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Brad Katsuyama talks high-frequency trading and IEX at the GSB

Brad Katsuyama doesn’t fit into the stereotype of Wall Street pervaded by the media.

“Movies like ‘[The] Wolf of Wall Street’ piss me off, because they give Wall Street a bad name. The people who watch a movie like Wolf of Wall Street and want to work on Wall Street are exactly the kind of people who shouldn’t,” he explained.

Brad Katsuyama, CEO and co-founder of IEX, an Alternative Trading System (ATS), gave a talk at the Graduate School of Business (GSB) this past Monday, Feb. 23. Katsuyama was profiled in Michael Lewis’ well-received book “Flash Boys.” IEX became well-known for being the the first equity pool owned exclusively by buy-side investors and is dedicated to institutionalizing fairness in the markets.

At his talk, Katsuyama focused on the importance of having integrity in a business that is transaction-oriented.

“I’m a capitalist,” he emphasized. “We want to make money, but we [IEX] want to make money doing the right things. I care very deeply about the function it serves in the economy.”

Integrity is, in fact, the very thing that drove him to create IEX in the first place. In 2007, Katsuyama was running U.S. trading and managing risk for the Royal Bank of Canada (RBC) when the Regulation National Market System (NMS) was promulgated by the United States Securities and Exchange Commission. Regulation NMS, which, in essence, ties the multiple stock exchanges together to comprise the entire market, came into play.

While Katsuyama was trading tech stocks on behalf of mutual funds, hedge funds or banks on capital, if he put in an order for 100,000 shares of Intel, he could only get 80,000 shares. In 2008, it decreased to 65,000 shares – in 2009, 48,000 shares. Katsuyama noticed that he was consistently unable to get the full order of shares that he intended to purchase.

“This actually drove me crazy for two whole years,” laughed Katsuyama. “People think I’m some renegade or crusade who was fighting this, but it was a long process and didn’t become clear until I joined the technology team in 2009.”

In 2009, Katsuyama left his team of traders at RBC to manage a group of technologists who were building the tools that traders used. It was at this point that he understood the discrepancies between what he perceived as the market and what he could access.

“That’s when I realized the market I saw on screens and the market I thought I knew wasn’t the real market,” he explained. “The market is a collection of multiple markets, but the issue was that they were all at different locations.”

He explained his point using the example of a simple purchase of 100,000 equity shares.

“Say I wanted to buy 100,000 shares,” he started.

“I’d send the order to a piece of technology that would take 4 orders and blast it out to the market, and it would arrive at BATS, the first and closest exchange; then Direct Edge; then NASDAQ; and finally NYSE. The orders were sent at the same time, but there was a two-millisecond difference in arrival time between the first and last exchange,” Katsuyama said.

One of Katsuyama’s technology team members built infrastructure for high frequency trading firms and explained to him that it only took 476 microseconds to get from the first to the last exchange. Katsuyama was also able to see that exchanges were selling technology and data that allowed high frequency traders to race the big banks and buy ahead of their purchases. By sending his orders to NYSE first, Katsuyama discovered that his fill rate went back up to 100 percent – essentially he could purchase all the shares he wanted. But Katsuyama also realized that he couldn’t have been the first to discover this.

“It dawned on me that everyone else who knows this problem exists is part of the problem. The others weren’t trying to solve it – they exploited it and perpetuated it,” Katsuyama said. “I don’t blame them. You can’t fault for people for competitively doing what their competitors are doing.”

He does, however, place the blame on the exchanges.

“The national stock exchanges are selling the data and technology and have created multibillion dollar businesses out of this,” Katsuyama said. “It’s a problem if you trade on information that other people don’t have.”

So Katsuyama and his team set out to change the system.

“IEX creates a delay of 350 microseconds to even the playing field, forgoing hundreds of millions of dollars of revenue that other exchanges gain by selling technology or data,” Katsuyama explained.

“We spent 18 months building this exchange, and on Oct. 24, 2013, the night before we launched, we had no idea what was going to happen the next day,” he added. “We knew that in order for IEX to be a success, one of the big banks needed to buy in that we are the future.”

Today, Goldman Sachs is their number one client.

“We’re a market-based solution that gives people an option to act properly,” Katsuyama said. “It’s about giving people a rational choice that’s in the best interest of the market and their clients, and Goldman – which many people find ironic – took that option. We’re making a bet on people, not on a corporation or brand.”

He ended his talk with a comment about the future, especially in the context of all the business students in the room.

“Wall Street is going through this disruption, and it’s a great opportunity for all of you,” Katsuyama said. “The entrenched businesses are the hardest to break in, but when shit’s going on all over the place, it’s a great time to be young, ambitious and curious.”

 

Contact Jenny Lu at jenny123 ‘at’ stanford.edu.

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