Thursday, November 14, 2013

How the Stock Market Is Rigged, According to a Robo-Trading Whistleblower

“If you’re on Wall Street, you would just assume that you’re being ripped off, unless you were the one doing the ripping off,” says Dave Lauer, who has helped build robotic systems at top firms like Citadel.

This is the opening of The Wall Street Code, a new documentary on the mysterious and sometimes incomprehensible world of high frequency trading produced by Backlight, a Dutch public broadcasting company. The focus of the documentary isn’t on Lauer, who has testified as an expert at a Senate Committee Hearing on HFT, but on Haim Bodek, a "genius" algorithm architect who dared to break Wall Street’s notorious omerta, the industry’s unwritten rule of silence and secrecy.

Lauer, for instance, refuses to discuss the details of his past work. “I can’t get into that,” he says, breaking a smile. “I’m terrified of Citadel lawyers.”

Lauer left the scene after the 2010 Flash Crash, in which the market dropped 1000 points in minutes, only to bounce back again—an event, he says, that would irrevocably change him.

Known as the Algo Arms Dealer, Bodek reveals not only the ins and outs of how Wall Street traders cash in on the marketplace with an advanced amalgamation of speed and artificial intelligence, but also details of how the market is rigged. Bodek would report his findings to the Securities and Exchange Commission, which, on Wall Street, almost never happens, at least from a well-known insider.

Bodek made his discovery when his own algorithms—he had started his own high frequency trading firm, called Trading Machines—suddenly stopped working one day.

“There’s kind of a rule. Never blame other people. Never blame the market. Never blame the other trader,” Bodek explains. “It’s always you. Your ‘code’ is wrong.”

Despite his well regarded skill for sussing out the answer to such problems, Bodek couldn’t figure it out, and he wouldn’t for twelve months, despite scanning a million lines of code for a possible bug. The answer wouldn’t come from inside his machine. Instead, he found out at a bar, when an exchange insider let him in on a little secret. The game was rigged, and unless you knew the secret passcode, you were shit out of luck.

Indeed, it’s sort of like trying to buy a ticket for a Metallica concert, Bodek explains in the film (starting at minute 24):

    Metallica is playing at this concert hall. The ticket counter opens at 6 p.m., so I'm going to go and stand in line. After a while, other people come in after me, and I'm no longer at the end of the line.

    There are these scalpers. They're in line with me also. I can see them, because they're all wearing the same T-shirt. They also have a very very close relationship with the exchange, uh, you know, with the venue.

    What is that relationship? Maybe one of [the scalpers] brings a significant amount of volume to this. (What does that mean? He buys a lot of tickets. Of course he sells those tickets to other customers.) Another guy actually owns 10% of the venue. A third guy... he doesn't have a lot of volume. He's not big on this venue. But he's big on another venue, and he's got a board seat on this venue.

    So there's a very very close relationship between these scalpers and this venue.

    When the ticket counter opens, I'm going to equate that to the moment when a price can change in the stock market. And at 6 p.m. on the dot, this is what I'm going to witness: Every single one of these guys is literally going to teleport. In one picosecond, they are all ahead of me.

    How did that happen? I ask some of the people, and they say, "Oh, they're really fast."

    And I'm like "No. They teleport. That guy was behind me. How does he get ahead of me?"

It's a common narrative on Wall Street: insiders profiting at the expense of everyone else, similar to how Wall Street firms helped fund ratings agencies before the market collapsed in 2008. Then, ratings agencies like S&P and Moody’s were pressured to provide top ratings for questionable investments, which the banks then pawned off to unsuspecting clients. This time around, it’s the exchanges providing favorable treatment, allowing choice clients to cut in line by specifying a special order type.

And so it’s less about speed or having the smartest algorithm, and more about knowing the right people and exploiting a potential conflict of interest.  READ MORE: