Disrupting Wall Street with Tech

Let’s talk about the challenges for disrupting conservative markets – such as Wall Street – with technology.

This is not about Wall Street itself (and its confusing procedures, dark pools and trading ‘gymnastics’). Here I am much more interest on the forgotten tangible aspect of technology, how developers and algorithms are exploring markets gaps, and ultimately about the challenge of disrupting establish markets with huge players and barriers.Book Insights-FlashBoys-BookCover

This is based on Flash Boys, a non-fiction book about what was happening on the backstage of Wall Street after
2009. It follows the efforts of a group of traders to understand how the technology and gaps within SEC rules were shaping the unfair advantage of high frequency traders. Their answer was to create a new model of stock exchange – dubbed as “A market that works for investors”. 

What is money nowadays anyway?

Pretty much just a figure in your screen. The money you may have on your current account, pension funds, investments or bitcoins is roughly a simple number. You click a button, press your contactless card, or input your pin, and an electronic system takes over and figure out how to subtract numbers from your account and add the right amount on someone else’s.

The same is somewhat true for Wall Street. Forget about 1980s’ movies hectic and loud look onto Wall Street (do you remember Trading Places ?). Today traders sit on fancy offices with fancy screens and trading becomes pressing buttons and watching indexes and figures.

But the screen is an entire representation of your bank account, right? That would not happen within Wall Street though. And this is the problem behind ‘Flash Boys’. The book follows a group of traders and professionals – leaded by Brad Katsuyama) – and their obsession to find out why their screen were no longer a reliable representation of the financial market. The answer was the key concept of millisecond. And it all started with technology.

Milliseconds and High frequency trading

Millisecond is the time lapse that takes electronic signal is travelling from underground cables of optic fibres. In this context, the time lapse that takes an order to travel from the trader screen to get to the stock exchange’s server and be executed. It takes time because fibres are ‘physical’ channels in which physical distance and underground paths matters.

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Let’s go back to 2008. Leman Brother collapsed dragging a snowball effect on financial markets around the globe. Investors were highly concerned about liquidity and regulators had to address it fast. In 2009, SLPs were created in the U.S as a mechanism; trading firms would be paid a fee of $0.0015 per transaction to add liquidity to the market. High frequency trading (HFT) emerged as an almost risk free trading model.Trading_Algorithm

To maximise their transactions volume and profit, HFT firms figured out that they could pick up the interest of a trader in selling a large amount of shares. The closer HFT were to the stock exchange server, the better. When a trade push a button to interact with the market, HFT would pick up their intentions and acted in anticipation, changing the share price on their favour with the privileged information obtained on the ‘millisecond’ advantage.
Because of the millisecond delay, the order would take different times to travel to Stock X and Stock Y. As HFT were at ‘minimum’ millisecond delay to reach the stocks exchanges servers, they had an advantaged; a legal advantage.

It seems crazy that such fractions of time and fractions of cents can have such a huge impact. But if you consider that it is possible to buying stock a $1.00 and selling at $1.0001 over 10,000 times A SECOND, you can start understand how HTF makes (a lot) of money. In one famous case of Virtu Financial, the HFT firm lost money on only one single day of 1,238 days of trading, according to its S-1 regulatory filing.

And it’s all possible because of technology

Otherwise, how can a single firm effect 10,000 orders per second? Or how can you analyse the behaviour of a trader or share along the time? Or even how can you recognise the action, compare with the pattern you have identified and react accordingly within 300 milliseconds (equivalent to a blink of eye)?

Algorithms became the core of Wall Street trading. It is no surprise that technology positions and developers have found their huge role within Wall Street.

How algorithms have changed Wall Street

 

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HFT, powered by their automated trading algorithms, resulted in a dramatic change of the market microstructure, particularly in the way liquidity is provided to the market. Search for ‘2010 Flash Crash’ and check out how further the questions and fragility of this system reach. More advanced analysis on HFT and electronic market leaded by MIT Sloan School of Management is available here.

[Quick update: Not yet convinced about the huge effect of tech on financial systems? See the issue unfolding – Hackers indicted for masterminding $100 million Wall Street insider trading scheme]

 

Disrupting the market

Brad and his gang enter on the play. On his position within Royal Bank of Canada, Brad lead the development of Thor, an algorithm that would even out the time an order would arrive at different stock exchanges. Yet, the solution were unpredictable and not always effective. The problem was the physical cables network and the fact HFT were co-located on stock exchanges servers and pay millions for access to their data, and would always have advantage.

The solution. Create a new stock exchange where, by principle, profit would not come from incentivising HFT predatory trading mechanisms. But how would that be possible?

The new exchange and its impact (so far)

Launched on October 25, 2013, IEX is an Alternative Trading System (ATS), an electronic trading platform that matches buyers and sellers of stocks. On their own words:

IEX’s main innovation is a 38-mile coil of optical fiber placed in front of its trading engine, which adds a round-trip delay of 700 miliseconds for all incoming orders. It limit traders’ ability (and HFT) to respond ahead of IEX’s own pricing algorithms.

IEX-Box

IEX established operations protocols that combats predatory trading. It does not allow co-location (the share of its premises by HFT firms), does not sell access to their data, do not offer any rebate for stock (preventing HFT’s advantage of inflating the trade volume by nor price), and only offer four types of order.

IEX also innovated on its ownership structure. It owned by leading mutual funds and hedge funds including Greenlight Capital, Capital Group, Brandes Investment Partners, Pershing Square, and Third Point Partners; IEX’s employees and individual investors also have a stake in IEX. Bottom line, is that only investors can have a stack on the company, which forbids proprietary trading affiliates (such as banks and brokers that might add conflict of interest).

Impact

iex stats

IEX Exchange launched in25 October 2013.  On August 7th, it had a 1.531% of market share and handling over 238 million shares.  According to Forbes:

‘While other trading venues or dark pools may attempt to replicate its methods, IEX does have “first mover” advantage. The increase in trading volumes is a promising sign for IEX, and proves that its measures to combat predatory trading have been well received by the large institutions who have been victimized for years by these activities, which has collectively cost them in the billions.’

Having reached the break-even point on December 2013, and proven the efficacy of the technology to prevent predatory trading, IEX Exchange is ready for the next step of becoming a full-fledge stock exchange. By 2017, it aims to have 8% market share and is on process of applying for the exchange status at SEC.

What do you think? Would their model prevail over HFT competition?

IUB – Insights from Unexpected Books. Lessons about change and entrepreneurship from unconventional places. Regularly, a new book or article is revisited and some cool ideas are shared. Collaborate with suggestions and comments. I’ll be pleased to hear from you at hello@entrepreneurlog.com.

 

About the author: nprieto