got the lowest cost got the greatest volume, which led to higher market share and higher profits, which led to lower costs, and so on. It was a road toward legal monopoly, insofar as laws permitted.

Porter’s rules were learned very well: by Jack Welch at GE, by Walmart, by the mortgage business, by Wall Street traders, and by every exec ed program in every business school in the world. It became – and I do not use the word lightly – gospel truth that the highest business good was to lower costs.

The root purpose of lower costs was to gain sustainable competitive advantage for the company. But the collateral benefit, the offshoot which could be spun for great PR, was that the consumer benefited as well. Allegedly.

This insight took only a little bit of tweaking (let’s revise Adam Smith and Milton Friedman, season with a dose of Ayn Rand and a dash of Alan Greenspan, and voila!) to come up with an ideology that said not only is low cost a successful business strategy, it is also the Key to Capitalism, which in a capitalist society is also the source of ethics. Allegedly.

This is how we get to Ms. Aldridge’s high dudgeon at being accused of unethical behavior (“Moi?!”) In this all-too-common alternative view of the world,  profit underlies ethics, business success is the root of morality, and low cost is the Ur-explanation that requires no further referent point for ethical discussion.

“We are the ones cutting margins – you are the ones being unethical.” In that statement, the transformation is complete: low cost is the new moral high ground.

Be careful what you wish for.