En español l He doesn't look like a revolutionary. Yet in a small office overlooking Ground Zero, ex-trader Brad Katsuyama, a 36-year-old Canadian, is changing the system of trading — one that has rigged the stock market.
That was the provocative conclusion that Katsuyama, then an employee of the Royal Bank of Canada (RBC) in New York, came to in 2008 after observing how high-frequency trading [HFT] — a term for the computerized buying and selling of financial products in a matter of microseconds — affects prices. His findings became the focus of Flash Boys: A Wall Street Revolt, by best-selling author Michael Lewis.
Katsuyama himself has testified about the practice before a Senate subcommittee. In 2012, in an effort to address the abuse, he left the Royal Bank of Canada to found his own alternative trading system, IEX. Here's an edited excerpt of a recent interview with him.
Q: How can high-frequency trading deprive investors of a fair price?
A: When you place an order, buy or sell, it travels over high-speed cable to maybe a dozen different markets, arriving at different times. Even though the times that your order arrives may differ by milliseconds, even microseconds, this allows high-frequency traders to determine your intention to buy or sell and to "front-run" you — to get in ahead of you, once they know what you're doing, buy the shares you want and then sell them to you at a higher price. That's how the game is played. The market is designed in such a way that certain people are at a disadvantage.
The best analogy: Your family wants to go to a concert, and there are four tickets next to each other for $20 each. You put in an order for four tickets at $20 each, and you're told that you've only bought two seats and the other two seats that you didn't buy are now being sold for $25 each.
Q: How much money does this actually cost investors?
A: It's billions of dollars a year in trading. But the better number are the billions of dollars being spent annually on these strategies and the high-speed technology that have nothing fundamentally to do with buying and selling stock, with raising capital. For example, the market isn't meant to support payment for microwave towers used by high-frequency trading. HFT has created a multibillion-dollar cottage industry.
Q: But does this actually affect individual investors who hold on to their stock for the long term?
A: Most private investors are participants in the stock market through pooled assets — mutual funds, pension funds — and those are being traded. HFT affects them in three ways. First, they're missing money they don't know they're entitled to because it's happening on a granular basis.
Second, the overall stability of the market is being damaged. The market is increasingly complicated, moving at unfathomable speeds, and we have seen a pretty consistent occurrence of breakdowns — and that has a big psychological impact on investors. When we had the "flash crash" in 2010 where the price of some stocks briefly fell to zero, high-frequency trading played a big role in that event.
Third, what affects me the most is the principle of what the market stands for. Just because nobody notices that money is being siphoned away from the investing public doesn't mean that the behavior should be condoned.
Q: What are you doing to change the system?
A: When I was at RBC, we did something counterintuitive — we built a system that slowed down the trades. When we sent out our orders to various exchanges, our goal was to arrive everywhere as close as possible to simultaneously. So we could buy what we wanted to buy or sell what we wanted to sell without giving HFT time to react.
This solution worked incredibly well, but we realized that we couldn't solve the larger problem while at RBC. Our system didn't solve our clients' overall trading problem because they traded with many brokers. The most profitable thing to do would have been to start our own high-frequency-trading firm. The second most profitable would have been to stay at RBC. But the best way to solve the problem was to be the stock market rather than work around the edges.
IEX was a long shot initially. It took us nine months to raise funding. Some banks refused to connect with us. We've been growing, but there are still many obstacles. Some brokers who are our clients also run their own alternative trading systems, so their incentives to use IEX aren't that high. But in terms of volume, our participants traded 500,000 shares our first day, we were averaging about 30 million per day in March, and we recently had a record day of 133 million shares. The market is growing quickly.
Q: So brokers have a choice. But what about people who just own a few mutual funds? What can they do to avoid a "rigged" market?
A: Society has changed so dramatically that it's empowered the individual, and technology has a lot to do with that. Years ago, if you had a bad experience at a restaurant, you could complain to the manager. Maybe you could picket. Now, you go online and write a review that may go viral. People are empowered to stand up for themselves, what they believe in. The smallest person can have a big impact.
Sandra Salmans is a freelance writer and editor who frequently covers financial and business topics.
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