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He’s the CEO of IEX, a new stock exchange that is set apart from established players like the NASDAQ and the New York Stock Exchange by a speed bump.
At RBC, Katsuyama figured out that high-frequency traders were skimming billions off the market, using light-speed Internet connections to the big exchanges to outrace buyers and sellers and tilt the market in their own favour.
That’s why, at IEX, everyone trades at the same speed. Every order goes through a 38-mile coil of fibre-optic cable, which adds enough of a delay—though still measured in millionths of a second—to limit the worst aspects of computerized front-running while still allowing orders to flow.
Katsuyama’s mission to uncover the worst of conflicted exchange practices and high-frequency trading was detailed in Michael Lewis’s 2014 bestseller, Flash Boys. Since then, IEX has fought for and won approval from the Securities and Exchange Commission to operate as a full exchange.
Katsuyama spoke at two RBC events this month about the challenges of disrupting an unfair market, how outsiders and insiders can work for change, dealing with regulators, and why education is his most powerful sales pitch. Here are some of the highlights.
The Incumbent as Obstacle
Stock exchanges are private, for-profit companies, and it’s in their interests to make money by offering preferential access to high-frequency traders and anyone else who wants to pay for it.
Some traders use this access to get an advantage, sniffing out big orders and racing to buy up the available stocks before the original order can be completed. This all happens in microseconds, far beyond the ability of any humans to react. But for computers, such a task is trivial.
Katsuyama, who worked as a summer intern at RBC and graduated from Wilfrid Laurier University, recognized there was a problem while working on the RBC trading desk in New York in the mid-2000s.
If he tried to buy a big chunk of stock, the order would only be partially fulfilled before the price moved higher. After years of investigation, he realized high-frequency traders were using their high-speed technology to outrun his order and then try to sell the stocks back to him at a higher price. What’s more, not only were the exchanges unable to do anything about it, they were enabling the gaming —after all, those same high-frequency traders were paying millions to fulfill their need for speed.
Katsuyama worked with a small group at RBC to create THOR, an order-routing system that allowed buyers to stay ahead of the front-runners. He left the bank in 2012 to found IEX.
“We thought, ‘Why not start a stock exchange that doesn’t sell these advantages?'” he said.
Katsuyama left the bank in 2012 to pursue the idea, and IEX—and its speed bump—were born.
“For us, the speed bump was about saying let’s put as many people on a level playing field as possible,” he said.
The Insider as Disruptor
Disruption is usually seen as an external force, where outsiders bring in new ideas that can destabilize an established industry. Yet Katsuyama said an insider’s knowledge is key to the process.
Steve Jobs wasn’t new to consumer technology when he created the iPhone. One Netflix founder was a veteran software entrepreneur; the other had extensive experience in mail-order sales. Jeff Bezos worked on Internet businesses, including international financial transactions and online consumer services, before founding Amazon.com.
“You have to have experienced the problem that you’re trying to solve,” Katsuyama said. “That experience will guide you through times of turbulence and self-doubt.”
Katsuyama shies away from calling the market rigged. But he said it gives an unfair advantage to the high-frequency traders who front-run other investors.
“If you’re invested in a pension fund or mutual fund, there’s a multi-billion-dollar skim,” he said. “It’s a diffuse harm with a concentrated benefit.”
Only someone with an insider’s knowledge, he said, could have discovered the problem in the first place.
“Finance is going to be disrupted by people working in finance,” Katsuyama said.
The Regulator as Ally
When it comes to disruption, regulators can often be an incumbent’s best friend.
“Regulation makes it harder to disrupt,” Katsuyama said. “It actually benefits those who are being regulated.”
Nobody knows the complex regulatory structure of equities trading better than those who are being regulated, and they can use that as a competitive advantage to keep out new entrants stymied by the thicket of rules and requirements.
IEX began operating as an alternative trading system in 2014, and applied to the SEC to operate as an exchange soon after.
Katsuyama said the SEC received more comments on the IEX application than all the comments on all previous stock exchange applications in the history of the regulator.
The big exchanges fought hard against the application, with the head of the company that owns the NYSE calling IEX “un-American.” Members of the public also chimed in, supporting IEX and the idea of a level playing field.
One reason: Flash Boys had made Katsuyama a celebrity in the trading world. He said he participated in the book because he knew Lewis would do the story justice and bring the story of an unfair market to a much wider audience.
IEX received its certification in June 2016, and its first trading day was Sept. 2.
The Customer as Challenge
Katsuyama’s sales pitch for IEX isn’t much of a pitch. He tells CEOs how the market operates and how traders can front-run buyers. And after an hour-long meeting, he said, he’s often asked back.
Executives are often completely in the dark about the modern world of trading, he said, where always-on computers, dark pools and private exchanges have created a complex and interconnected market that is mostly invisible.
“It’s not a sales pitch, it’s about saying here’s what’s going on,” he said. “I meet corporate CEOs all the time who don’t know that 85 per cent of their stock doesn’t trade on the New York Stock Exchange.”
Front-running by high-frequency traders takes a tiny bit off a transaction. With billions of transactions on the market every day, those tiny bits add up to a huge sum—one that Katsuyama says is a tax on every listed company.
“People shouldn’t have to be experts in the stock market to have a belief that the stock market is fair, that it’s designed in their interests,” he said. “Our hope is to return that trust back to the market.”
The Business Plan as Principle
Restoring trust in the market is clearly more than a business proposal for Katsuyama. He said IEX has fielded buyout offers, but selling the company simply to cash out would violate his principles.
That’s not to say he’s not a capitalist, though.
“For us it’s more about the mission than it is anything, but we’re not going to shy away from the fact that we think there’s an opportunity here,” he said.
That was one of Katsuyama’s arguments to the SEC: that instead of regulatory action against predatory high-frequency trading, IEX represented a free-market solution to the problem.
Katsuyama noted that even before it opened the doors on its exchange, the company had already been in the black for more than a year.
Building a successful startup is a monumental task, to say nothing of challenging the basic assumptions of your industry and taking on powerful incumbents. Katsuyama said his belief in the principle of fair trading kept him going in the face of opposition.
“A lot of powerful people don’t like me,” he said. “When you’re faced with that kind of controversy, I just keep going back to ‘I know this problem exists. I faced it as a trader. And that gives me the resolve to keep battling.'”
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