“Every brokerage firm strongly encouraged investors who wanted to buy or sell big chunks of stock to do so in that firm’s dark pool. In theory, the brokers were meant to find the best price for their customers. If the customer wanted to buy shares in Chevron, and the best price happened to be on the New York Stock Exchange, the broker was not supposed to stick the customer with a worse price inside their dark pool. But dark pools were opaque. Their rules were not published. And while the brokers often protested there were no conflicts of interest inside their dark pools, all the dark pools exhibited the same strange property: A huge percentage of the customer orders sent into a dark pool were executed inside the pool.” —Flash Boys, p. 86
Wall Street leading up to the crisis, and afterwards. So much has been written about it, but Michael Lewis, also author of The Big Short and Moneyball, does an exceptional job of bringing it to life, and with all the intrigue of a Hollywood thriller.
Flash Boys has villains and heroes, and the villains are all too familiar. Lewis takes complex financial systems and makes them understandable. The reader quickly realizes that everyone is affected by events such as those he describes—no one is immune or unscathed.
Lewis ties together several complicated stories into one, all of which hinge on having information, and acting on it, fractions of a second sooner than competitors.
Trading at the speed of light
Lewis describes how he became interested in this story. He read about a Russian computer programmer who left Goldman Sachs, and was then arrested by the FBI. The agency charged him with stealing the firm’s computer code. Lewis found it strange that “after the financial crisis, in which Goldman Sachs had played such an important role, that the only Goldman Sachs employee who had been charged with ANY sort of crime, was the employee who had taken something from Goldman Sachs.”
The man had been a “high frequency trading programmer.” This job illustrates how Wall Street has evolved. The craziness that was once the trading floor now exists in very, very fast and orderly computers—black boxes located in New Jersey and Chicago that are better guarded than most nuclear missiles. The “exchanges” exist in this world, not on the traditional trading floors.
This story comes from the book’s introduction and is fleshed out later. The book’s main thread actually begins with Dan Spivey. Spivey realized that fiber-optics lines are key to faster trading. Faster as in 12 milliseconds, a millisecond being one/thousandth of a second. Spivey figured out that fiber optic cable laid straight allowed information to travel fastest and he persuaded Jim Barksdale, the former CEO of Netscape Communications, to fund a $300 million tunnel to set-up a cable running from Chicago to New Jersey. The end result was an 827-mile line that would convey information in 13 milliseconds, round trip.
These developers were gambling, but it paid off. Initially, all the big banks and players approached—except Credit Suisse—signed-up. They paid $10.6 million up front for five years’ worth of service.
Out of the fiber loop
The story then moves to Brad Katsuyama, who worked for the Royal Bank of Canada (RBC). In 2002, his bosses in Canada moved him to New York when they decided they wanted to be a “Wall Street player.”
Katsuyama worked on the RBC trading floor there. He was promoted to run the equity trading department and all was going reasonably well until RBC purchased an electronic trading firm, Carlin Financial, in 2006.
This was a culture clash, to put it mildly. Polite Canadians were teamed up with brash boiler room style traders—the guys portrayed in Hollywood movies (and not in a good way). Aside from the opposing personalities that were now part of Katsuyama’s world, RBC moved their offices into the ones occupied by Carlin. Katsuyama’s computers wouldn’t function, and it was as if everything he had trusted after seven years as a trader was an illusion.
He would see an offer on screen, but when he pushed the button to execute the trade, the offer vanished. Katsuyama traded in big lots of stock and this new system was proving to be very costly and something he couldn’t ignore. When he took a position, the public market reaction was instantaneous and it would seem that his action was anticipated in advance.
After tens of millions of dollars were lost and costs were rising, Katsuyama’s bosses in Canada told him to figure this out. He had already met with every tech person from the “IT support guy” all the way to the developers—with no answers.
Multi-exchange trading and “dark pools”
Meanwhile, something else that was happening simultaneously was the introduction, allowed by government deregulation, of multiple exchanges trading. Previously 85% of all stock orders traded on the NYSE and humans were part of that process. All of these new exchanges were essentially a stack of computer servers in New Jersey with a program called a “matching engine.”
The new exchanges also came with complicated fee structures. RBC made the move to replace the head of Carlin and after not finding what they were looking for, asked Katsuyama to take on the role of head of their electronic trading division. Once in his new role, Brad went back to the group of developers (whom were collectively called “the Golden Goose”) and asked what they could do to make money.
Their answer: Create a “dark pool.”
A dark pool is a private stock exchange run by big brokers. These report their trades, but not immediately and only the brokers that run them know what is going on inside of them.
Katsuyama rejected the idea. He didn’t see where RBC could make enough since it was only 2% of the market. He then learned that high frequency traders (HFT) would be interested in being in their dark pool.
A high frequency trader (HFT) uses its own proprietary strategies based on trading algorithms that are carried out by their computers to move in and out of positions; in this process a lot of money is made.
When a trade processes in the new version of Wall Street, the broker presses a button and in speed that is quicker than a blink of an eye, that order goes to a router that determines where that trade will go. This might be a “dark pool” or an exchange. The trading algorithm will also determine how that trade is divided—for example, a 100,000 share order may be divided into 20 smaller orders at a specific price point.
On top of this, certain exchanges will pay the brokers to process there versus the broker paying the exchange a buy-side commission and on the flip side, charge the sellers. For a fee, the exchange will “flash” information about their orders before they become public, allowing high-frequency traders to get ahead of—“front run”—the trade on other exchanges.
Hence the title, Flash Boys.
“Why is this permitted?”
Katsuyama began wondering why this would be allowed. He built a team of trusted people to investigate this for RBC.
The team began testing theories. One was that the orders were not arriving at the same time—mind you, we are speaking in milliseconds.
They wrote a program that would ping their orders to the various exchanges at just the same time (by slowing down the order to the closest exchanges) and it worked!
They successfully tested the program with their own traders and they named it “Thor.”
Katsuyama then decided that, for the good and integrity of the markets, to go on a public service campaign which would balance the playing field. This is where he meets Ronan Ryan. Ryan was originally from Ireland. After graduating college, he ended up working in the telecom industry, although working on Wall Street had always been his passion.
Ryan became a technical expert in his field. As his expertise grew, more and more his clients were big Wall Street banks. They had little or no understanding of the technology that supported their industry and the traders had constant demands for everything to be faster. It was Ryan who came up with the idea of “proximity services”—paying to be the server closest to the exchange servers’ matching engine. This gains the user a money-making millisecond or two over the competition.
Ryan’s challenge quickly became a game of players literally vying for proximity down to a few feet of distance.
Word of Ryan’s expertise had spread. Katsuyama realized it was his technical knowledge he needed. Dangling a job on the trading floor—Ryan’s longtime dream—cinched it. Ryan was named “Head of High Frequency Trading Strategies.”
In 2010, Katsuyama and Ryan had met with hundreds of investors to explain their (the investors’) predicament and their proposed solution. When the “Flash Crash” occurred on May 6, 2010, with no real reasonable explanation Katsuyama’s phone began to ring off the hook.
In September 2010, another market event occurred. The CBSX exchange in Chicago inverted its fee system and the CBSX, of course, exploded with activity. It was then that Ryan told Katsuyama about Spread Networks.
Spread Networks is the company mentioned earlier that enabled high frequency traders to front-run their transactions back to New Jersey.
Not only high frequency trading firms had signed up. So had big Wall Street banks. With Katsuyama trying to help the investors and do the right thing, RBC ended up #1 in 2010 on the Greenwich & Associates report. RBC became the most popular broker by selling Thor—whose only purpose was to protect investors from the rest of Wall Street.
Lewis makes an easy comparison to the reckless abandon of gamblers playing with house money when discussing the HFT firms. When discussing dark pools, Katsuyama described it as this way, “If only one gambler was permitted to know the scores of last week’s NFL games, with no one else aware of his knowledge, he places bets in the casino on every game and waits for other gamblers to take the other side of the bet. There is no guarantee that anyone will do so; but if they do, he is certain to win.”
The telephone man
Now the already complex threads winds to Sergey Aleynikov, or Serge, whose story opened this review.
Aleynikov immigrated to America from Russia in 1990. He came to America with no money and no prospects. He eventually found employment programming computers for $8.75 an hour. That job led to another—this one at Rutgers University where he was able to get his masters. In 1998, he was offered a job in telecom at IDT where he designed computer systems and wrote code to route calls to the cheapest available phone lines.
Wall Street headhunters began pursuing Aleynikov and in 2007, he joined Goldman Sachs. Goldman had pursued him because they realized one of the reasons they were not making the money that the other HFTs were was due to the speed of their system.
Aleynikov compared Goldman’s computer system to a giant rubber-band ball and described his job as the guy who fixes it when one of the rubber bands pop.
Aleynikov had nothing to do with anything used by Goldman’s customers, only what their proprietary traders used. To fix the continuous problems inherent in an old system, Aleynikov and the other programmers used open-source software—software developed by collectives of programmers and made freely available on the intranet, for their daily patches.
While open source was developed to be a collaboration, Goldman refused to allow anything released back to open source, claiming once they had it, it was their property.
Aleynikov was routinely sought after by headhunters but really wasn’t looking to make a change to do the same thing elsewhere.
But one day he was offered a position where he would have the opportunity to build a trading platform from scratch—this idea interested and excited him. From his telecom days, he loved building systems from the ground up. He refused their counter-offer, since it wasn’t about the money for him, gave his notice and stayed for 6 weeks to transition the Goldman programmers so they could take over when he was gone.
In that time, he did what he always did since his first month at Goldman—he sent himself files with open source code that he was working on but had modified for Goldman that he used in the course of his job.
Nailed by the FBI
Aleynikov left Goldman and was travelling to his new job the following month. When his airplane landed, he was met at the airplane door by the FBI who identified him and took him into custody. He first thought they had him mistaken for someone else. Then he thought it may have something to do with his new employer.
The programmer was shocked to learn he was arrested for stealing Goldman computer code. To make matters worse, the agent in charge was a former trader who had been put out of business by the computers that had replaced the traders.
Aleynikov, who was not acting with malice, kept trying to explain everything to the agent. He reasoned that if the agent could only understand what was going on, he would understand it to be the trivial matter that Aleynikov considered it to be.
When the agent wrote everything down, in a form that would be interpreted as a confession, Aleynikov had to keep correcting his terminology and his understanding of the computer processes. He would cross out and re-write correct verbiage to help them.
He was missing the point.
As soon as he signed the form, he was placed in detention, denied bail, and later sentenced to eight years in federal prison. It wasn’t until 2012 that an appeals court would rule that the laws he was accused of breaking did not actually apply to his case.
The shock that shocked the Street
In a turn that shocked all of RBC, in January 2012, Katsuyama quit RBC. He had been trying to discuss the big picture market issues and the thought of establishing a new stock exchange. However, his higher ups would just listen and assume this would pass. He had asked his closest team members about leaving with him.
When Katsuyama read about Aleynikov, he realized that the big Wall Street players were using fear and intimidation tactics on their technologists. They were also keeping the technologists from understanding the finance side. If the technologists didn’t understand how their work affected the money the firms were making and the finance side didn’t understand the technology side, it was much easier to keep everyone in line.
Katsuyama and his team created Investors Exchange, IEX. The idea was to establish the IEX computer so that it matched buyers and sellers (matching engine) at a meaningful distance from where the traders connected in theory to eliminate the advantages created by speed and in effect re-create fairness.
Everything about the new exchange was aimed at making it more transparent and hopefully forcing Wall Street to follow. Nine weeks after its launch, despite specific orders from investors to do so, the banks were still not routing to IEX. The banks still wanted to trade in their own dark pools, where they made more money, and to work with the high-frequency traders to exploit the orders in their dark pools.
Technology had created efficiencies but it had also created market inefficiency that was not easy to correct. On Dec. 19, 2013, Goldman Sachs routed to IEX—the exchange had its first big day—40 million shares traded and the office went wild! Katsuyama also took it to mean that Goldman Sachs understood that something needed to change.
What is coming next?
Lewis ends his book not with a definitive statement, but an epilogue that sets up a mystery, albeit one you can solve through the internet.
It is titled “Riding The Wall Street Trail,” and involves a group of women cyclists; a trenching crew operating in Amish country; and aged microwave towers bearing new equipment. We don’t want to spoil your inquiry. Lewis will leave you with an anonymous FCC license number, and you will want to find out why.
The book doesn’t conclude with any obvious solutions—Lewis is telling a tale of the dark side of the Street and not conducting a federal inquiry culminating in recommendations.
He has provided a story to illustrate the jaded nature of the U.S. financial markets, enhanced with a glimmer of hope that some individuals are out there trying to make a change and bring fairness and transparency to a very dark pool.
[Editor’s Note: The reader should be forewarned, before buying and reading Flash Boys, that this often fascinating book is filled with profanity. Chiefly this comes in connection with quotes from Wall Streeters and others who seem incapable, at least as Lewis portrays things, of communicating without frequent uses of obscenities describing bodily functions. Like the buyers of stocks portrayed in the book, proceed at your own risk.]