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Brad Katsuyama Hailed As Hero Battling Wall Street's High-Tech Scalpers

Brad Katsuyama, founder of Investors Exchange (IEX), emerges as the latest Wall Street hero in Flash Boys, the new book on high-speed trading by best-selling financial writer Michael Lewis.

Katsuyama’s first exposure to predatory high-speed trading — or “scalping” — came in 2002 when he was sent by the Royal Bank of Canada (RBC) to open a New York trading office. He noticed that the instant he pressed the enter key to finalize the purchase of a block of shares of stock, the shares offered would disappear only to be replaced a moment later by shares offered at a slightly higher price.

After some painstaking and groundbreaking digital sleuthing Katsuyama identified the cause of this maddening phenomenon: secretive trading platforms using powerful servers located at or very near stock exchanges to provide a few milisecond jump on the many brokers trading via servers located farther away from the various exchanges. This milliseconds edge allowed scalpers using high-frequency trading programs to hijack the buy order, then re-offer the same shares to the victim at a slightly higher price. The difference in price gave the scalpers a few cent profit per share. Multiplied by hundreds of millions of shares per day, the profits became obscenely large.

With the help of the RBC team he had assembled to ferret out this inside knowledge, Katsuyama came up with a solution — deliberately slow down the speed of trades just enough to equalize the connection speed to all exchanges and deny high-speed scalpers this lucrative split-second edge.

“Essentially, our fill rates went to 100 per cent,” Katsuyama told 60 Minutes on Sunday. “We couldn’t believe it when we actually figured it out.”

Katsuyama decided the technique — implemented by adding miles of coiled fiber to simulate miles of extra distance — could be used by RBC to create its own stock exchange, one that could protect every trade from scalpers. The problem was an exchange created and owned by North America’s fifth largest bank would be shunned by other major banks and investment firms unwilling to aid a competitor. The only option, decided Katsuyama and team, would be to start their own stock exchange.

“We just sat there for a while,” recalled IEX chief technology officer Rob Park, “kind of staring at each other. Create your own stock exchange. What does that even mean?”

The ultimate result of their bold decision is the Investors Exchange, known as IEX, “the first equity trading venue owned exclusively by a consortium of buy-side investors, including mutual funds, hedge funds, and family offices. Dedicated to institutionalizing fairness in the markets,” according to its website. It opened its doors on October 25, 2013. On December 19 it received an order from Goldman Sachs, the first major investment broker to use IEX. That pushed IEX trading volume ahead of the American Stock Exchange, AMEX.

Since then IEX has added JP Morgan and other major banks and investment houses, though the vast majority are staying away. Monday’s publication of Flash Boys as well as various lengthy excerpts in The New York Times, has thrust Brad Katsuyama and IEX front and center in the investment world for tackling the market-destabilizing forces unleashed by the advent of high-speed trading. The media exposure has prompted calls for laws to crack down on high-speed trading abuses. An FBI investigation into the practice was announced a day after the book’s publication.

If Moneyball, Liar’s Poker and The Big Short are any indications, Flash Boys is headed for bestsellerdom and Brad Katsuyama is likely to become further lionized in a major Hollywood movie.

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Comments

Joe Thomason · Apr 14, 08:59 PM · #

I agree that Brad is a hero. I have just begun reading a second book on the topic but after listening to O’Brien debate Katsuayma, the former made a salient point which I am yearning to have clarified. If in fact the spreads are monstrously lower since the advent of HFT, then why is the investor not still better off, being that the scalps are apparently less substantial than the erstwhile spreads?

flybynite · Apr 15, 08:24 AM · #

That’s like asking why it’s wrong to use a wireless bug to eavesdrop on the plans of your business competitors when wireless communications have made business so much more efficient and convenient.

Yes, the use of computers for trading has lowered spreads, but it’s still wrong to abuse that technology to scalp someone else’s buy by forcing him to pay you a premium.

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