To explain claims of stock market rigging in the latest scandal to rock Wall Street, one US television news network resorted to a rather crude analogy to help its financially illiterate audience understand.
Before interviewing author Michael Lewis about his new book, Flash Boys: A Wall Street Revolt , on Tuesday, Matt Lauer, host of NBC's Today show, told his audience to imagine a girl you want to ask out on a date. You send her a text message but another guy sees what you are doing and decides to ask her out too, Lauer explains. He has a smarter phone and his text message gets to the girl first, so he gets the girl.
The example is perhaps a little too simple to describe the practice of high-frequency trading. Clearly, NBC does not have the exceptional skills Lewis displayed in previous books about the financial markets, in turning complex detail into a page-turning narrative with mould-breaking heroes. High-frequency trading involves high-speed buying and selling of shares using sophisticated computer programmes that crunch data such as differences in share prices or interest rates.
"The United States stock market, the most iconic in global capitalism, is rigged," Lewis told the US news programme 60 Minutes on Sunday, a broadcast coinciding with the publication of the book that has rattled cages in the US financial markets.
He alleged the stock market is rigged against the average investor to benefit high-frequency traders, stock exchanges and Wall Street banks using high-speed, complex algorithms.
The trading firms use speed to their advantage by getting ahead of other investors, from day traders to mutual funds, so that they can see the intent of an investor to buy shares in a particular company, buy them in front of the investor and sell them back to the investor at a higher price. They might only scrape a few cent on the dollar on each share traded but, when the volumes rack up, the profits run to billions.
The advantage is won through a technological edge – by using fibre-optic cables that carry messages at two-thirds the speed of light and by locating the computers that process those messages as close as possible to 13 public exchanges and 45 private trading platforms that operate “dark pools” across the US.
“This speed advantage that the faster traders have is milliseconds, some of it fractions of milliseconds,” said Lewis.
The speeds are lightning fast when you consider that a millisecond is a thousandth of a second and that the blink of an eye takes between 100 and 400 milliseconds.
The claims, although not new, have been lent further credibility by the fact that the FBI, the New York state attorney general and the markets regulator, the Securities and Exchange Commission, said this week that they are investigating whether the high-speed traders are engaging in insider trading, an illegal activity, by selling and buying shares using information that is not public to the market.
Lewis tells his story through the eyes of Wall Street rebels, a team led by Canadian whizz kid Brad Katsuyama, Royal Bank of Canada's former head trader in New York city. While trading, Katsuyama noticed that when he sent a large order to buy shares to the market, the order would only be part-filled and that he would have to pay a higher price to complete the remainder of the order.
A key member of Katsuyama's team that cracked the high-speed trading secret was Dublin-born Ronan Ryan (39), a wannabe Wall Street trader who ended up working in telecoms after leaving college in 1996.
Hiring Ryan to join the trading team at Royal Bank of Canada in 2009, Katsuyama paired his knowledge of the trading markets with the Irishman's technological know-how. Together, they discovered that the traders closest to the market exchanges could spot orders coming from other investors and use this speed advantage to give them a technological edge and beat other investors to the trading data.
Corporate clients
Using algorithms generated by computers, the shares could be bought first at a better price slightly before other orders arrived at the exchange, so stocks would be bought lower and sold higher in a fraction of a second. The practice became better known to Ryan as "electronic front-loading", the computer equivalent of the human practice that lands traders with big fines for insider trading.
One of the heroes in Lewis's story, Ryan grew up in Dundrum, south Co Dublin, attending the nearby St Benildus College in Kilmacud. He moved to the upmarket town of Greenwich, Connecticut, a commuter feeder town north of Manhattan, in 1990 at the age of 16 when his father became the IDA's executive director in charge of overseas operations based in New York city.
After graduating from Fairfield University in 1996, a friend of his father's John Sharkey, a board member of the philanthropic group, the American Ireland Fund, gave Ryan a job working for telecoms giant MCI Communications with a view to selling more communications technology into big corporate clients including investment banks and brokerages on Wall Street. Describing his appointment to The Irish Times as a "Sharkey Special", Ryan said he only landed the job because he was Irish. "I don't publicise it but that would have been part of it," Sharkey said, explaining his recruitment policy.
Ryan first spotted the market's potential of technological speeds in trading in 2006 when he helped a hedge fund client move his computers from his offices in Kansas city to a data centre near an exchange in New Jersey. He managed to reduce the client's latency – the time it takes to send and receipt a trade – from 43 milliseconds to 3.9 milliseconds.
For the service, Ryan's employer, telecoms company Radianz, received a monthly fee of about $22,000 (€16,000).
Curious to know how much a millisecond was worth to a trader, Ryan asked the hedge fund client over dinner. The trader explained that, in the days after the change, that he made enough money to pay Ryan’s company fee for 18 months – a figure north of $360,000.
“Here I was doing regular telecoms stuff, always very interested in Wall Street and trading, and these guys were really excited that I could make things faster for them. I was really intrigued that the physics were so critical to this,” Ryan said in an interview.
From 2005 to 2009, high-frequency traders and the technology companies supplying them sought out Ryan to make market trades faster and to get them closer to exchanges, making him hundreds of thousands of dollars richer. Traders simply pay a higher fee to the exchange for a faster connection.
Describing himself as the “central repository” for trading faster and locating closer to exchanges, Ryan said: “I kind of became the navigator of the entire trade cycle from an infrastructure and technology point.”
As technology became outdated and was replaced, the speeds became even faster with traders now seeking advantages of as quick as nanoseconds, or one billionths of a second.
“If someone is technically a nanosecond closest to the exchange, they get into that exchange’s queue ahead of you. As nuts as it sounds, the latency is critical,” he said.
Market estimates put the value of high-frequency trading at between $8 billion and $50 billion, says Ryan. He has seen companies investing several billion dollars in new technology. “If they are spending that kind of money, there is obviously billions in it,” he said.
Technology has overtaken any kind of manual form of trading, says Ryan. Everything is done electronically, and traders on the floor of the New York Stock Exchange carrying electronic devices to trade stocks have no manual role in the exchange. He describes how one Wall Street guy, referring to the applause at the closing bell of the exchange, said: “We are nothing but clapping seals.”
Rather than profiting from their knowledge of the insider market tricks, Katsuyama and Ryan last October started their own trading platform called IEX that slows down trades and levels the playing field so no one trader can use tech- nological loopholes to get ahead of another. IEX has lured investment from David Einhorn, a billionaire hedge fund owner, and received the blessing of Goldman Sachs.
Predictably, in the flurry of publicity accompanying the publication of the book and the controversy over more sharp practices to emerge following the financial crisis, high-frequency traders and share exchanges have come out swinging, attacking Lewis and Katsuyama’s team.
Investor confidence
"Michael and Brad, shame on both of you for falsely accusing literally thousands of people and possibly scaring millions of investors in an effort to promote a business model," said William O'Brien, president of exchange operator BATS Global Markets. O'Brien labelled the book a "300-page commercial" for IEX.
Defenders of the high-frequency trading have said that the practice is perfectly legal and that foreseeing trends in the market is very different to cheating investors out of money.
"There's no unfair advantage to using your brain, last time I checked, in a capitalist society," Manoj Narang, chief executive of high-frequency trading company Tradeworx, told the New York Times .
Since the 60 Minutes programme, IEX has received numerous calls and emails from the likes of firefighters, teachers and pensioners, who have no faith in Wall Street and applauded Ryan and his colleagues for exposing how technologically-savvy investors are getting one over everyday traders.
“We come out and we say that we have a way to fix it all and all of a sudden we are being painted as tarnishing investor confidence – the sheer irony of that statement is remarkable,” said Ryan.
“You have a small few who have had a great time over the last decade and you call them out on it and they are like, ‘You guys are destroying the markets’ – that is the complete opposite of what we are doing.”
Ryan says his father, who retired in 2006, calls him every few days to see how many more shares have been traded through his company.
His parents live in Dalkey, Co Dublin, and he returns at Christmas every year to visit his family. His sister worked as a solicitor at Arthur Cox and Ulster Bank. His brother works in investor relations for media giant AOL in New York.
The fact that Lewis quoted Ryan describing Dublin in 1990 as “kind of like a shithole” – negatively comparing his birthplace to his new home in Greenwich – sits uncomfortably with him now. Ryan jokes that his friends call Dublin a shithole but say it’s unacceptable when an outsider like him calls it that.
Ryan remained in the US when his parents returned to Ireland in 1996. He told Lewis he didn’t think Ireland was a place anyone would ever go back to if they had the choice. Even though he recalls the Dublin of his youth as poor, he liked its charm and detested what Dublin became during the boom.
“Ironic as it seems, I just saw opulence and people over-extending themselves buying two and three properties and new BMWs,” he said.
Ryan describes his hard-working parents as role models for his work. He quotes his mother's advice in response to the Wall Street attacks on IEX and the transparency he and his colleagues are trying to introduce in the markets: "My mom used to always say to me: 'Don't let them see that they're getting at you'."
Complex computer programmes: How high-frequency trading works
This is a form of trading that involves high-speed buying and selling of shares using complex computer programmes that absorb information on market trends and use that data in less than a second – in some cases, much quicker than a blinking eye – to make profits for investors.
Front-running allows high-frequency traders to buy large blocks of shares, fractions of a second before an investor places an order, so they can sell them back to the investor at a higher price.
As an example, let’s say a company is trading at $10.01 a share and you decide to place an order to buy at this price. If the purchase price drops to $10 and a high-frequency trader knows an investor has placed a purchase order to buy at $10.01, the investor can, in a matter of milliseconds, buy the share knowing there is someone willing to pay $10.01 and sell the share to them, making a one-cent profit.
This simple profit can multiply into billions of dollars if the practice is repeated on a much greater volume of share purchases.
Some high-frequency trades are perfectly acceptable and involve traders playing price differentials between market exchanges and assets.
For example, investors can bet on the difference in the share price of the Canadian company behind the Blackberry phone, Research in Motion, between its share prices and currency rates on the Toronto and New York stock exchanges where the stock is listed.
High-frequency trading: Defending the 'perectly legal' fast feeds
Defenders of high-frequency trading have said the practice is perfectly legal and that capturing publicly available information in the market is very different from cheating investors out of money.
Manoj Narang, chief executive of high-frequency trading company Tradeworx, said they trade on public information that is easily available to anyone who wants it.
The notion that these firms can see other people’s orders because they use the fastest commercially available feeds was “preposterous”.
“That’s like saying that you can predict the future by reading the morning paper as opposed to watching the evening news,” he said.
“The feeds tell you where the market really is at, and nobody should be obliged to use slower information when faster information is freely and publicly available.”
Mr Narang said it was “a great technical challenge” to process the massive amount of data generated by the markets and to make trading decisions based on this information in real time.
“There was no way for regulators to ensure traders operated at the same speed because of the tremendous skills involved.
“But there is certainly nothing illegal or immoral about exercising one’s skills, is there?” he said.
“That’s what capitalism is about.”
