One of this year’s hottest business books was Michael Lewis’ Flash Boys, in which the author plumbs the complexity of the highly fragmented US stock market to expose the questionable trading practices of High Frequency Traders, brokers, and exchanges. The unlikely hero of the book is Canadian Brad Katsuyama, formerly a trader at RBC’s New York desk. Brad felt gaming in the market had become severe enough to start his own exchange, called IEX, with a mission to bring fairness and transparency back to Wall Street. MISC had a chance to speak with Matt Trudeau, IEX’s Head of Product Development, about how Brad and his team are achieving their mission.
/ Does the stock market need a reset?
Matt Trudeau: More like a recalibration than a reset. For the last 10–15 years, we’ve seen an evolution of the market at an almost unmanageable pace, happening at the intersection of technology, regulation, and industry practices, which in many instances has produced unanticipated and suboptimal outcomes. The market has come out of balance. While we want to retain all the innovation and the cost efficiencies technology has brought, there is an opportunity to think more holistically about the design of the entire ecosystem, not just the information systems.
/ As your COO John Schwall once discovered, whatever the regulators do to make the market fairer just triggers more corruption by those with the resources to find and exploit any loophole. In this kind of environment, is recalibration enough?
MT: The history of Wall Street has been a cat-and-mouse story. The more prescriptive the rules are, the easier it is to find ways to work around them. It’s very challenging for the regulators to keep up with the speed of technology. These days we talk about trading in nanoseconds; just 10 years ago, they were writing rules considering trading in seconds. So we’ve had a 10,000-fold increase in the speed at which we need to think.
/ Sounds like Moore’s Law on steroids!
MT: Exactly. So if rules become obsolete before the ink is dry, now the regulators have to ask themselves, what are all the possible unintended results of the rules we’re writing? It’s a question that is almost impossible to answer and regulators generally seem to have the unspoken prime directive of “first, do no harm.”
/ How do you get past that?
MT: We think the market would benefit more by self-healing rather than by new rules that just generate more ways to work around them.
/ You have expressed an interest in design thinking. How has that informed the creation of the IEX business model?
MT: We think of ourselves as market designers. There is a subtle, but important distinction from pure engineers or builders. Typically, the exchange has looked at the market through the lens of its own interests. In the last 10 years or so, the most profitable clients of the exchanges have been the High Frequency Traders. As they delivered more business to the exchanges, the exchanges in turn created more products and services tailored to the HFTs. That’s where the market has come out of balance. When you do that over and over during the course of a decade, the whole market starts to skew in favor of one group of players.
At IEX, we don’t look at this only from our own self-interested perspective. We look at the market as a whole, starting with its purpose of allocating capital from investors – who want to generate wealth and prosperity for themselves – to issuers that want to build companies, products, and services that create new wealth and new jobs. Can we better help investors and issuers by reorienting the priorities of the market? What does the issuer need, what does the broker need, what does the trader need, and what does the investor need from the system? Can we design a marketplace that balances all those interests?
/ Do you think you’ve managed to do that?
MT: Here’s an example: In our ownership model, we took investment only from institutional investors. We didn’t take any broker money. All the other dark pools are owned by brokers and designed to maximize the brokers’ benefit, not necessarily the end investor’s. So we only took investment from institutional investors, and then decided that only brokers would be customers of IEX. It’s designed so that no one party can have undue influence over the other. Of the 45 or so ATSs, we are the only one to have taken this approach.
/ Design thinking always begins with a human-centered problem, which requires empathy. Sounds like you identified that there is a real need for fairness and transparency and designed your model to provide that.
MT: Exchanges have started to offer technological advantages and order types that are designed for the most sophisticated trading firms, with a level of comprehension well above that of the average investor. The entire industry apparatus has been oriented towards them now.
It has completely lost sight of the average investor – the end user if you will.
Our founder Brad Katsuyama experienced this when he was a trader at RBC. His experience was that the market didn’t work for him and his clients anymore, and this started him and his team down the path of building something that would focus on the human element, not the machines and the technology. In this way, he was definitely starting with a real human need.
/ Can we talk about your goals of greater transparency, greater focus on the investor, less fragmentation, and fewer predatory trading strategies?
MT: We want to empower the end investor. The best way to do that is to provide them with the transparency to make informed decisions. You can roll a number of things into transparency, such as conflicts [and] hidden incentives. Awareness of these things makes for a more educated investor. So if we put those two things together – investor focus and greater transparency – we can address some of the structural inefficiencies in the market that create opportunities for predatory strategies.
With fewer structural inefficiencies, we think there will be less fragmentation. In a market with 11 exchanges and 45 dark pools, there’s not a lot of differentiation. This is not a picture of efficiency. When 50+ venues are virtually the same as each other, and when these structural inefficiencies are exposed by greater transparency, we think there will be consolidation and that some of these operations will naturally go out of business. This should create a small number of higher quality venues.
/ How can the architecture of the markets be made less complicated?
MT: Greater situational awareness. As part of our product dev cycle, we always ask: is this good for the ecosystem as a whole? Historically, decisions were made in isolation and out of self-interest. When everyone else is acting in their own self-interest, we’re trying to think about how our decisions affect the entire system.
/ To what extent does the unfairness and corruption of the US markets reflect the nature of today’s capitalism? Does capitalism itself need to be reset?
MT: I’d argue that more specifically Wall Street culture may need a reset. The irresponsible risk-taking and heads-I-win, tails-you-lose, zero sum mentality of a minority has tainted the image of the financial markets as a whole (and nearly destroyed the world economy). The culture needs a reset to one of responsibility, accountability, and stewardship.
Capitalism is the engine for the creation of wealth and prosperity. Like the equities market, it could do with some recalibration. Some describe this as an evolution to “conscious capitalism” that considers societal and environmental impact. We are optimists and believe that transparency, culture, and design are key components to the perpetual endeavor of creating a more perfect form of capitalism, and a more perfect market.
Photo: Brian Glanz