Brad Katsuyama’s Next Chapter
His once tiny dark pool got a big boost from ‘Flash Boys.’ Now, this unlikely celebrity is out to prove IEX Group has what it takes to become a public stock exchange.
Brad Katsuyama never thought he’d be famous.
Not even famous-for-Wall-Street famous. He was Canadian, for heaven’s sake. He’d worked at Royal Bank of Canada, not Goldman Sachs or JPMorgan. He was running a startup—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 Lewis flew to Toronto to talk to his parents and high school friends, even after he discovered Lewis had actually made him—Brad Katsuyama—the book’s hero, even after the 60 Minutes camera crew showed up … even then, 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.”
Lewis’s 2014 best-seller—with its controversial premise that the U.S. stock market is rigged—made Katsuyama, 37, a celebrity. “People recognize me, which is a little weird,” he says. He’s testified before the U.S. Senate. He’s been invited to join a U.S. Securities and Exchange Commission advisory panel. In April 2014, he bested 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’s sold his life story to Sony Pictures. He even considered employing a bodyguard. On Lewis’s suggestion, he’s stopped reading much of what’s written about him. “The less time I spend thinking about it, the more normal I feel,” he says.
What Katsuyama does spend his time thinking about is IEX, the upstart stock-trading venue he co-founded in 2012. IEX’s goal: to level the playing field between high-frequency traders and everyone else.
When 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 U.S. 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.
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. Katsuyama says the fragmented market structure in the U.S. is riven with conflicts of interest. With trading currently spread over 11 public stock exchanges and more than 40 dark pools (trading venues that don’t 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, and co-location—the right to put their computers in the same data centers as the exchange’s so they can trade even faster.
Katsuyama, who was a tailback on his high school football team, uses a sports analogy to explain his objections. “No one,” he says, “is saying the teams have to be equal—just that the referee shouldn’t have an interest in the game’s outcome.” 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 U.S. dark pools. Already backed by some of Wall Street’s biggest hedge fund managers, it has attracted serious venture capital. Many brokers say IEX has pushed U.S. equity markets toward greater transparency and simplicity, although its critics say it has merely accelerated trends previously under way. They also accuse IEX of hypocrisy—demonizing HFT in its marketing while relying on fast-trading firms for liquidity. Even some of IEX’s supporters say it’s been hyped as a panacea. “IEX doesn’t solve all problems,” says Brian Levine, co-head of global equities and execution at Goldman Sachs, which has sent some of its order flow to IEX but also has its own dark pool. While Katsuyama was right to tackle latency arbitrage, Levine says, “IEX is not the be-all and end-all.”
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 Katsuyama’s startup 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 startup for hundreds of millions of dollars.
Still, IEX’s attempt to become an exchange could backfire. There’s no guarantee the SEC will approve IEX’s 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. (With the exception of the Chicago Stock Exchange, all currently operating U.S. public exchanges are subsidiaries of companies that run multiple exchanges.)
Around IEX, where innovation is crucial to continued success, Daniel Aisen, a 28-year-old Stanford University computer science grad, is known simply as “Puzz.” It’s short for “Puzzle Master,” the nickname he got when he worked with Katsuyama at RBC; Aisen’s team won the 2007 Microsoft College Puzzle Challenge, a kind of brainteaser olympiad.
In the summer of 2014, Puzz had another puzzle to solve. From March to July, the frequency with which an IEX customer could have gotten a better price less than 10 milliseconds after a trade posted rose from about 3 percent to as much as 10 percent. This wasn’t meant to happen. IEX was supposed to protect investors from what’s known as stale quote arbitrage; that’s when a high-frequency trader takes advantage of milliseconds-long delays in how markets update prices to reflect movements on other exchanges. These tiny delays allow high-speed traders to see a price fluctuation on one exchange and then quickly send an order to another market—often a dark pool—that it knows updates its prices more slowly, hoping to pick off the orders resting there at stale prices. It’s a bit like betting on yesterday’s horse race against someone who doesn’t know the result.
IEX prevents stale quote arbitrage with its “magic shoe box,” a metal container in its data center in Weehawken, New Jersey. Crammed into it are 38 miles (61 kilometers) of coiled fiber-optic wire, creating IEX’s speed bump of 350 microseconds (about one one-thousandth of the time it takes to blink). The idea of countering super-fast traders by creating a slower market might seem like a paradox. It’s not. IEX uses the same high-speed data feeds as HFT firms do to monitor other exchanges for price changes. But because IEX didn’t want to be in a technological arms race with the high-frequency traders to process this information faster than they do, it uses the speed bump to slow down all new orders—just enough to ensure IEX has time to update its prices to reflect any movements on public exchanges. This prevents orders on IEX from being traded against at stale prices.
So how, Aisen wondered, could HFT firms be picking off IEX orders despite the magic shoe box? It didn’t take Puzz long to solve the riddle. He discovered that some HFT algorithms could predict price changes—like surfers sitting out past the break, scanning the swell for their next ride—and target orders before the magic shoe box’s speed bump could protect them. As a defense, Aisen helped IEX create its own price-change-prediction software and a new order type (the discretionary peg, or D-peg for short) that trades less aggressively when prices are in transition, shielding customers from this form of latency arbitrage, too. He says IEX has to remain constantly vigilant against evolving predatory strategies of HFT firms.
Brian Goldman, senior equities trader at Calamos Investments, which has $24 billion under management, says he gets better-quality execution on IEX compared with other platforms. “On a lot of other venues, you can just tell that the HFT guys have seen you coming a mile away and trade directionally in front of you with the intention of picking you off,” he says. “We’ve not observed this sort of adverse movement in the stock we’re trading on IEX.”
IEX’s office on the 44th floor of the new 4 World Trade Center building, with views of the 9/11 Memorial, looks like many trading floors: open plan, exposed ductwork, glassed-in conference rooms. But the vibe is more Birkenstock than brogue. There’s a communal kitchen and lots of dudes 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 9:30. 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 consecutive days. Even so, since its launch, IEX has steadily gained market share. On the June day I visited, cheers erupted shortly after 11 a.m. as IEX hit a new milestone: trading more than 1.5 percent of all U.S. equity volume. A few weeks later, on Aug. 4, it hit another record—1.86 percent of U.S. volume.
That may sound like nothing. But in today’s fragmented market, 1.86 percent is something. The NYSE and Nasdaq, which run three public exchanges apiece, and Bats, which owns four, each control around 20 percent of U.S. equity volume most days. IEX, with from 1.1 to 1.9 percent 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 U.S. 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.
“I think the traction they’ve gained,” he says of IEX, “has propelled them past critical mass and forced people to begin routing orders there.”
If IEX becomes a public exchange, John Schwall, an IEX co-founder and the firm’s chief operating officer, is confident its market share will grow significantly. The SEC requires brokers to route orders to whichever exchange is offering the best price for a stock at any given moment. The same rules don’t apply to dark pools, so right now, brokers can choose not to send IEX any orders or to send orders in ways that minimize their chances of being filled.
That’s what happened after IEX launched. In April 2014, 55 percent of brokers’ orders routed to IEX were immediately canceled if they weren’t instantly filled. “Let’s just say they didn’t embrace us,” Ronan Ryan, another IEX co-founder and the company’s chief strategy officer, says of the brokers. Now, brokers show IEX more respect: That number has dropped to less than 16 percent.
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 prioritizes, prices, and matches orders. About a third of all dark pools have followed suit. “That is a huge step in terms of transparency,” says Haim Bodek, a former high-frequency trader who turned SEC whistle-blower.
Not everyone sees it that way. Form ATS is a dense legal document. “They are not written in a way that makes it easy for people to evaluate what is happening,” says Eric Hunsader, CEO of Nanex, a firm that provides real-time market data, and a prominent critic of HFT. Still, he says, IEX has shifted the debate from “Why would a dark pool bother publishing?” to “What are they hiding if they don’t?”
While 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 percent of IEX’s trades.
HFT firms are present on IEX in such numbers because, contrary to the premise of Flash Boys, HFT practitioners aren’t predators, says Bill Harts, chief executive of the Modern Markets Initiative, an HFT industry association founded by four large firms (Global Trading Systems, Tower Research Capital, and Hudson River Trading in New York and Houston-based Quantlab Financial). Harts says HFT firms that are IEX customers are providing liquidity—narrowing the spread between buyers and sellers—“just as they do on most other venues in the world.” As for IEX’s magic shoe box, Harts says, it’s basically a marketing gimmick. He says there’s no convincing evidence that latency arbitrage even happens.
Comments like that infuriate Katsuyama, who says Harts and Modern Markets are part of “the giant smoke monster” that spreads confusion through oversimplification, twisting the facts in order to preserve the status quo. “We are trying to talk about calculus, and these guys are trying to say two plus two equals five,” he says. The problem, he says, is that the general public knows so little about how stock trading in the U.S. actually works that they can’t tell the difference between the nuanced, sophisticated arguments he’s advancing and the simplistic untruths he accuses Harts of peddling.
Katsuyama says that despite the perception created by Flash Boys, IEX was never anti-HFT. Rather than labeling some HFT outfits “good” and others “bad,” Katsuyama prefers to talk about HFT strategies that are “predatory” versus those that provide “legitimate market making.” He says that IEX, with its speed bump and D-peg, prevents high-speed traders from engaging in predatory tactics such as latency arbitrage. But, he says, high-speed traders are free to act as market makers on IEX. He also acknowledges some HFT firms may try to pick up signals on IEX they can then use, ironically, to engage in predatory tactics on other dark pools that update their prices much more slowly than IEX. To make this less likely, IEX uses a second speed bump when relaying information back to the customer.
IEX has repeatedly praised one HFT firm in particular: Virtu Financial, which is not a member of the Modern Markets trade group. 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 CEO, 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,” he says.
Ronan Ryan, IEX’s strategy officer, is standing in a conference room, in front of a whiteboard, explaining why the existing U.S. stock exchanges are screwed. As public companies, under shareholder pressure for ever-increasing quarterly earnings, they’ve become addicted to speed, Ryan says: “You have revenue in your back pocket in terms of latency—just make that cable two microseconds faster and mark it up 30 percent.”
If IEX becomes an exchange and starts stealing significant market share, the existing exchanges will struggle to respond without sacrificing revenue. Every move they might make to match IEX’s anti-speed innovations—forbidding co-location, creating a speed bump, cutting back on order types, charging both sides of a trade the same amount, or giving away market data feeds—will mean surrendering something from which they currently make significant amounts of money or that helps drive trade volume to their exchange, Ryan says. As Lewis says in a telephone interview from his home in Berkeley, California, “I would not want to be a long-term investor in Nasdaq right now.”
Nasdaq says it’s not beholden to high-speed traders for revenue: What are known as “high-order-to-trade customers”—a stand-in for HFT firms—account for at most 11 percent of its equities and options revenue. Walt Smith, Nasdaq’s head of U.S. equities, says that predatory HFT is less of a problem than IEX claims. “If it was overly toxic and bad, the largest stock exchange in the U.S. by volume traded would not be the Nasdaq,” he says, noting that investors would choose to route orders elsewhere.
A disruptor whose model can not easily be mimicked by incumbents is catnip to venture capitalists, which is why IEX has had little trouble raising money. “It’s a classic innovator’s dilemma: The existing stock exchanges can’t change their business model,” says Alex Finkelstein, a general partner at Spark Capital in Boston, which led IEX’s latest financing round. Finkelstein was on vacation in the Turks and Caicos Islands and reading Flash Boys by the pool when he struck up a conversation with a trader who was also reading it. “I asked him if this was really the way it works. He said, ‘If anything, it’s worse,’” Finkelstein recalls. The morning he got back from vacation, he cold-called Katsuyama. Within weeks, IEX had raised $75 million from Spark and a group that includes Bain Capital Ventures and MassMutual Ventures, as well as Netscape Communications founder Jim Clark and casino mogul Steve Wynn.
It’s far from certain, however, whether IEX can become an exchange while preserving its innovative structure. One unique feature of IEX is broker preferencing. Currently, if a broker has a buy order resting on IEX and then submits a matching sell order, those orders get to trade against one another first, jumping ahead of a match already submitted by anyone else. What’s more, the matching broker doesn’t get charged. IEX implemented this system to overcome the tendency of some brokers, including big banks, to route trades to their own dark pools. The SEC frowns on the practice because it disadvantages independent market makers and smaller brokerages. So IEX has decided to drop it from its exchange application.
A bigger question for IEX is whether its vaunted magic shoe box will survive. Regulation National Market System, the 2005 SEC rule that created the current U.S. 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. Smith says that in 2010, when Nasdaq was starting PSX, the smallest of its three exchanges, it nixed incorporating a speed bump after the SEC indicated it would likely object.
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. SEC Chairman Mary Jo White, in a June 5, 2014, speech, wondered whether current SEC rules should be revised so they don’t impede “initiatives that seek to de-emphasize 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 isn’t as great as it seems when one considers that IEX doesn’t 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, 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, Ashley , who grew up in Jacksonville, Florida, had considered leaving New York and Wall Street behind. But first, Katsuyama wanted to try creating IEX. “If this is my last stop on Wall Street,” he says, “I’m OK with it.” After all, Katsuyama never wanted to be anything other than what he is: a normal guy who thought he could build a better stock exchange.
This story appears in the October issue of Bloomberg Markets magazine.