Flash Boys: A Wall Street Revolt

by Michael Lewis

Over the past decade, the financial markets have changed too rapidly for our mental picture of them to remain true to life. The picture I’ll bet most people have of the markets is still a picture a human being might have taken. In it, a ticker tape runs across the bottom of some cable TV screen, and alpha males in color-coded jackets stand in trading pits, hollering at each other. That picture is dated; the world it depicts is dead. Since about 2007, there have been no thick-necked guys in color-coded jackets standing in trading pits; or, if they are, they’re pointless. There are still some human beings working on the floor of the New York Stock Exchange and the various Chicago exchanges, but they no longer preside over any financial market or have a privileged view inside those markets. The U.S. stock market now trades inside black boxes, in heavily guarded buildings in New Jersey and Chicago. What goes on inside those black boxes is hard to say—the ticker tape that runs across the bottom of cable TV screens captures only the tiniest fraction of what occurs in the stock markets. The public reports of what happens inside the black boxes are fuzzy and unreliable—even an expert cannot say what exactly happens inside them, or when it happens, or why. The average investor has no hope of knowing, of course, even the little he needs to know. He logs onto his TD Ameritrade or E*Trade or Schwab account, enters a ticker symbol of some stock, and clicks an icon that says “Buy”: Then...

Like every other trader on the Chicago exchanges, he saw how much money could be made trading futures contracts in Chicago against the present prices of the individual stocks trading in New York and New Jersey. Every day there were thousands of moments when the prices were out of whack—when, for instance you could sell the futures contract for more than the price of the stocks that comprised it. To capture the profits, you had to be fast to both markets at once. What was meant by “fast” was changing rapidly. In the old days—before, say, 2007—the speed with which a trader could execute had human limits. Human beings worked on the floors of the exchanges, and if you wanted to buy or sell anything you had to pass through them. The exchanges, by 2007, were simply stacks of computers in data centers. The speed with which trades occurred on them was no longer constrained by people. The only constraint was how fast an electronic signal could travel between Chicago and New York—or, more precisely, between the data center in Chicago that housed the Chicago Mercantile Exchange and a data center beside the Nasdaq’s stock exchange in Carteret, New Jersey.

His other problem was Spivey, who was all over him about the slightest detours. For instance, every so often the right-of-way crossed over from one side of the road to the other, and the line needed to cross the road within its boundaries. These constant road crossings irritated Spivey—Williams was making sharp right and left turns. “Steve, you’re costing me a hundred nanoseconds,” he’d say. (A nanosecond is one billionth of one second.) And: “Can you at least cross it diagonally?” Spivey was a worrier. He thought that when a person took risks, the thing that went wrong was usually a thing the person hadn’t thought about, and so he tried to think about the things he wouldn’t naturally think about. The Chicago Mercantile Exchange might close and move to New Jersey. The Calumet River might prove impassable. Some company with deep pockets—a big Wall Street bank, a telecom carrier—might discover what he was doing and do it themselves. That last fear—that someone else was already out there, digging his own straight tunnel—consumed him. Every construction person he talked to thought he was out of his mind, and yet he was sure the Alleghenies were crawling with people who shared his obsession. “When something becomes obvious to you,” he said, “you immediately think surely someone else is doing this.”

Once their disbelief faded, most of the Wall Street guys were just in awe. Of course they all still asked the usual questions. What do I get for my $14 million in assorted fees and expenses? (Two glass fibers, one for each direction.) What happens if the line’s cut by a backhoe? (We have people on the line who will have it up and running in eight hours.) Where is the backup if your line goes down? (Sorry, there isn’t one.) When can you supply us with the five years of audited financial statements that we require before we do business with any firm? (Um, in five years.) But even as they asked their questions and ticked their boxes, they failed to disguise their wonder. Spivey’s favorite meeting was with a trader who sat stone-faced listening to him for fifteen minutes on the other side of a long conference table, then leapt to his feet and shouted, “SHIT, THIS IS COOL!”

For $300,000 a month plus a few million more in up-front expenses, the people on Wall Street then making perhaps more money than people have ever made on Wall Street would enjoy the right to continue doing what they were already doing. “At that point they’d get kind of pissed off,” says Carley. After one sales meeting, David Barksdale turned to Spivey and said, Those people hate us. Oddly enough, Spivey loved these hostile encounters. “It was good to have twelve guys on the other side of the table, and they are all mad at you,” he said. “A dozen people told us only four guys would buy it, and they all bought it.” (Hudson River Trading bought the line.)

Citigroup, weirdly, insisted that Spread reroute the line from the building next to the Nasdaq in Carteret to their offices in lower Manhattan, the twists and turns of which added several milliseconds and defeated the line’s entire purpose. The other banks all grasped the point of the line but were given pause by the contract Spread required them to sign. This contract prohibited anyone who leased the line from allowing others to use it. Any big bank that leased a place on the line could use it for its own proprietary trading but was forbidden from sharing it with its brokerage customers. To Spread this seemed an obvious restriction: The line was more valuable the fewer people that had access to it. The whole point of the line was to create inside the public markets a private space, accessible only to those willing to pay the tens of millions of dollars in entry fees. “Credit Suisse was outraged,” says a Spread employee who negotiated with the big Wall Street banks. “They said, ‘You’re enabling people to screw their customers.’ ”

At the last minute they overcame some objections from Pennsylvania bridge authorities and were permitted to cross the river on the bridge—by boring holes through its concrete pylons and running the cable on the underside of the bridge.

When he began to grasp, along with the rest of the world, what big American firms had done—rigged credit ratings to make bad loans seem like good loans, created subprime bonds designed to fail, sold them to their customers and then bet against them, and so on—his mind hit some kind of wall. For the first time in his career, he felt that he could only win if someone else lost, or, more likely, that someone else could only win if he lost. He was not by nature a zero-sum person, but he had somehow wound up in the middle of a zero-sum business. His body had always tended to register stress before his mind. It was as if his mind refused to accept the possibility of conflict even as his body was engaged in that conflict. Now he bounced from one illness to another. His sinuses became infected and required surgery. His blood pressure, chronically high, skyrocketed. His doctors had him seeing a kidney specialist. By early 2009 he’d decided to quit Wall Street.

Allen, Brad noticed, had no interest in conforming to the norms of corporate life. He preferred to work on his own, in the middle of the night, and refused to ever take off his baseball cap, which he wore pulled down low over his eyes, giving him the appearance of a getaway driver badly in need of sleep. Allen was also incomprehensible: What was just possibly English came tumbling out of him so quickly and indistinctly that his words tended to freeze the listener in his tracks. As Brad put it, “Whenever Allen said anything, I’d turn to Rob and say, ‘What the fuck did he just say?’ ”

That question implied an understanding: Someone out there was using the fact that stock market orders arrived at different times at different exchanges to front-run orders from one market to another.

Brad explained to Mike Gitlin how his team had placed big trades to measure how much more cheaply they bought stock when they removed the ability of the machine to front-run them. For instance, they bought 10 million shares of Citigroup, then trading at roughly $4 per share, and saved $29,000—or less than a tenth of 1 percent of the total price. “That was the invisible tax,” said Rob Park. It sounded small until you realized that the average daily volume in the U.S. stock market was $225 billion. The same tax rate applied to that sum came to more than $160 million a day. “It was so insidious because you couldn’t see it,” said Brad. “It happens on such a granular level that even if you tried to line it up and figure it out you wouldn’t be able to do it. People are getting screwed because they can’t imagine a microsecond.”

Brad had no idea how dark and difficult the picture he’d create would become. All he knew for sure was that the stock market was no longer a market. It was a collection of small markets scattered across New Jersey and lower Manhattan. When bids and offers for shares sent to these places arrived at precisely the same moment, the markets acted as markets should. If they arrived even a millisecond apart, the market vanished, and all bets were off. Brad knew that he was being front-run—that some other trader was, in effect, noticing his demand for stock on one exchange and buying it on others in anticipation of selling it to him at a higher price. He’d identified a suspect: high-frequency traders.

“I needed someone from the industry to verify that what I was saying was real,” said Brad. He needed, specifically, someone from deep inside the world of high-frequency trading. He’d spent the better part of a year cold-calling strangers in search of an HFT strategist willing to defect. He now suspected that every human being who knew how high-frequency traders made money was making too much money doing it to stop and explain what was going on. He needed to find another way in.

Part of Ronan’s problem was that he didn’t look like a Wall Street trader. He had pale skin and narrow, stooped shoulders, and the uneasy caution of a man who has survived one potato famine and is expecting another. He also lacked the Wall Street trader’s ability to bury his self-doubt, and to seem more important and knowledgeable than he actually was. He was wiry and wary, like a mongoose. And yet from the moment he caught his first glimpse of a Wall Street trading floor, in his early twenties, Ronan Ryan badly wanted to work on Wall Street—and couldn’t understand why he didn’t belong. “It’s hard not to get enamored of being one of these Wall Street guys who people are scared of and make all this money,” he said. But it was hard to imagine anyone being scared of Ronan.

The single biggest determinant of speed was the length of the fiber, or the distance the signal needed to travel to get from Point A to Point B. Ronan didn’t know what a millisecond was, but he understood the problem with this Kansas City hedge fund: It was in Kansas City. Light in a vacuum traveled at 186,000 miles per second, or, put another way, 186 miles a millisecond. Light inside of fiber bounced off the walls and so traveled at only about two-thirds of its theoretical speed. But it was still fast. The biggest enemy of the speed of a signal was the distance the signal needed to travel. “Physics is physics—this is what the traders didn’t understand,” said Ronan. The whole reason Bountiful Trust had set up shop in Kansas City was that its founders believed that it no longer mattered where they were physically located. That Wall Street was no longer a place. They were wrong. Wall Street was, once again, a place. It wasn’t actually on Wall Street now. It was in New Jersey. Ronan moved the computers from Kansas City to Radianz’s data center in Nutley and reduced the time it took them to find out what they had bought and sold from 43 milliseconds to 3.8 milliseconds.

One group of guys Ronan saw over and over: four Russian, one Chinese. The arrogant Russian guy who was clearly their leader was named Vladimir. Vladimir and his boys ping-ponged from prop shop to big bank and back to prop shop, writing the computer code that made the actual stock market trading decisions. Ronan watched them meet with one of the most senior guys at a big Wall Street bank that hoped to employ them—and the Wall Street big shot sucked up to them. “He walks into the meeting and says, ‘I’m always the most important man in the room, but in this case Vladimir is.’ ”

The U.S. stock market was now a class system, rooted in speed, of haves and have-nots. The haves paid for nanoseconds; the have-nots had no idea that a nanosecond had value. The haves enjoyed a perfect view of the market; the have-nots never saw the market at all. What had once been the world’s most public, most democratic, financial market had become, in spirit, something more like a private viewing of a stolen work of art.

Once you had figured out which broker was behind any given stock market order, you could discern patterns in each broker’s behavior. If you knew which broker had just come into the market with an order to buy 1,000 shares of IBM, you might further guess whether those 1,000 shares were the entire order or a part of a much larger order. You might also guess how the broker might distribute the order among the various exchanges and how much above the current market price for IBM shares the broker might be willing to pay. The HFT guys didn’t need perfect information to make riskless profits; they only needed to skew the odds systematically in their favor. But, as Brad put it, “What you’re looking for ultimately is large brokers who are behaving idiotically with their customers’ orders. That’s the real gold mine.”

The customer (you, or someone investing on your behalf) is typically entirely oblivious to the inner workings of both algorithms and routers: Even if he demanded to know how his order was routed, and his broker told him, he would never be sure what was said was true, as he has no sufficiently detailed record of where orders were routed or when they traded. The brokers’ routers, like bad poker players, all had a conspicuous tell. The tell might be a glitch in their machines rather than a twitch of their facial muscles, but it was just as valuable to the HFT guys on the other side of the table.

After Brad and Ronan had left his office, the president of this big hedge fund, who had never before thought of himself as prey, reconsidered the financial markets. He sat at his desk watching both his personal online brokerage account and his $1,800-a-month Bloomberg terminal. In his private brokerage account he set out to buy an exchange-traded fund (ETF) comprised of Chinese construction companies. Over several hours he watched the price of the fund on his Bloomberg terminal. It was midnight in China, nothing was happening, and the ETF’s price didn’t budge. He then clicked the Buy button on his online brokerage account screen, and the price on the Bloomberg screen jumped. Most people who used online brokerage accounts didn’t have Bloomberg terminals that enabled them to monitor the market in something close to real time. Most investors never would know what happened in the market after they pressed the Buy button. “I hadn’t even hit Execute,” says the hedge fund president. “I hadn’t done anything but put in a ticker symbol and a quantity to buy. And the market popped.” Then, after he had bought his ETF at a higher price than originally listed, the hedge fund president received a confirmation saying that the trade had been executed by Citadel Derivatives. Citadel was one of the biggest high-frequency trading firms. “And I wondered, Why is my online broker sending my trades to Citadel?”

The unit of trading was now the microsecond, but the exchanges might report their activity in increments as big as a second. There were one million microseconds in a second. It was as if, back in the 1920s, the only stock market data available was a crude aggregation of all trades made during the decade. You could see that at some point in that era there had been a stock market crash. You could see nothing about the events on and around October 29, 1929.

Then came the financial crisis, and, in 2008, the acquisition, by Bank of America, of a collapsing Merrill Lynch. What happened next upended Schwall’s worldview. Merrill Lynch had been among the most prolific creators of the very worst subprime mortgage bonds. Had they been left to the mercy of the market—had Bank of America not saved them—the Merrill Lynch people would have been tossed out on the street. Instead, right before their acquisition, they awarded themselves massive bonuses that Bank of America wound up having to pay. “It was incredibly unfair,” said Schwall. “It was incredibly unjust. My stock in this company I helped to build for nine years goes into the shitter, and these assholes pay themselves record bonuses. It was a fucking crime.” Even more incredibly, the Merrill Lynch people ended up in charge of Bank of America’s equity division and set about firing most of the people in it. A lot of those people had been good, loyal employees of the bank.

A product manager, to be any good, had to be obsessive. The role had been spawned by the widespread belief that traders didn’t know how to talk to computer geeks and that computer geeks did not respond rationally to big, hairy traders hollering at them. A product manager stood between the two groups, to sort out which of the things the traders wanted that were the most important and how best to build them. For instance, an RBC stock market trader might demand a button on his screen that said “Thor,” which he could hit when he wanted Thor to execute his order to buy stock. To design that button might require twenty pages of mind-numbingly detailed specifications. That’s where Schwall came in. “He goes into details that no one else will go into, because for some reason that’s what he likes to do,” said Brad.

Before Brad explained to him how Thor worked and why, Schwall hadn’t thought twice about the U.S. stock markets. After he met Brad, he was certain that the market at the heart of capitalism was rigged. “As soon as you realize this,” he said, “as soon as you realize that you are not able to execute your orders because someone else is able to identify what you are trying to do and race ahead of you to the other exchanges, it’s over,” he said. “It changes your mind.” He stewed on the situation; the longer he stewed, the angrier he became. “It really just pissed me off,” he said. “That people set out this way to make money from everyone else’s retirement account. I knew who was being screwed, people like my mom and pop, and I became hell-bent on figuring out who was doing the screwing.”

How was it legal for a handful of insiders to operate at faster speeds than the rest of the market and, in effect, steal from investors? He soon had his answer: Regulation National Market System. Passed by the SEC in 2005 but not implemented until 2007, Reg NMS, as it became known, required brokers to find the best market prices for the investors they represented. The regulation had been inspired by charges of front-running made in 2004 against two dozen specialists on the floor of the old New York Stock Exchange—a charge the specialists settled by paying a $241 million fine. Up till then the various brokers who handled investors’ stock market orders had been held to the loose standard of “best execution.” What that meant in practice was subject to interpretation. If you wanted to buy 10,000 shares of Microsoft at $30 a share, and the broker went into the market and saw that there were only 100 shares offered at $30, he might choose not to buy those hundred shares and wait until more sellers turned up. He had the discretion not to spook the market, and to play your hand on your behalf as smartly as he could. After the brokers abused the trust implicit in that discretion once too often, the government took the discretion away. Reg NMS replaced the loose notion of best execution with the tight legal one of “best price.”

Like a lot of regulations, Reg NMS was well-meaning and sensible. If everyone on Wall Street abided by the rule’s spirit, the rule would have established a new fairness in the U.S. stock market. The rule, however, contained a loophole: It failed to specify the speed of the SIP. To gather and organize the stock prices from all the exchanges took milliseconds. It took milliseconds more to disseminate those calculations. The technology used to perform these calculations was old and slow, and the exchanges apparently had little interest in improving it. There was no rule against high-frequency traders setting up computers inside the exchanges and building their own, much faster, better cared for version of the SIP.

In a paper published in February 2013, a team of researchers at the University of California, Berkeley, showed that the SIP price of Apple stock and the price seen by traders with faster channels of market information differed 55,000 times in a single day. That meant that there were 55,000 times a day a high-frequency trader could exploit the SIP-generated ignorance of the wider market. Fifty-five thousand times a day, he might buy Apple shares at an outdated price, then turn around and sell them at the new, higher price, exploiting the ignorance of the slower-footed investor on either end of his trades.

During the 1987 crash, Wall Street brokers, to avoid having to buy stock, had stopped answering their phones, and small investors were unable to enter their orders into the market. In response, the government regulators had mandated the creation of an electronic Small Order Execution System so that the little guy’s order could be sent into the market with the press of a key on a computer keyboard, without a stockbroker first taking it from him on the phone.