Is Brad Katsuyama, the “conformist” trader who exposed the previously secret behavior of high frequency traders (HFT) featured in Michael Lewis’s new book Flash Boys, about to disrupt the stock exchange business model?

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New stock exchange established that “sells trust”

This past fall, Katsuyama established a new stock exchange, IEX, based on a novel concept.  “We’re selling trust,” he said in a 60 Minutes interview. “To think that trust is actually a differentiator in a service business, it’s kind of a crazy thought, right?”

The genesis for this “radical” idea – an exchange that differentiates itself based on trust – came as a result of a “bait and switch” play in the stock market.  Katsuyama ran the trade desk at Royal Bank of Canada (NYSE:RY) (TSE:RY) when he ultimately discovered his stock orders were being “front run” by HFT firms who would buy nanoseconds ahead of his orders, temporarily raising the cost of the stock, a practice that costs investors billions per year.  While at RBC, he set out to understand how this could happen, and in the process uncovered one component of what is called the “rigging” of the stock market.

HFT: One method the exchanges are “rigged” exposed

To explain how the market is “rigged,” Katsuyama uses a simple analogy of buying tickets to a concert. “You go onto StubHub, there’s four tickets all next to each other for 20 bucks each. You put in an order to buy four tickets, 20 bucks each and it says, ‘You’ve bought two tickets at 20 bucks each.’ And you go back and those same two seats that are sitting there have now gone up to $25,” he said in an interview on 60 Minutes.

When he tried to identify the problem, speaking to various technical, exchange and regulatory sources, he was stonewalled.  “I had no idea. I couldn’t get answers,” he said, highlighting the difficulty in discovering the exchange rules and special opportunities provided to HFT firms.

At first he thought the problem was RBC’s technology.  But when he discovered that he and other major institutional investors were victim of a “skimming” scheme, the light bulb went off.  “Holy cow, this is, this is a huge problem,”  he said in the 60 Minutes interview.  “It just didn’t feel right. It didn’t feel right that people who are investing on behalf of pension funds and retirement funds are getting bait and switched every single day in the market.”

Rich stealing from the rich

And here is the key to the current uproar – and the laudatory early success of Katsuyama’s embryonic stock exchange: HFT is “skimming” from the most influential players on Wall Street.  It’s a matter of the rich stealing from the rich.

For the average investor, HFT takes potentially no more than a single penny from each trade.  But for an institutional investor it can add up quickly.  One $9 billion fund player anonymously quoted in the 60 Minutes piece said it cost their investors $300 million annually.

“When a scheme targets the most powerful forces on Wall Street, (the major hedge funds, pension funds and mutual fund players) odds are it won’t last long,” said a source who had seen select galleys from the book Flash Boys before publication. The source noted that the Michael Lewis book identified one major method used by HFT firms, but didn’t identify all the issues.

Pre-publication support from major players

Katsuyama’s stock exchange is based on the concept that HFT firms are not provided special advantages.  After launching the IEX exchange, Katsuyama and his team spoke to major HFT firms to clue them in to what they were doing and how their technical configuration would level the playing field.  The HFT firms never said their solution wouldn’t work, but rather asked if they could be given preferred treatment through a “back door” to access the exchange.

The IEX exchange has received early support from some powerful quarters.  Goldman Sachs, for instance, issued an e-mail to employees that was leaked to the press that expressed support for the exchange and invested in the start up as well.  This might be surprising given that the influential investment bank owns one of the largest “dark pool” exchanges that competes with IEX.

Goldman is not alone.  David Einhorn, who operates major activist investing hedge fund Greenlight Capital, also an exchange investor, was quoted as saying in the piece that IEX is “going to succeed in a very big way.”

As previously reported in ValueWalk, before the book release and 60 Minutes piece, Goldman Sach Chief Operating Officer Gary Cohen wrote an opinion piece in the Wall Street Journal that now looks like a direct response to the problems raised in Flash Boys.  In the piece he called on exchanges to change their profit motive and proposed a radical “transaction fee” on exchange transactions that had been vigorously opposed by the financial lobby, among other radical proposals.

In advance of the anticipated uproar the book and 60 Minutes interview would receive, informed speculation is regulatory and justice officials are standing at the ready to push changes – depending on the public outcry and power exerted by the major hedge fund and banking forces that typically lobby Congress and regulators.  In a tweet one day in advance of the 60 Minutes interview, Fox Business reporter Charlie Gasparino noted that HFT could be the next law enforcement target, based on a conversation with a senior prosecutor in the southern district of New York, the legal jurisdiction that handles most Wall Street crime cases.  Expect to see changes as powerful players line up.  The New York Stock Exchange has recently shaken up its technology department in what is said to be an unrelated issue, but sources note that in the coming months a number of moves to appear on the “right side” of the HFT issue will occur.