Is the stock market rigged?

Brad Katsuyama has never been one to start a fight. In fact, he’s usually the one who tries to diffuse a tense a situation. But seemingly overnight, Katsuyama (BBA ’01) went from being a humble trader in New York City to being right in the thick of one of the most contentious and public fights Wall Street has ever seen.

Katsuyama was thrust into the spotlight in late March after the release of Flash Boys: A Wall Street Revolt, a book by Michael Lewis, author of previous bestsellers The Big Short and Moneyball. The book chronicles the use of computerized highfrequency
trading and asserts the stock market is rigged for the benefit of insiders. Since its release, the mild-mannered Katsuyama, a central figure in the book, has become the face of its controversial argument.

From being featured in a 60 Minutes segment, to getting in a heated exchange on live television that later went viral, to testifying in front of a U.S. Senate subcommittee, Katsuyama has found himself in some unfamiliar situations since he went from a “normal guy” to an unlikely public figure. And though he wasn’t looking for a fight, when one found him, he was ready to fight back.

Rise to fame

While Katsuyama’s rise to fame last spring seemed meteoric, his journey can be traced back over seven years. It was 2007 and Katsuyama was working as a trader for the Royal Bank of Canada in New York City. He had been with the company for six years when he noticed that something was off with the trades he was trying to execute — the orders would only be partially filled, and he would have to pay a higher price for the rest.

Katsuyama would later realize his trades were falling victim to high-frequency trading.

High-frequency trading (HFT) is done by automated computers that can execute trades in 1/1000th of the time it takes to blink an eye. These computerized traders can access and react to information on changing stock prices before a human trader’s order is even completed, all within a matter of microseconds. 

One of the main reasons HFT has become such a hotly debated topic is a process known as “electronic front running.” When a trader attempts to execute a large order — 100,000 shares for example —splitting the trade into several smaller orders and sending them through multiple stock exchanges is the only way the trade can be fulfilled. Predatory high-frequency traders can capitalize by seeing the order when it reaches the first exchange, and cancelling all remaining sell orders while buying stock on other exchanges. They can then sell it back to the original buyer at a higher price. 

Katsuyama is quick to point out that not all high-frequency trading is predatory.

“Not everyone who’s using a computerized trading strategy is harming the market, but there are traders out there who are [front running] and we found distinctive evidence of that happening,” he says from his office in Manhattan’s financial district.  

It is ironic that in today’s world of the global village and technology making geographical location irrelevant, that a large part of the advantage high-frequency traders enjoy comes from reducing distance. In a practice called co-location, HFT firms place their trading computers in the same data centers that house an exchange’s computer servers, meaning market information travels only a few feet by fibre-optic cable

“It’s pretty simple — the farther away from something you are, the longer it takes you to get there,” says Katsuyama. “So they said ‘Why not just be in the same room?’ Which is what they’ve done.” 

From his desk at RBC, Katsuyama could see there was a problem, but he wasn’t sure what was causing it. He didn’t even realize the issue went beyond RBC until he was offered a new position at the bank in 2009 and watched some of his mutual fund and hedge fund clients execute trades.

“I was sitting next to a friend of mine who’s a trader for one of the biggest hedge funds in the world and he was using all of these different bank algorithms to trade, and he was having the exact same experience I was having sitting in my seat at RBC,” says Katsuyama. “That’s when it hit me that this is a system wide problem.’” 

THOR effectively solved the front-running problem for RBC, but the response Katsuyama and his team received was the problem was much bigger than just the trades executed through RBC.

“We felt like we made this great discovery, but the feedback was ‘You’ve only solved a very small problem for the end client’,” Katsuyama says. At the same time, there was another issue at play: Katsuyama and his team were getting lucrative job offers from other firms.

“It was like a team winning the Stanley Cup and then getting broken up the next year in free agency,” Katsuyama says, his Canadian heritage showing through. It was clear that if he wanted to keep his team together, and even the playing field on Wall Street, Katsuyama would have to leave RBC.

As challenging as the decision would be, taking the road less travelled seems to come naturally to Katsuyama. 

As a student at Laurier, he gave up playing on the Golden Hawks football team after his second year to focus on his studies. He even cut a post-graduation trip through Europe and Australia short to attend his convocation ceremony when he found out he would receive the Alumni Gold Medal. 

Even in his schoolwork, Katsuyama often went against the grain. He recalls working on a project for the School of Business and Economics’ Integrated Case Exercise competition, during which students are asked to analyze a company’s financial situation and make a recommendation for its future direction. The majority of groups recommended aggressive expansion, but Katsuyama’s group went in a different direction and ended up winning. 

“Our recommendation was, ‘don’t do anything other than get your own house in order,” he says. “It was very sensible and I remember thinking we weren’t going to win because it wasn’t exciting at all.”

The decision may not have been difficult from a moral perspective, however Katsuyama admits there were some things that were difficult to walk away from. RBC was the only place he had worked, starting right after graduating from Laurier. Some of his best friends were at the company, as were several people he considered mentors, not to mention the stable and lucrative paycheque. Plus, perhaps most importantly: “Our second child was born three days after my last day at RBC, so life was definitely changing pretty rapidly,” he recalls.

After several discussions with his family, friends and colleagues, Katsuyama left RBC in 2012 and started his own stock market, called IEX. He took a small part of the team that had developed THOR with him.

IEX, which had its first day of trading in October 2013, was founded on a simple principle: fairness. The goal of the exchange is to match buyers and sellers without allowing intermediaries such as predatory high-frequency traders getting in the way. 

“The big misperception out there right now is that the race is between the high-frequency traders and other investors, but the real race is between high-frequency traders and the markets themselves,” says Katsuyama. He says that stock exchanges are supposed to act as referees, ensuring fair trading environments for all parties involved. However, on most exchanges, high-frequency traders operate faster than the market itself, which leads to an unfair advantage for whoever can get to information first, even by microseconds.  “If you’re the referee and you can’t keep up with the play, how can you possibly say that you’re doing the best possible job of keeping things fair?” he says. 

IEX uses technology, including what it calls “the magic shoebox,” which involves 38 miles of cable coiled in a box at its server facility in New Jersey, to slow down the fastest traders, ensuring everyone is trading on a level playing field.  It also doesn’t permit co-locating trading computers and servers.

“We’re fast, but we’re not as fast as high-frequency traders. So to make sure they can’t trade on IEX using information we don’t have, one thing we did was push them very, very far away,” says Katsuyama. “The magic shoebox synthetically creates distance, and we’ve also pushed everyone to a different building.” 

Katsuyama believes IEX is returning to the true principles of the stock market and taking steps towards repairing the negative perception most people have about Wall Street. But not everyone on Wall Street agrees.

Since the release of Flash Boys and its contention that the stock markets are rigged, Katsuyama has become the target of heavy backlash and criticism from Wall Street. While he has received a lot support, he’s also been called a “fear monger” and has been accused of blowing the issue out of proportion.

Many got a first-hand look at some of the pushback Katsuyama has received during a live segment on CNBC in early April. William O’Brien, then president of BATS Global Markets, pestered Katsuyama to answer the question: Is the stock market rigged? After much prodding, Katsuyama responded: “I believe the markets are rigged, and I also think that you’re part of the rigging, so if you want to do this, then let’s do this.”

Katsuyama and O’Brien then got into a heated debate that lasted 23 minutes, an eternity in television terms, and brought the New York Stock Exchange’s trading floor to halt as traders gathered around TV screens to watch. They debated the basic nature of the stock market and if it was still possible for an average investor to compete with the giants of Wall Street, particularly with the prevalence of HFT. In a poll on CNBC’s website, 67 per cent of viewers though Katsuyama won the debate (O’Brien received five per cent of the vote). O’Brien left BATS, a high-frequency trading exchange that fell under the eye of regulators for its trading practices, in July.

While much of the criticism Katsuyama and Lewis have received has been inflammatory, Laurier Associate Professor of Finance Andriy Shkilko offers a more measured critique. Shkilko, who studies securities trading and financial markets, has devoted his recent research specifically to HFT. “Would I say that the markets are completely warm and fuzzy? Probably not,” Shkilko says. “But are they as bad and as rigged as Lewis says? No. No one has been able to prove that high-frequency traders are systematically doing the nefarious kind of front running that Lewis’ book describes.” 

Shkilko concedes that some of the activity relating to HFT is “not good,” but he doesn’t believe there is enough evidence to conclude the markets are rigged. Shkilko explains that computerized high-frequency traders have taken the place of “specialists”, or intermediaries in the market ready to provide liquidity. In the old days, these specialists were humans in the middle of the trading floor. Today the role is filled by HFT computers. However, in Katsuyama’s experience, intermediaries have much more of an influence than simply providing liquidity.

“Technology in many ways should have eliminated the need to have someone standing in the middle, but it hasn’t,” he says. “I think the shocking part to a lot of people is that Wall Street is saying it’s not a big deal because it’s been happening forever. The fact that it’s been happening for centuries — someone standing in the middle and scalping money off of someone else — is not a proper excuse to ignore the problem as it exists today.” Katsuyama believes a big reason why the argument over HFT has become so contentious is because the debate is still unfolding — Flash Boys was released right in the thick of the debate over the practice. Katsuyama says another reason it has gained traction is because the general public sees this as another situation where the Wall Street suits are pulling one over on them. 

“I think the principle of it strikes at the heart of why society has such a big issue with Wall Street,” he says. “Who’s looking out for people when they’re not paying attention?” While Katsuyama does his best to avoid reading his own press, he has a straightforward response to his critics. “When your stance is grounded in the truth, it makes it very easy to have these discussions,” he says. “I’ve yet to see anything that says ‘Brad Katsuyama said this, and this is why it’s not true, and here’s the truth.’ If I was going out there with a bunch of skeletons in the closet and I didn’t want to be asked certain questions, I would be acting in a very different manner.” 

What Katsuyama is most proud of these days is staying true to himself. He’s still close with the friends he grew up with in Markham and he considers himself “a normal guy thrown into an abnormal situation.” “I still try to make it home in time to give my kids a bath and just try to keep things as normal as I possibly can,” he says. “I’m really, really lucky in so many different ways — with the friends and family that I have, that I’m married to the wife that I have, that I was at RBC and I was in the right situation. Luck had a huge role in me being in this position and I feel luckier now than I’ve ever felt in my career.”