Courtesy of the author, here is the post-script from the excellent Dark Pools: High-Speed Traders, AI Bandits, and the Threat to the Global Financial System, by Scott Patterson, author of The Quants. To read the previous excerpts, see here, here and here.
“The Year of the Glitch”
On the morning of December 18, 2012, a Tuesday, U.S. Senators rubbed elbows with K Street lobbyists, stock-market honchos, and luminaries from the increasingly powerful and controversial world of high-frequency trading.
They had gathered in an oak-paneled hearing room on the fifth floor of the Dirksen Senate Office Building in heart of the nation’s capitol. The tension was high. The hearing came near the end of one of the most tumultuous years in the history of U.S. stock markets. Lawmakers in D.C. wanted answers—now.
The focus of the hearing: looming signs of even-greater instability in the nation’s stock markets and an explosion of trading in dark pools.
Signs of trouble started early that year. On March 23, computer glitches doomed BATS’s own public offering, causing the upstart exchange to scuttle its IPO altogether. Two months later, on May 18, Nasdaq oversaw a magnificently sloppy listing of the social network Facebook Inc. Technical errors delayed the launch of the stock—the most highly anticipated IPO in years—that spring morning, causing mass confusion among traders and investors trying to grab a piece of Mark Zuckerberg’s online empire.
The stock, expected to surge amid a fury of retail cash seeking to benefit from Facebook’s success, instead withered on the day of the launch, casting further gloom over the nation’s stock exchanges. The mistakes eventually caused millions in losses to Nasdaq clients.
Together with the BATS IPO flop, Nasdaq’s Facebook debacle raised stark questions about whether U.S. markets were too dysfunctional to perform their most basic function: serve as a platform for companies to raise cash, expand operations, and hire new workers. At a time of anemic economic growth and an unemployment rate hovering around eight percent, such troubling questions were drawing intense scrutiny from lawmakers at the highest levels of the nation’s government.
The spotlight intensified on August 1. For a chaotic forty-five minutes in early trading, one of the most sophisticated trading operations in the world, Knight Capital Group, lost more than $450 million when one of its high-speed computer trading systems went haywire. For a few days, Knight teetered on the edge of collapse before a group of investors, including Chicago high-speed trading giant Getco (which would eventually buy Knight for $1.4 billion), agreed to inject $400 million into the firm to keep it afloat.
The loss stunned the trading world. That a firm with the pedigree of Knight—it had been a pioneer in computer trading since the mid-1990s, when it was founded—could shred nearly half a billion dollars in little more than half an hour defied belief. The debacle was a wake-up call. If Knight could suffer such staggering losses, anyone could.
Knight, in fact, was potentially a more frightening red flag of dangers lurking in the market than the Flash Crash.
Knight was a massive broker dealer that sat at the heart of the stock market. On many days it accounted for more trading on the New York Stock Exchange and Nasdaq than any other firm in the world. It seemed a matter of mere luck that the losses weren’t higher—and that the ripple effects weren’t more severe.
What’s more, Knight’s trading debacle showed that other brokers dealers–Too Big to Fail giants such as Goldman Sachs, J.P. Morgan, or Bank of America—were also at risk. Each of these giant banks had high-speed trading operations sitting inside their walls, operations almost exactly like the one that devastated Knight.
Congress wanted to know what would happen if such a “glitch” ate a hole in the balance sheet of a Too Big to Fail bank?
The answer: yet another round of tax-payer bailouts.
There was more. BATS, Facebook, and Knight were just the three most prominent computer glitches of the year. Outsiders were realizing what the insiders had known for years: The U.S. stock market was plagued with glitches that happened on a daily basis, and not just in stocks. Markets for commodities, bonds, and currencies all had their fair share of computer-driven mishaps. Increasingly, investors were wondering not only if the market was rigged, but whether it was completely broken. Indeed, the trade publication Traders Magazine called 2012 “The Year of the Glitch.”
Congress was also growing concerned about reports that stock exchanges had been offering advantages to high-frequency traders. On September 19, The Wall Street Journal, in an article co-written by this author, reported in a page one story that the SEC was investigating ties between high-speed traders and exchanges. The investigation had been sparked by a Wall Street insider who’d worked at Goldman Sachs and UBS before launching his own trading firm: Haim Bodek.
“Mr. Bodek approached the Securities and Exchange Commission last year alleging that stock exchanges, in a race for more revenue, had worked with rapid-fire trading firms to give them an unfair edge over everyday investors,” the Journal reported. “He became convinced exchanges were providing such an edge after he says he was offered one himself when he ran a high-speed trading firm—a way to place orders that can be filled ahead of others placed earlier. The key: a kind of order called ‘Hide Not Slide.’ ”
The allegations became the focus of intense debate on Wall Street. Its implications—that exchanges had been secretly offering benefits to certain favored clients—would reverberate in the halls of Capitol Hill.
Such scrutiny was evident on that Tuesday morning in December in the Dirksen Senate Office Building.
The hearing had been called by Rhode Island Senator Jack Reed, a Democrat. Little known outside his home state, Reed, a dignified, soft-spoken man with a bulbous nose, round face, and businesslike head of trim slicked-back white hair, was one of the savviest lawmakers in Washington when it came to complex market issues.
It was the second of a series of hearings that probed the rules of the road for computer trading. At the first hearing, in September, high-speed experts such as Chris Concannon—the former Island lawyer who now sat near the top of Virtu Financial, one of the largest high-frequency players in the world—had testified.
Reed’s second hearing focused on the clash between dark pools and stock exchanges and the role high-speed trading played in that ongoing battle. Witnesses included Dan Mathisson, head of stock trading at Credit Suisse (and host of the bank’s annual trading forum at the Fontainebleau Hotel in Miami Beach); Joe Mecane, executive vice president at the NYSE; and Eric Noll, Concannon’s successor at Nasdaq as head of trading services.
Reed launched the hearing by bluntly laying out his worries. They were were plentiful.
“The Flash Crash, the BATs and Facebook IPOs, and the Knight trading debacle all bring to question the very rules that govern our market structure,” he said. “Are markets fair and transparent? Is the market too complex or too fragmented? Is there greater potential for system risk propagated as a result of the interconnection of highly computerized markets?”
Reed also hit on order types. The “proliferation of order types,” he said, “adds to complexity and raises lots of questions” about the fairness of the market.
The witness for the NYSE, Joe Mecane, told the panel that far too much trading had shifted away from exchanges to the dark. More than 3,000 stocks, he said, had more than forty percent of their trading volume taking place away from the public markets. “We’ve seen two markets evolve,” Mecane said. “The lit, public, regulated and accessible market versus the dark, selective and private nontransparent market.”
Mecane also agreed that order types added to complexity, but he said that they were designed to comply with government regulations and to “guarantee economic results” for trading clients.
Of course, that was the very criticism Bodek was making about such order types. Why should exchanges provide guaranteed economic results for any client? It seemed clear that those results were coming at the expense of other clients of the exchanges, such as mutual fund investors.
What’s more, Mecane seemed to missing one of the primary reasons why more trading was moving to the dark. Traditional investors were getting their faces ripped off on the exchanges, in part due to all the advantages the exchanges had given to their high-speed pals. In many ways, the exchanges had no one to blame but themselves. They’d made a deal with the devil. Now, they were paying the price.
Mathisson, for his part, said the root of the problem went back to the move by the exchanges in the mid-2000s to become for-profit entities. Now, their focus was entirely on the bottom line, not on maintaining a healthy venue for companies to list stocks and investors to profit from the growth of American capital.
“Within the past decade, our nation’s exchanges have transitioned to a for-profit model, after more than 200 years as not-for-profit, member-owned organizations,” Mathisson told the panel of Senators. “We believe that this new model for the markets has proven itself to be costly to investors, unfair to broker-dealers, and rife with conflicts for the exchanges themselves.”
It all seemed so obvious. The exchanges, geared to serve their shareholders, had evolved to favor a single breed of investor: the high-frequency trader. Institutional investors, sick of getting taken to the cleaner, were fleeing into the dark, to opaque pools overseen by people such as Dan Mathisson at Credit Suisse.
But would anything change? Could the process be reversed?
The SEC seemed like a deer caught in the headlights, unable to implement any changes without endless navel gazing and fears of the “unintended consequences” of rule changes, a constant refrain at the agency. And while Congress held hearing after hearing, there was little indication that lawmakers would push for meaningful reform.
There was a sliver of hope, however. A few days after Reed’s hearing, the NYSE announced a blockbuster deal: A little-known, twelve-year-old futures exchange based in Atlanta, IntercontinentalExchange Inc.—better known as ICE—had agreed to buy the storied Big Board for $8.2 billion and change.
The wildcard in the deal was the mercurial founder of ICE, a gregarious engineer called Jeff Sprecher. At ICE, Sprecher had made several moves to limit the activities of high-frequency traders on his exchange, moves he said had paid off for regular investors. Early on, he was giving signs that he wanted do the same at the NYSE. “It’s clear there’s going to be change,” he said on a conference call with analysts soon after the deal was announced. “The leadership to drive that change…is going to come from the New York Stock Exchange.”
Sprecher seemed particularly incensed by business practices that favored high-frequency traders. Specifically, he drew a bead on the lucrative trading rebates the speedsters won through the maker-taker system first set up years ago by Josh Levine at Island. As Bodek had told the SEC, the manipulative order types he’d encountered were specifically designed to put high-speed traders in front of other investors so that they could nab those rebates.
Sprecher thought it was an outrage. “The pendulum has swung too far,” he complained on an ICE conference call in January. Favoring one kind of client over others is “destructive, it is not good for shareholders and it is not good for long-term investors,” he added.
Sprecher said he planned to use his seat at the helm of the NYSE as a “pulpit” to push for fundamental changes in the U.S. stock market. (Sprecher had also read this book and asked his entire senior management to read it.)
It was difficult to tell if Sprecher had a chance. There were many entrenched players who’d suffer if he succeeded, and they’d do everything they could to stop him, including mobilizing their increasingly hefty lobbying axes in Washington. What’s more, the NYSE didn’t wield the market force it had just a decade ago when it controlled some seventy to eighty percent of trading of the biggest companies in the country. Now, it controlled a mere twenty percent of the market, a number that kept shrinking year by year.
But perhaps Sprecher, an outsider to the stock market who wasn’t beholden to the powers-that-be, would seize the opportunity. If he reformed the Big Board and pushed out the predatory traders, perhaps the trend would reverse itself—perhaps more institutions would stop pushing their trades into the dark and return to the NYSE. Other exchanges, always worried about missing out on the next trend, might follow suit.
It seemed a long shot. Then again, who would have thought a high-school dropout working out of a cluttered office on 50 Broad could lay low the most powerful forces in the stock market?
One thing was clear—the market had to change. It was spinning out of control, plagued by costly glitches, manipulative activity, and plunging investor confidence. If nothing was done to fix it, next time the devastation could be irreversible.