Unformatted text preview: ALSO BY SCOTT PATTERSON
How a New Breed of Math Whizzes Conquered
Wall Street and Nearly Destroyed It Copyright © 2012 by Scott Patterson
All rights reserved. Published in the United States by Crown Business, an imprint of the Crown Publishing Group, a division of
Random House, Inc., New York.
CROWN BUSINESS is a trademark and CROWN and the Rising Sun colophon are registered trademarks of
Random House, Inc. Library of Congress Cataloging-in-Publication Data Patterson, Scott, 1969–. Dark pools : high-speed traders, AI bandits, and the threat to the global financial system / by Scott
Patterson. — 1st ed. p. cm. 1. Electronic trading of securities. 2. Online stockbrokers. I. Title. HG4515.95.P284 2012 332.640973—dc23 2012003096
Jacket design by Laura Duffy Jacket photography: (swirl) Design Pics/Ryan Briscall;
(numbers) Mark Segal
v3.1 For Eleanor Had there been full disclosure of what was being done in furtherance of these schemes, they could not
long have survived the fierce light of publicity and criticism. Legal chicanery and pitch darkness were
the banker’s stoutest allies. —FERDINAND PECORA CONTENTS Cover
Other Books by This Author
PROLOGUE: LIGHT POOL PART I: MACHINE V. MACHINE
1: TRADING MACHINES
2: THE SIZE GAME
3: ALGO WARS
4: O+ PART II: BIRTH OF THE MACHINE
6: THE WATCHER
7: MONSTER KEY
8: THE ISLAND
9: THE GREEN MACHINE
11: EVERYONE CARES
12: PALACE COUP
13: BAD PENNIES
14: DUMB MONEY
15: TRADE BOTS 16: CRAZY NUMBERS
17: “I DO NOT WANT TO BE A FAMOUS PERSON” PART III: TRIUMPH OF THE MACHINE
18: THE BEAST
19: THE PLATFORM
20: PANIC TICKS
21: VERY DANGEROUS PART IV: FUTURE OF THE MACHINE
22: A RIGGED GAME
23: THE BIG DATA
24: ADVANCED CHESS
About the Author PROLOGUE LIGHT POOL L oudspeakers boomed Eminem’s hit single “Without Me” as Dan Mathisson stepped onto a low-slung dais in the Glitter Room of Miami Beach’s exclusive
Fontainebleau Hotel. Greeting Mathisson: the applause of hundreds of hedge fund
managers, electronic traders, and computer programmers, the driving force
behind a digital revolution that had radically transformed the United States stock
market. They had descended on the Fontainebleau for the annual Credit Suisse
Equity Trading Forum to rub elbows, play golf, swap rumors, and bask in the
faded glory of the hotel where stars such as Frank Sinatra, Elvis Presley, and
Marlene Dietrich had once sipped cocktails and lounged in private poolside
Smartly clad in a light blue cotton shirt and charcoal-gray suit, sans tie, a soft
pink Credit Suisse logo illuminated on the wall behind him, Mathisson was
pumped. He loved the Miami Beach conference. Over the years, it had become
the Woodstock of electronic trading. Closed to the press, the March 10, 2011,
gathering was a private congress of wealthy market wonks who’d created a
fantastic Blade Runner trading world few outsiders could imagine, a worldwide
matrix of dazzlingly complex algorithms, interlinked computer hubs the size of
football fields, and high-octane trading robots guided by the latest advances in
Mathisson was an alpha male of the electronic pack. In another life, the
bespectacled five-seven onetime trader would have been teaching students
quantum physics or working for Mission Control at NASA. Instead, starting in
2001, he’d devoted himself to building a space-age trading platform for Credit
Suisse called Advanced Electronic Systems. He was an elite market Plumber, an
architect not of trading strategies or moneymaking schemes but of the pipes
connecting the various pieces of the market and forming a massive computerized
Plumbers such as Mathisson had become incredibly powerful in recent years.
Knowledge of the blueprints behind the market’s plumbing had become
extremely valuable, worth hundreds of millions of dollars to those in the know.
The reason: A new breed of trader had emerged who focused on gaming the plumbing itself, exploiting complex loopholes and quirks inside the blueprints
like card counters ferreting out weaknesses in a blackjack dealer’s hand.
Mathisson was keenly aware of this. Since launching AES, he’d been a firsthand
witness of the powerful computer-driven forces that had irrevocably altered the
face of the stock market. He’d created AES’s original matching engine—the
computer system that matched buy and sell orders—which by early 2011
accounted for a whopping 14 percent of U.S. stock-trading volume, nearly one
billion shares a day. He was the brains behind Guerilla, the first mass-marketed
robot-trading algorithm that could deftly buy and sell stocks in ways that evaded
the detection of other algos, a lethal weapon in the outbreak of what became
known as the Algo Wars.
Operating in forty countries across six continents, AES was a moneymaking
machine. In 2008, a year when most of Wall Street was single-mindedly engaged
in the act of self-destructing, AES had pulled in about $800 million, making it the
most profitable arm of Credit Suisse. That number—that $800 million—was just
one reason among many why Mathisson’s words on that Miami Beach stage
meant serious business.
But while the Miami confabs had always been about business, they were also
about celebrating, and they typically involved a conga line of cocktail parties,
pool parties, and dance clubs. In years past, after the day’s long string of speeches
and presentations, Mathisson’s right-hand man, a charismatic, larger-than-life
sales machine named Manny Santayana, would troll the local clubs, pick out the
best-looking local girls, and tell them about the real party packed with
millionaire traders looking for a good time.
Santayana always joked that he never threw parties. He threw networking events
at a socially accelerated pace. Santayana was king of the socially accelerated pace.
He ran poker tournaments for traders in the exclusive Grand Havana Room in
Manhattan, dinners for bankers at the Versace Mansion in Miami Beach. All year
long, there were networking events at a socially accelerated pace around the
world—in Tokyo, Singapore, Zurich, London, Oslo, Paris, Hong Kong.
But an iron rule on Wall Street is that every party leads to the inevitable
hangover. As Mathisson looked out over the audience, he knew Santayana
wouldn’t be trolling clubs for bleach-blond babes this year. A freakish stock
market crash on May 6, 2010—the so-called Flash Crash—had revealed that the
computer-driven market was far more dangerous than anyone had realized.
Regulators were angry, fund managers furious. Something had gone dramatically
wrong. Senators were banging down Mathisson’s door wanting to know what the
hell was going on. A harsh light was shining on an industry that had grown in the
Mathisson was ready to confront the attack. He hit a button on the remote for
his PowerPoint presentation. A graph appeared. A jagged line took a cliff-like plunge followed by a sharp vertical leap. It looked like a tilted V, the far righthand side just lower than the left.
“There’s the Flash Crash,” he said. “We all remember that day, of course.”
The chart showed the Dow Jones Industrial Average, which took an eighthundred-point swan dive in a matter of minutes on May 6 due to glitches deep in
the plumbing of the nation’s computer-trading systems—the very systems built
and run by many of the people sitting in the Glitter Room.
The audience stirred. The Flash Crash was a downer, and they were restless. It
was going to be a long day full of presentations. Later that night, they’d be
treated to a speech by the Right Honorable Gordon Brown, former prime minister
of the United Kingdom. Ex–Clinton aide James Carville would address the group
the following morning. (It was nothing unusual. Past keynote speakers at the
conference had included luminaries such as former Federal Reserve chairman
Alan Greenspan, former secretary of state Colin Powell, and the onetime junkbond king Michael Milken.)
Mathisson hit the button, calling up a chart showing that cash had flowed out
of mutual funds every single month through 2010, following the Flash Crash.
Legions of regular investors had become fed up, convinced the market had
become either far too dangerous to entrust with their retirement savings, or just
outright rigged to the benefit of an elite technorati.
“This is pretty damning,” Mathisson said soberly, noting that the outflows
continued even as the market surged higher later in the year. “Even with a
historic rally, mutual fund outflows continued through December. This is cause
for concern in the U.S.”
Mathisson hit the button.
A grainy photo of President Barack Obama appeared, along with his notorious
quote from a December 2009 episode of 60 Minutes: “I did not run for office to be
helping out a bunch of fat cat bankers on Wall Street.”
Mathisson’s point was clear: The feds are going to come down on this industry
like a sledgehammer if we don’t fix the system from within, fast. “We have to do
something,” he said.
The heart of the problem, Mathisson explained, was that fast-moving robot
trading machines were front-running long-term investors on exchanges such as
the New York Stock Exchange and the Nasdaq Stock Market. For instance, if
Fidelity wanted to buy a million shares of IBM, the Bots could detect the order
and start buying IBM themselves, in the process driving up the price and making
IBM more expensive. If Fidelity wanted to sell a million shares of IBM, the Bots
would also sell, pushing the price down and causing Fidelity to sell on the cheap.
To escape, the victims of the front running were turning to dark pools. “Why are people choosing to send orders to dark pools instead of the displayed
markets?” Mathisson asked his audience. “They’re choosing dark pools because of
a problem in the lit markets.”
A controversial force in the market in the 2000s, dark pools were private
markets hidden from investors who traded on the “lit” pools such as the NYSE
and Nasdaq (in the industry, any venue where trading takes place, including an
exchange, is known as a pool). Large traders used dark pools like a cloaking
device in their efforts to hide from robo algos programmed to ruthlessly hunt
down their intentions like single-minded Terminators on exchanges. But unlike
exchanges, dark pools were virtually unregulated. And the blueprints for how
they worked were a closely guarded secret. As such, there were highly paid
people on Wall Street, often sporting Ph.D.s in fields such as quantum physics
and electrical engineering, who did nothing all day long but try to divine those
secrets and ruthlessly exploit them.
The new wave of dark pools epitomized a driving force in finance as old as
time: secrecy. In part a solution to a problem, they were also the symptom of a
disease. The lit market had become a playground for highly sophisticated traders
—many of the very traders sitting in Mathisson’s audience—who’d designed and
deployed the robo algos that hacked the market’s plumbing.
Sadly, the exchanges had helped make all of this possible. They provided to the
high-speed trading firms expensive, data-rich feeds that broadcast terabytes of
information about specific buy and sell orders from giant mutual funds to the Bot
algos. So much information that it could be used to engage in the hit-and-run
tactics regulators, fund managers, and senators were screaming about. This was
all playing out every day, every nanosecond, in the lit markets—a frenzied dance
of predator and prey, with Mathisson’s peers playing the part of the swarming
piranha. Every single investor in the United States was involved—and at risk.
Mathisson was all too aware of this dynamic. Indeed, in 2004, he’d created a
dark pool of his own called Crossfinder. It was so successful that it had gone on
to become the largest dark pool in the world. By 2011, roughly 10 to 15 percent
of all trading took place in dark pools, and Crossfinder accounted for a significant
chunk of that volume.
Why? The exchanges had gotten in bed with the Bots. Now investors were fed
up, Mathisson argued.
“The policies of today’s exchanges cater to the needs of high-volume, shortterm opportunistic traders,” he said. “The pick-off artists.”
The audience visibly tensed.
To an outsider, Mathisson’s statement would have seemed relatively innocuous.
To the insiders—those sitting in the room—it was a shocker. It was an outrage. It
wasn’t what Mathisson said. Others had been attacking the speed Bots. What was shocking was that Dan Mathisson was saying it. Mathisson, one of the architects of
the electronic system itself, one of the elite Plumbers—he was trashing it.
Mathisson knew what he was talking about. Because the dirty little secret of
most dark pools was that they relied on those very same pick-off traders he was
trashing. Indeed, they’d been AES’s bread and butter for years. In Wall Street
parlance, the Bots helped provide the liquidity behind the massive AES pool, the
rivers of buy and sell orders the turtle-slow average traders—the mutual funds,
the pension funds—relied on when they wanted to buy or sell a stock.
While Credit Suisse monitored Crossfinder for manipulative Bot behavior, it
still depended on the Bots’ steady flow. Mathisson’s promise to clients running
away from the Bots in the lit pools was that over-the-top hit-and-run gaming
activity would be kept to a minimum. Egregious violators were kicked out of the
pool. But there was little he could do to entirely stop it.
In short, the dark pools themselves were swarming with predator algos. The
dynamic spoke to how powerful the Bots had become.
And there was no place to hide.
Mathisson’s kind of straight talk was not heard on Wall Street unless something
very troubling was going on behind the scenes. He knew that regulators were
zeroing in on the industry. He wanted to be ready.
Mathisson laid out his case. Before electronic trading came along in the 1990s,
most markets operated on a floor. Market makers—the people who buy and sell
all day long on behalf of investors, collecting a small slice of the deal for their
troubles—were able to sense which way the market was going simply by looking
around them, staring into the nervous eyes of another trader, watching a
competitor frantically rush into a pit and start selling—or buying. General Electric
is in trouble. IBM is about to surge.
With electronic trading, a placeless, faceless, postmodern cyber-market in
which computers communicated at warpspeeds, that physical sense of the
market’s flow had vanished. The market gained new eyes—electronic eyes.
Computer programmers designed hunter-seeker algorithms that could detect, like
radar, which way the market was going.
The big game in this hunt became known as a whale—an order from a
leviathan fund company such as Fidelity, Vanguard, or Legg Mason. If the algos
could detect the whales, they could then have a very good sense for whether a
stock was going to rise or fall in the next few minutes or even seconds. They
could either trade ahead of it or get out of its way. The bottom line: Mom and
Pop’s retirement accounts were full of mutual funds handing over billions of
dollars a year to the Bots.
Dark pools like Crossfinder had (for a while at least) evened the game in the Algo Wars, giving traditional investors a place to hide. But the evidence was now
all too clear: The Bots in their relentless quest for the whales had thoroughly
infiltrated the dark pools. And it was all cloaked in the darkness of a market
mired in complexity and electronic smoke screens.
Mathisson, for his part, had decided to fight back. To beat the speed traders at
their own game, in 2009 he’d launched a turbocharged trading algorithm called
Blast. Blast pounded its fleet-footed high-speed opponents with simultaneous buy
and sell orders like a machine gun. The firepower of Blast was so overwhelming
that it forced high-speed traders—who controlled upwards of 70 percent or more
of all stock-market volume by the late 2000s—to cut bait and run for cover.
Blast was effective. But Mathisson needed more. Now Mathisson had a new
weapon in his arsenal. He wasn’t attacking the very firms that had been AES’s
meal ticket for nothing. He had an angle: yet another extraordinary machine.
He called it Light Pool.
Light Pool would weed out the “opportunistic” traders, he told the audience.
Using metrics that could detect the pick-off artists, Light Pool would provide a
clean market where natural traders—investors who actually wanted to buy a
stock and hold it for longer than two seconds—could meet and do business. The
information about buy and sell orders inside Light Pool wouldn’t be distributed
through a private feed. It would go directly to the consolidated tape that all
investors could see, not just the turbo traders who paid for the high-bandwidth
feeds from the exchanges.
“All those sleazy hidden order types won’t be there,” Mathisson said. “We’ll
create criteria like ‘Are you a pick-off artist?’ This is effectively going to eliminate
the pick-off flow. We’re going to be transparent.”
Mathisson looked meaningfully at the audience—packed with the very pick-off
artists he was attacking—and said something he knew would get their attention.
“There will be no black box.”
MATHISSON knew, of course, that he was fighting against time, and he secretly
worried that there was nothing he could do to close the Pandora’s box that had
been opened in the past decade. The Plumbers had always believed that a
problem with the machine could be fixed with a better machine.
But what if the problem wasn’t inside the machine? What if it was the all-toohuman arms race itself, a race that had gripped the market and launched it on an
unstoppable and completely unpredictable path? Because with inscrutable algos
blasting away across high-speed electronic networks around the world, with
trading venues splintering into dozens of pieces, with secretive trading firms
spreading their tentacles across the globe, the entire market had descended into
one vast pool of darkness. It wasn’t only the everyday investors who were in the dark—even the architects of the system itself, the Plumbers, were losing the
ability to keep track of the manic activity.
And as trading grew more frenetic and managed by mindless robots, a new risk
had emerged. Insiders were slowly realizing that the push-button turbo-trading
market in which algos battled algos inside massive data centers and dark pools at
speeds measured in billionths of a second had a fatal flaw. The hunter-seeker Bots
that controlled trading came equipped with sensors designed to detect rapid,
volatile swings in prices. When the swings passed a certain threshold—say, a
downturn of 5 percent in five minutes—the algorithms would instantly sell, shut
down, and wait for the market to stabilize. The trouble was that when a large
number of algorithms sold and shut down, the market became more volatile,
triggering more selling.
In other words, a vicious self-reinforcing feedback loop.
The Flash Crash had proven this wasn’t merely a fanciful nightmare scenario
bandied about by apocalyptic market Luddites. The question tormenting experts
was how far the loop would go next time. Progress Software, a firm that tracks
algorithmic trading, predicted that a financial institution would lose one billion
dollars or more in 2012 when a rogue algorithm went “into an infinite
loop … which cannot be shut down.”
And since the computer programs were now linked across markets—stock
trades were synced to currencies and commodities and futures and bonds—and
since many of the programs were very similar and were massively leveraged, the
fear haunting the minds of the Plumbers was that the entire system could snap like
a brittle twig in a matter of minutes. A chaotic butterfly effect could erase
everyone’s hard-earned savings in an eyeblink and, for kicks, throw the global
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