Brad Katsuyama never thought he would be famous – not even famous-for-Wall-Street famous.
He was Canadian, for goodness sake. He had worked at Royal Bank of Canada, not Goldman Sachs or JP Morgan. He was running a start-up – and not one that made anything you could download from the App Store. So even after Michael Lewis interviewed him for Flash Boys, even after Mr Lewis flew to Toronto to talk to his parents and school friends, even after he discovered Mr Lewis had actually made him – Brad Katsuyama – the book's hero, even after the 60 Minutes camera crew showed up … even then, Mr Katsuyama says, he didn't quite grasp what was about to happen.
“I thought I could kind of blend in,” he says between spoonfuls of granola and yogurt at a lower Manhattan restaurant. “You know, Asian guy, normal haircut.”
The author’s 2014 bestseller – with its controversial premise that the US stock market is rigged – made Mr Katsuyama, 37, a celebrity. He has testified before the US Senate. He’s been invited to join a US Securities and Exchange Commission (SEC) advisory panel. In April last year, he got the better of William O’Brien, then president of Bats Global Markets, in a CNBC debate that transfixed Wall Street and became known simply as “The Argument”. He has sold his life story to Sony Pictures. He even considered employing a bodyguard. At Mr Lewis’s suggestion, he has stopped reading much of what is written about him. “The less time I spend thinking about it, the more normal I feel,” he says.
What Mr Katsuyama does spend his time thinking about is IEX, the upstart stock-trading venue he cofounded in 2012. The goal of IEX is to level the playing field between high-frequency traders and everyone else.
Speed kills
When Mr Katsuyama was a senior trader at Royal Bank of Canada, he found that he was increasingly unable to execute orders at the prices and volumes his trading screens indicated were available. He came to see high-frequency trading, public stock exchanges, and the fragmented nature of the US markets as the culprits. High-frequency traders could use their superior speed to take advantage of what’s called latency arbitrage, exploiting minuscule differences in the time it takes various markets and traders to receive data and execute orders.
Latency arbitrage forces slower investors – pretty much anyone who isn’t a high-frequency trader – to pay more. “The harm to most people is very small, but that small harm adds up to a large benefit for the few who take advantage,” says billionaire David Einhorn, manager and founder of hedge fund firm Greenlight Capital and an early investor in IEX.
Mr Katsuyama and the small group who joined him in founding IEX Group took on high-frequency trading, or HFT, with a cleverly engineered speed bump that slows down all incoming orders just enough to defeat most latency arbitrage strategies. But what IEX is really marketing is something less tangible and more fundamental – a fairer market. The Canadian says the fragmented market structure in the US is riven with conflicts of interest. With trading currently spread over 11 public stock exchanges and more than 40 dark pools – trading venues that do not publish pre-trade prices or volumes - market operators are dependent on HFT firms for liquidity and revenue. To cater to them, the exchanges sell advantages to HFT firms: myriad special-order types; faster data; price rebates; co-location – the right to put their computers in the same data centres as the exchange’s systems so they can trade even faster.
Mr Katsuyama, who was a tailback on his high school gridiron team, uses a sports analogy to explain his objections. “No one is saying the teams have to be equal, just that the referee shouldn’t have an interest in the game’s outcome,” he says. Positioning itself as the honest referee, IEX forbids co-location, charges both sides of a transaction the same fee, gives away its real-time market data feeds, and offers just five order types.
Since Flash Boys was published in March 2014, IEX has become one of the largest US dark pools. Already backed by some of Wall Street’s biggest hedge fund managers, it has attracted serious venture capital – investors include Netscape Communications founder Jim Clark and casino mogul Steve Wynn.
Many brokers say IEX has pushed US equity markets toward greater transparency and simplicity, although its critics say it has merely accelerated trends already under way. They also accuse IEX of hypocrisy – demonising HFT in its marketing while relying on fast- trading firms for liquidity.
Now, IEX faces its greatest challenge. Sometime in the first two weeks in September, the firm is expected to file an application with the SEC to become a public stock exchange. Being an exchange brings a host of benefits and increased prestige, but it also brings far greater SEC oversight. The move, which would compel brokers to send more business to IEX and also allow IEX to compete for lucrative public stock offerings, could catapult Mr Katsuyama’s start-up into the big leagues. It’s a threat that existing exchanges take seriously. Even before IEX’s first day of trading in October 2013, Intercontinental Exchange, owner of the New York Stock Exchange, offered to buy the start-up for hundreds of millions of dollars.
Still, IEX’s attempt to become an exchange could backfire. There’s no guarantee the SEC will approve its innovative design or that IEX will be able to wrest market share away from goliaths such as the NYSE, Nasdaq, and Bats. It could wind up forfeiting its position as a leading dark pool only to become a second- or third-tier exchange, possibly impairing its financial viability.
Ringing the bell
IEX’s office on the 44th floor of the new 4 World Trade Center building looks like many trading floors – open plan, exposed ductwork, glassed-in conference rooms. But the atmosphere is more Birkenstock than brogue. There’s a communal kitchen and lots of young staff in shorts and T- shirts. Anachronistically, on a pedestal in the middle of the room, sits a shiny silver bell. Each morning, one employee gets to ring open IEX’s market at 9.30am. If that day’s volume exceeds the previous day’s, the same person gets to ring the bell the next morning.
The longest run anyone has had so far is four days. Even so, since its launch, IEX has steadily gained market share. On the June day I visited, cheers erupted shortly after 11am as IEX hit a new milestone – trading more than 1.5 per cent of all US equity volume. A few weeks later, on August 4, it hit another record – 1.86 per cent of US volume. That may sound like nothing. But in today’s fragmented market, 1.86 per cent is something. The NYSE and Nasdaq, which run three public exchanges apiece, and Bats, which owns four, each control about 20 per cent of US equity volume most days. IEX, with from 1.1 to 1.9 per cent of total volume, consistently ranks third or fourth among dark pools, trailing those operated by Credit Suisse Group and UBS and sometimes Deutsche Bank’s. More than 160 brokers now connect to IEX, up from just 35 at the outset.
Matt Waldner, head of US equity trading at Columbia Threadneedle Investments, a global money manager that sends a portion of its trades to IEX, says the new market’s initial success with big brokerages such as Goldman Sachs and JPMorgan Chase has had a snowball effect. He says: “I think the traction they (IEX) have gained has propelled them past critical mass and forced people to begin routing orders there.”
Traditionally, dark pools were black boxes. Investors had no idea how orders were processed. IEX, in part because it always intended to become an exchange, has pushed for greater transparency. It was the first dark pool to publish its Form ATS, an SEC filing that details how it prioritises, prices, and matches orders. About a third of all dark pools have followed suit.
While Mr Lewis cast IEX as the hero of a story in which HFT was the villain, a few high-speed firms are among IEX’s best customers. Brokers trading their own principal – they include both HFT firms and the big banks’ proprietary trading desks – account for 23 per cent of IEX’s trades.
Mr Katsuyama says that IEX was never anti-HFT. Rather than labelling some HFT outfits “good” and others “bad”, he prefers to talk about HFT strategies that are “predatory” versus those that provide “legitimate market making”.
IEX has repeatedly praised one HFT firm in particular – Virtu Financial. Mr Katsuyama says Virtu engages in legitimate market making – taking the spread by buying at the offer and selling at the bid – and not predatory arbitrage. Doug Cifu, Virtu’s chief executive, says his firm has supported IEX from the start precisely because it is a market maker. He says Virtu likes IEX’s speed bump. “No one has more quotes in the market than a Virtu Financial, so if anyone is in danger of getting picked off, it’s us,” says Mr Cifu, who is co-owner of ice hockey’s Florida Panthers.
The next step
The big question for IEX is whether its vaunted magic shoebox will survive. Regulation National Market System, the 2005 SEC rule that created the current US market structure, says quotations must be “immediately accessible” and defines immediate as “precluding any coding of automated systems or other type of intentional device” that would delay them. When Nasdaq was starting PSX in 2010, the smallest of its three exchanges, it avoided incorporating a speed bump after the SEC indicated it would likely object.
Mr Katsuyama believes IEX’s speed bump will pass muster, largely because it’s designed to create a fairer market. More and more, the SEC has questioned whether fast trading hurts average investors. In a speech last year, SEC chairman Mary Jo White wondered whether current SEC rules should be revised so they don’t impede “initiatives that seek to de- emphasise speed”.
Even if IEX becomes an exchange, its pricing may hobble its prospects. Simply put, IEX is expensive. It charges each side of a completed trade 9 mils (9 cents per 100 shares). On competing exchanges, brokers can pay as little as 2 mils after rebates. Those exchanges also have tiered pricing – the more volume a broker sends, the less it pays per share.
That makes it harder for an upstart such as IEX to steal business, because brokerages are loath to lose this discount. Don Bollerman, IEX’s head of markets and sales, says the price difference between IEX and its competitors is not as great as it seems when one considers that IEX does not charge for data or co-location. He also says that as IEX grows, it should be able to lower prices.
Over breakfast, the silhouette of the new Freedom Tower visible through the window behind him, Mr Katsuyama reflects on his decision to leave banking. He says he was increasingly troubled by the way money on Wall Street bred corruption, encouraging people to make poor ethical decisions. Planning to start a family, he and his wife had considered leaving Wall Street behind. But first, Katsuyama wanted to try creating IEX. “If this is my last stop on Wall Street, I am OK with it,” he says.
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