CHAPTER 1

Busted

I always wondered when word would get out. I got my own look in 2003. That'swhen I went to work for the Citadel Investment Group, Ken Griffin's stealthyChicago hedge fund, to help them build a high-frequency trading system for theU.S. equity options market. There was only one fully automated options exchangein the United States at that time, the International Securities Exchange (ISE)in New York. Before the ISE opened for business in 2000, no options exchangewould allow market-makers (a type of trader we'll learn about presently) tosubmit their all-important quotations—bids to buy and offers tosell—electronically. For the most part, those were still communicatedverbally by human traders with loud voices and sharp elbows, standing all day inopen outcry trading pits wearing sensible shoes. ISE founders David Krell andGary Katz knew it was time to change that, and the success of their enterpriseproved to any remaining doubters how absolutely right they were. The ISE was thequintessential game changer. Their explosive success forced the traditional,floor-based options exchanges to make their own plans for electronic quoting.And Ken Griffin wanted Citadel to be all over it.

I had been managing financial systems development for several years by thistime, mostly for the pricing of derivative securities. The Citadel system,though, would not only calculate hundreds of thousands of option pricessimultaneously— an impressive feat in its own right—but also injectstreams of bids and offers into the markets at literally superhuman speed. Thecustom-built quoting engines would tirelessly inject many millions of quotesinto the markets every day, each of them a binding commitment to buy or sell alisted option contract at some specified price, each one the result of asoftware program running on a computer. And while the quoters were busy doingthat, "electronic eyes" would scan everyone else's quotations andorders—hundreds of millions per day—all in real time. It would belike standing at the end of an open fire hose and examining each drop of waterbefore it hit the ground. When the electronic eye (or EE) found someone offeringto buy an option for more than it was worth, or to sell it for less, it wouldimmediately submit an order to take the other side of the trade for a tinyprofit.

It was a dazzling sight, watching these machines pick the markets clean of itsinefficiencies. I would have loved to talk about it back then, to tell friendsand family what was going on in the gleaming glass tower at the intersection ofDearborn and Adams. But the confidentiality agreements one has to sign foremployers like Citadel are very, very effective. In this business, everyoneknows that loose lips get pink slips. So like everyone else, I kept my mouthshut and talked only with my small group of colleagues on the 37th floor.

By the time I left Citadel in 2005, their options market-making system—thework of a team not much larger than the Chicago Cubs' starting lineup—wasresponsible for more than 10 percent of all options trading in the UnitedStates, or more than a million contracts a day. Within three years, its marketshare had reportedly grown to a commanding 30 percent. The U.S. options markethad become dominated by the extraordinary machines of just a handful ofsecretive firms like Citadel. Still, nobody on the outside seemed to have aclue—or a care—that trading was no longer done by traders.

That all changed in 2009. As people licked their wounds in the aftermath of the2008 market meltdown, wondering where all the money went, word got out thatsomething like $20 billion of it went to these folks known as high-frequencytraders. The term was well known inside firms like Citadel but not so muchoutside. Now, it was bad enough that anyone made out like bandits in thehorrible year that was 2008, but a far more frightening contemplation causedmore than a few people to go grab a pitchfork from the shed: Was high-frequencytrading (HFT) somehow culpable? Did it cause the mother of all crashes oraccelerate it once it began? After all, the 1987 market crash was widelyattributed to automated trading, then known as program trading. Did thecomputers do it again?

Word went around that 50 percent of all stock trading— maybe 60 percent oreven 70 percent—was attributable to HFT computers trading with each other,supposedly just to collect tiny kickbacks, known as rebates, from the exchange.The HFT firms weren't even holding on to their stock. Once bought, they'dimmediately turn around and sell it, sometimes buying and selling the same stockhundreds or thousands of times a day. What was up with that? All this trading atungodly speeds, it was said, was creating massive price volatility thatotherwise wouldn't exist. Could this be good? Nerves were not settled when aformer Goldman Sachs employee was arrested for allegedly stealing proprietarycomputer code for high-frequency trading, with the bank asserting ominously,"There is a danger that somebody who (knows) how to use this program could useit to manipulate markets in unfair ways." Computer code to manipulate markets?What the heck was going on here?

Anyone following the HFT stories in 2009 learned a handful of new terms from themodern trading lexicon— none of them particularly comforting. The HFTfirms were supposedly using something called "flash orders" to get advance looksat customer trade orders before the rest of the market, then using those peeksto make their own trades at a profit. Wasn't that front-running and wasn't itillegal? The flash order robbers supposedly had only 30 milliseconds to do theirdirty work, but this was plenty of time because they "colocated" their computerservers in the same data centers as the exchange computers, at great expense.This also let them get their own orders in before any investor possibly could.Uneven playing field, anybody?

Unsatisfied with flash order thievery, the HFT smarties supposedly submittedsomething called immediate-or-cancel (IOC) orders with no intention oftrading, but only to force investors to reveal the true prices at which theywere willing to trade, information the HFT guys would use to move market pricesagainst the investor. Whoa. Were the HFT firms even qualified to be so close tothe exchange and trade at lightning speeds? Nobody could say, because it wasnearly impossible to know even the identities of high-frequency traders. Theydidn't need to make the infrastructure investments themselves. They could usedirect market access (DMA) or naked access, using their broker'sexchange connection to get in anonymously, then perform their lightning-fastderring-do as if wearing a mask.

"Dude," you could almost hear people asking, fatigued and more than a littleticked off, "What happened to our stock market?" Was it no...