Courtesy of the author, here is the last excerpt 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 and here.
Haim Bodek rushed out the front door of his home, jumped in his all-black Mini Cooper, and sped to the train station in downtown Stamford, thrash metal pounding from the car’s speakers.
It was the morning of March 25, 2011, his last day on the payroll of Trading Machines. Bodek was scheduled to give a speech later that afternoon at Princeton University, at a conference called “Quant Trading: From the Flash Crash to Financial Reform.”
He was running late. He hadn’t written his speech yet, so he banged it out on his laptop on the train to Princeton.
It was hard. He wasn’t sure what to say. He’d grown so cynical about the market that he’d become convinced that massive reform was required. But he didn’t know if he should be the one to spearhead changing the rules of the game. He worried about his career, whether the new elite at the high-speed firms and exchanges who’d built the market’s digital plumbing in the past decade would attack him and make it hard if not impossible for him to build another trading operation. He had a wife and three young children to support, and he was out of a job. The role of market-reform gadfly wasn’t high on his list of priorities. But his creeping belief that the market had been hijacked kept bugging him, like a bee buzzing in his face. And it wouldn’t go away.
In his talk, Bodek went halfway in calling for major changes. He spoke about the structural issues facing the options market, the evolution of algorithmic trading, and the negative impact stock market structure changes were having on the options industry. There was no mention of toxic order types or 0+ scalping strategies. He wasn’t ready to take on the whole system—yet.
Bodek knew his complaints sounded like excuses for failure. Critics would say he couldn’t take the heat. But he was convinced there was more to it. Exchanges and high-frequency firms had been working hand in glove to design a system that gave an advantage to the speedsters. The speed traders had been working closely with the electronic pools for more than a decade, from Island to BRUT to Archipelago. They’d pushed for more speed, for more information, for new exotic order types. And the pools complied willingly.
It all added up.
In Bodek’s eyes, there was nothing implicitly wrong with what had happened—at least at first. The relationship between high-speed firms and exchanges was in ways beneficial for all investors, he thought. The Bots pushed for better execution. That made the markets better for everyone.
But a problem developed. High-frequency trading became so competitive that on a truly level playing field no one could make money operating at high volumes. Starting in 2008, there had been a frantic rush into the high-frequency gold mine at a time when nearly every other investment strategy on Wall Street was imploding. That competition was making it very hard for the firms to make a profit without using methods that Bodek viewed as seedy at best.
And so a complex system evolved to pick winners and losers. It was done through speed and exotic order types. If you didn’t know which orders to use, and when to use them, you lost nearly every time.
To Bodek, it was fundamentally unfair—it was rigged. There were too many conflicts of interest, too many shared benefits between exchanges and the traders they catered to. Only the biggest, most sophisticated, connected firms in the world could win this race.
One apparent consequence of this hypercompetitive market was its fragility. Because high-speed traders were now competing for wafer-thin profits, they’d grown incredibly pain-averse. The slightest loss was unacceptable. Better to cut and run and trade another day. The result, of course, was the Flash Crash. It was an algorithmic tragedy of the commons, in which all players, acting in their self-interest, had spawned a systemically dangerous market that could threaten the global economy.
Bodek knew he’d made mistakes. He’d wasted months trying to hunt for a bug in the code of the Machine, when the problem was actually abusive order types.
Then he’d started using the order types himself to protect his firm from the abuses. But it felt dirty. He’d become one of the bad guys. One of the tipped-off insiders. Kill or be killed. He didn’t like it, but it had become a matter of survival.
It was not how the market should work. Investors should be re- warded for their intelligence, for being able to make accurate pre- dictions and take risk—not for knowing the location of secret holes inside the plumbing (or, worse, creating the holes).
That was Bodek’s biggest complaint: The Plumbers had won.
Finally, Bodek became determined to reveal what he believed was a corrupt insiders’ game that came at the expense of everyday investors. Was it outright collusion? He didn’t have enough hard information to know for certain. But he believed the exchanges were locked in cutthroat competition, not only with one another but with the dark pools and the internalizers like Citadel and Knight. It was a dynamic that went all the way back to the late 1990s when Island, Archipelago, Instinet, and other electronic networks were engaged in a kill-or-be-killed Darwinian struggle. That struggle led to massive innovation and changes and, to be sure, benefits for nearly all investors.
But something else had changed along the way. The competition had become toxic. The exchanges’ backs were against the wall, and they’d made a deal with the devil at the expense of regular investors.
And so in the summer of 2011, he decided to explain it all to federal regulators. He hired a major law firm to help him use his understanding of toxic order types he’d gained from his exchange contacts while at Trading Machines, combined with the details of his understanding of high-frequency strategies he’d learned from the 0+ Scalping Strategy document, to lay out a road map. The road map detailed his argument that high-speed traders and exchanges had created an unfair market that was hurting nearly all investors.
Were the regulators listening?