Welcome to our new series — How did you get that job? — where we’ll run interviews with interesting people about their work and how they came to be doing it.
When Brad Katsuyama came to the US in 2002 to run the trading desk for the Royal Bank of Canada, he thought he understood the game. If he wanted to purchase a block of shares for a client, he could find an amount at a certain price and buy it. But around 2007 something began to change. Increasingly he could no longer get what he saw offered on his screen. A purchase order would get him only a fraction of the shares he wanted, and when he went to buy the rest, the price had suddenly gone up.
As Katsuyama dug into this issue, he found a deep, dark world of high-frequency trading that he came to believe was distorting the stock markets and preying on both ordinary investors and even his clients, the big banks and hedge funds. As he set out to understand what the modern markets had become, and try to find an alternative, he became the subject of a book by Michael Lewis, Flash Boys, that roiled the entire financial industry.
Today Katsuyama is the co-founder and CEO of IEX, a new trading platform that hopes will become the first stock exchange that outlaws what it sees as abusive practices engineered by firms using automated algorithms to trade in massive volumes at incredible speeds. On Monday IEX crossed a big milestone, handling over 200 million shares in a single day of trading. We sat down with Katsuyama in his office just beside the Freedom Tower in lower Manhattan.
How did you get your start in this industry?
I started as a clerk at Royal Bank of Canada in Toronto. I was taking paper files and turning them into digital files. Press a button and scroll through, it was like a giant elevator of documents, pull out a stack and stick it on my desk and punch it in by hand. I ended up on the trading desk in Canada and moved to the US in 2002. And eventually I became the head of trading in the US.
When did you realize there was something fishy happening in the markets?
In 2006, if I saw 100,000 shares of AMD offered, and I wanted it, I could go out and buy it. It was a simple as that. In 2007, if I tried to buy 100,000 shares, I would get 80,000. Then in 2008 I would get 60,000. The market is showing me a volume at a price that I can no longer buy or sell at. I can’t buy or sell what I see on my screen.
Traders still have this problem today. People say it has gone away; it hasn’t.
What was creating this problem?
If I saw 100,000 shares offered, for instance at $2.91, this 100,000 wasn’t just at one exchange. AMD lists on the NSYE, but it can trade at any one time, on as many as 11 exchanges. Let’s pretend there are four major exchanges with 25,000 each and I want to buy 100,000. My order goes to a smart router that would look out and say DirectEdge, BATS, NYSE, and NASDAQ each have 25,000 shares; it would take my orders, line them up, and blast them out.
RBC’s data center was at One Liberty Plaza. All the exchanges are located in New Jersey. You pull up CNBC, and it shows you the floor of the NYSE in Manhattan. You see all these guys running around in jackets. But no trading actually happens there. All the trading happens in a data center in New Jersey. Those guys are actually farther away from the point of sale than they have ever been! It’s a TV set.
So my order travels across the fiber to New Jersey. First it gets to BATS, then DirectEdge, then NASDAQ, the NYSE. The difference between getting to BATS and to NYSE was 2 milliseconds. It takes 300 milliseconds to blink your eye, so I thought, 2 miliseconds, that’s pretty fast. Well one of the guys I hired was Ronan Ryan who was building infrastructure for HFT [high-frequency trading] clients. He said, I can get there in 476 microseconds, which was four times faster than me.
They could see my order at BATS, race me to the next exchange, and cancel all their sell orders and buy whatever is left, buy everything up, then turn around and try and sell stock back to me at a higher price. So that was the game.
How were they doing that?
The exchanges sell fast data for higher prices. You can buy space in their data center so your servers are closer. Once you’re closer, you can buy different kinds of cable, and based on what you pay, your access to the exchange will be 2 microseconds faster than the other guy, who is 2 microseconds faster than the next. We sometimes call it a two-tiered playing field, it’s really like a hundred-tiered playing field if you add up all the different things exchanges are willing to sell you. What that leads to is, people can buy advantages in a market that the general population at least hopes is fair.
Is what they are doing illegal?
I feel like there are a lot of parallels between net neutrality, what it’s trying to accomplish, and what’s happening in the equity markets. In the sense that, you have an exchange, they are for-profit companies, NYSE and NASDAQ, yet they also serve as a form of public utility.
People view them as a utility. They say if I want to buy or sell shares, here are two places I can do that, and there is an expectation that all participants will be treated consistently and fairly. But that’s not the case. That’s not the case in the market today.
How much is it costing the people getting gamed?
I get asked this a lot. I get half of what I order, and it goes a penny higher; if I try to buy that the next round, I will get less than half; and if I try to buy it a third time, less than the second time, because I am reinforcing the signal that there is a big buyer in the market. I end up paying, on average $2.94 cents a share or 50,000. That $3,000 and change is a cost to my client, who had to buy stock at a higher price, and it’s a profit to somebody else.
It’s happening in pennies. It’s like Office Space. It’s the rounding error of bank accounts, but then you open it up and you’re like damn that’s a lot of money. People are scalping pennies, but it’s adding up to billions.
So you set out to try and solve this?
At a time when everyone was getting faster, we decided to get slower. We extended the delta in arrival. [He slowed some orders to arrive at NYSE first and trick the system that had been racing him.] Our fill rates went to 100 percent. We solved the problem. We have a product.
RBC’s revenues took off, then started to flatten out. Clients can only trade with one bank so much. They want to deal with multiple partners. At the end of the day, RBC was only getting about 3 percent of client orders.
We were solving just a fraction of the problem. What about the other 97 percent of the trades happening out there? How do you solve it at the biggest possible scale? Become an exchange. Let’s be an exchange that doesn’t sell advantages. Let’s use technology to build a marketplace that is fair to everyone. That is what we’re doing with IEX.
So there is no high-frequency trading on your exchange?
HFT is a very broad, nebulous term. The way we look at it, HFT is when you have no customers and trade in a very fast and automated way. There are two camps of HFT, at least from how I see it. Anchoring one camp are market makers, people that are sitting on the bid or offer, trying to find ways to make money on the spread. And then there is what we call predatory HFT, where people are trying to spot your trades and get ahead of them.
There is nothing inherently wrong, I don’t think, with selling fast data. Because you can never ensure that everyone gets data at the same time. Someone across the street from IEX will get our data before someone in London. The issue I have is when people can act on it first and trade against people who don’t have it. Selling colocation and fast cabling means you can do that.
A billion dollars a year are earned doing that. We pushed everyone 43.5 miles away from our market. Our matching engine sits here. People have to connect in a different building, and we have coiled 38 miles of cable in a box that creates this physical distance. So people can get info faster, but when they place a trade on IEX, it has to travel through this coil, and by the time the order arrives, the info has no value, and we will have adjusted updated the price, so no one buys an edge over others. It’s truly a level playing field.
The HFT market makers love what we did. The other HFT guys got pissed. They went batshit. They all say they are market makers providing liquidity. Well how come some people, who actually do provide liquidity, are ok with this?
In the broader market, HFT is about 50 percent of the volume. On IEX it’s about 20 percent, which is good because we are pro-technology. It was never about, oh people who use computers to trade rapidly are bad. It was about saying we won’t sell an advantage by letting people buy special access. The exchanges have found it very lucrative to enable that.
What are the challenges of trying to build a new exchange?
One of the reasons there isn’t a huge amount of disruption on Wall Street is that it’s so heavily regulated. It took us 18 months from the time we started the company to the day we traded our first share. Going through FINRA, the SEC, and building exchange technology from scratch.
We started with our own money and ran out of that very quickly. Then we did a friends and family round. That went quickly, too. The problem was a lot of banks wanted to give us money, but if you do that, all the banks that aren’t investors won’t want to trade with you. In order to create a proper utility, you can’t have any alliances.
It took us nine months to raise $9.5 million, which was not enough to be an exchange, but enough to be an alternate trading system, what’s called a dark pool. That’s what we are now. We’re in the process of converting out of that.
So you’re not an exchange?
There are 40 alternative trading systems, and we are now the fourth largest. We are larger than the dark pools run by Goldman Sachs, or JP Morgan, or Citi, because those banks are also clients. The big banks, on behalf of their clients, see the value of what we’re doing.
We are not an exchange yet, but we’re working toward that.
Did people think you were crazy?
When we went out to raise money people gave us a one in a million shot of surviving. That is hard feedback to take when you just quit a high paying job. But I think the timing was right. Society is starting to hold Wall Street accountable because so much of how it makes its money is not transparent.
If I wanted to get into the business today, what should I study?
It has to be a combination of both business and technology.
During our last round as I went to venture and private equity folks, they would always ask me, ‘Brad how much of this company do you own?’ The answer is not a lot. To a person, they were all shocked. But the reason is that one person can’t own a stock exchange. There are so many different roles across such a wide range of expertise. It took everyone. To get the best people I had to give them a piece of the company.
If you can understand both trading and technology, you are a very valuable person on Wall Street.