Canadian says ‘moral compass’ led him to solve unfair gaming of stock markets by high-frequency traders; the modest Mr. Katsuyama is being heralded as the hero in the new book Flash Boys: a Wall Street Revolt

Canadian says ‘moral compass’ led him to solve unfair gaming of stock markets by high-frequency traders

Armina Ligaya | March 31, 2014 | Last Updated: Mar 31 10:22 PM ET
Even though Canadian trader Brad Katsuyama had found the elusive answers to a question that baffled even the most powerful Wall Street investors, he had a tough time, at first, even getting a meeting in the executive offices of one of the top financial firms in the United States.

The Markham, Ont.-native worked in the Manhattan offices of the Royal Bank of Canada, a bit player in Wall Street eyes, and was armed with a degree from Wilfrid Laurier University, not an ivy-league pedigree school.

But after a few minutes with Mr. Katsuyama, it was clear he had cracked the code of the next frontier of finance: how some high-frequency trading firms game the stock-market system to skim profits in a fraction of the time it would take to blink an eye, and how his software could get around this.

“I think at first, when I walk into the office, I’m not impressing anyone, right?” said Mr. Katsuyama, in a phone interview from New York. “But after five minutes of talking, I think I had their attention. It is kind of nice that it had more to do with what I was saying and not what I looked like.”

Now, the modest Mr. Katsuyama is being heralded as the hero in the new book Flash Boys: a Wall Street Revolt, a look at the controversial high-frequency trading industry, by Michael Lewis, of The Big Short and Moneyball fame.

In the book, released Monday, Mr. Lewis praises Mr. Katsuyama — “a Canadian, of all things” — as the figure at the centre, who gathered a rag-tag team of experts to shine a light on the inner workings of the high-speed financial trading industry.

“His willingness to throw open a window on the American financial world, and to show people what it has become, still takes my breath away,” Mr. Lewis wrote.

Since 2007, the realm where stock trades are made no longer resembles the iconic image of a packed trading floor full of screaming alpha males. Thanks to new technologies, shares change virtual hands via lightning-fast electrical impulses over fiber optic wires stored in bulky servers.

With high-frequency trading, algorithms are used to read market activity and buy and sell securities in fractions of seconds. Some say this brave new financial world may have resulted in benefits for the market, such as greater liquidity and lower costs.

Critics argue it has created an uneven playing field in which the fastest machines and least-regulated players can disrupt trading in order to squeeze profits from tiny differences in prices across markets.

On Monday, the Federal Bureau of Investigation said it was probing whether high-frequency trading firms violate U.S. laws by acting on non-public information to gain an edge over competitors.

It was in 2007 that Mr. Katsuyama began seeing strange trading activities in his role at RBC in New York. He noticed that by the time he hit enter to make a purchase in a trade, some of the available shares had already disappeared. He was only able, on average, to buy about half of what he intended to buy before the price on offer had jumped.

“It was just absurd that the quotes on my screen didn’t represent what I could buy and sell,” he said.

After determining that the problem was widespread, Mr, Katsuyama hired an eclectic team that eventually found the culprit.

They discovered that when a trade is sent electronically to exchanges, it wasn’t reaching them at the same time. The milliseconds of difference between the time a trade reached one exchange and another was enough for a high-frequency trader to zip in, buy up the stock at the lower price and sell it at the other exchange for a higher price.

Mr. Katsuyama used this discovery to develop THOR, a software that slowed the process by staggering the trades so they would reach each of the exchanges at relatively the same time. THOR was deployed in 2010, and patented in the U.S. last year.

The move to share this with clients, rather than use the information to RBC’s advantage, was a “moral decision,” he said.

Mr. Katsuyama, along with other former RBC traders, went on to launch IEX Group Inc., a balanced exchange with built-in mechanisms to deter high-frequency traders looking to manipulate the system, he said.

‘It was just absurd that the quotes on my screen didn’t represent what I could buy and sell’

Since IEX launched, on October 25, its trading volumes have grown from a few million trades to 40 million shares a day, said Mr. Katsuyama.

“Certain high frequency firms are trading on our platform, but a number aren’t,” he said. “And they told us they can’t trade on our market, which gives us a lot of confidence that we built something that works.”

Mr. Katsuyama, who lives in New York with his wife Ashley and his two sons, Brandon and Rylan, is quick to say he isn’t the first one to realize the factors at play in high-frequency trading.

But he decided to do something about it because of the “moral compass” at RBC. A Canadian niceness played a role too.

“I think Canadians in general are practical, and rational, ” he said. “And that’s probably a gross stereotype, but it helped ground me.”