- September 18, 2012, 10:31 p.m. ET
For Superfast Stock Traders, a Way to Jump Ahead in Line
By SCOTT PATTERSON and JENNY STRASBURG
Mr. Bodek approached the Securities and Exchange Commission last year alleging that stock exchanges, in a race for more revenue, had worked with rapid-fire trading firms to give them an unfair edge over everyday investors.
He became convinced exchanges were providing such an edge after he says he was offered one himself when he ran a high-speed trading firm—a way to place orders that can be filled ahead of others placed earlier. The key: a kind of order called “Hide Not Slide.”
The encounter set off an odyssey for Mr. Bodek that has fueled a sweeping SEC inquiry into the activities of sophisticated trading firms and stock-exchange operators—including Nasdaq OMX Group Inc., NYSE Euronext, Direct Edge Holdings LLC and BATS Global Markets—according to exchange and other officials, and lawyers with knowledge of the inquiry.
At issue is whether exchanges sometimes allow high-speed trading firms to trade ahead of less-sophisticated investors, potentially disadvantaging them and violating regulatory rules. The inclusion of Nasdaq and NYSE in this high-profile probe, and the role Mr. Bodek has played in it, haven’t previously been reported.
High-frequency traders use computer algorithms to place blizzards of buy and sell orders—many of which they instantly cancel—in an effort to detect and exploit the tiniest shifts in demand for stocks.
This kind of trading now generates some two-thirds of all share volume on U.S. markets. Critics worry that the flood of orders driven not by investors evaluating stocks but simply by computers makes markets increasingly vulnerable to incidents like the May 2010 “flash crash,” when stocks plunged hundreds of points for no evident reason, and this summer’s mess at Knight Capital Group Inc., when a trade-coding problem caused a $440 million loss for the brokerage firm.
The upshot, say critics, is a stock market grown so complex and opaque that many investors have little idea how it operates, and are made wary by the repeated glitches. Any notion that the computer-armed traders are being given an unfair edge could only heighten investor concerns. Just last week, the SEC fined NYSE Euronext for providing data slightly faster to certain traders than to a public database, in allegations the NYSE settled without admitting or denying them.
The ongoing probe comes at a sensitive time for Nasdaq, which has acknowledged that technical problems bungled the Facebook Inc. initial public offering in May. The sloppy IPO appears to have worsened a continuing exodus of cash from stock mutual funds. Representatives of Nasdaq and the other stock exchanges all declined to comment on the inquiry.
Exchange officials don’t deny making available certain advantages, like data feeds with detailed information about trades, that the high-frequency traders can use. The exchanges’ position is that these are fully disclosed; they can be used by anyone with the right hardware and technical savvy; and they ultimately benefit all investors because by pulling in a higher volume of orders, they make it possible to buy and sell more easily and at better prices.
Many high-frequency trading firms similarly say that their activity in constantly buying stocks from investors who want to sell, and selling to investors who want to buy, helps keep the markets running smoothly. But it involves risk, and advantages such as detailed streams of trade data help compensate them for the risk, the firms and the stock exchanges say.
In papers filed with the SEC, Mr. Bodek took aim not at the data streams but at the way orders from high-frequency traders work. He focused on “order types”—programmed commands traders use to tell exchanges how to handle their bids and their offers to sell.
Hundreds of order-type options are available, which translate to thousands of variations because they behave differently depending on how an investor’s trading programs are coded. One thing investigators want to know is whether stock exchanges have worked with programmers or officials at high-speed trading firms to create order types that, when used with certain trading algorithms, can be unfair to less-savvy investors, people familiar with the probe say.
Looking closely at order types “is the first step for regulators to understand the fundamental interactions in the marketplace, which have literally gone unchecked and untested” in recent years, says Christopher Nagy, a consultant who formerly handled the routing of orders for brokerage firm TD Ameritrade Holding Corp., which serves individual investors.
A stock exchange that wants to offer a new order type must get it approved by the SEC, in a process that entails public notice and comment. That makes the probe tricky, because the SEC is examining the effects of procedures the agency itself approved. Among questions the regulators want to answer is whether exchanges have at times misled them in seeking approval for certain order types or mischaracterized to investors how the orders work, those familiar with the probe say.
A spokesman for the SEC said its staff “is in daily contact with market participants on a variety of market structure issues, including new ways exchange order types may be used by sophisticated firms in their evolving trading strategies. If the staff discovers that exchange order types are being used in ways that present concerns under the Exchange Act, it will develop an appropriate regulatory response or recommend enforcement action, as warranted.”
The spokesman didn’t comment on Mr. Bodek’s involvement in its inquiry. Mr. Bodek could gain from passing along information. The issues he raised were taken up by the SEC under a new whistleblower program that became effective last year. If the SEC were to collect a fine in an enforcement case growing out of the inquiry—there aren’t any cases at this point—Mr. Bodek might snare up to 30% of it.
A lawyer for Mr. Bodek described him as a Wall Street veteran who is “sounding an alarm.” Investors, said the lawyer, Shayne Stevenson of Seattle law firm Hagens Berman LLP, “needed to know the allegations he was bringing forward.”
Mr. Bodek’s career has tracked the rise of computer trading on Wall Street. Now 41, he began in the late 1990s creating programs to trade options—contracts that provide the right to buy or sell a stock for a certain price within a certain time.
He first worked with a sophisticated operation in Chicago called Hull Group. Goldman Sachs Group Inc. bought Hull in 1999, and Mr. Bodek worked at Goldman until 2002, when he helped launch a technology company. He later helped run a global options-trading desk at Swiss bank UBS AG. In 2007, with a partner, he started a high-frequency trading firm called Trading Machines LLC.
His firm did well at first, Mr. Bodek says, but in 2009 its performance worsened on several trading platforms, including Direct Edge, a computerized market based in Jersey City, N.J. Trading Machines’ profits fell by more than $10,000 a day, Mr. Bodek says.
He suspected a bug in his trading code and talked with officials of several trading venues. Then at a holiday party hosted by Direct Edge on Dec. 2, 2009, Mr. Bodek says, he spoke with the company’s sales director, Eugene Davidovich. Mr. Bodek says Mr. Davidovich told him his problem wasn’t a bug—he was using the wrong order type.
Mr. Bodek had been using common “limit orders,” which specify a price limit at which to buy or sell. Mr. Davidovich, according to Mr. Bodek, suggested that he instead use an order type called Hide Not Slide, which Direct Edge had introduced in early 2009, about the same time Trading Machines’ performance started to suffer.
Mr. Bodek says Mr. Davidovich told him Direct Edge had created this order type—which lets traders avoid having their orders displayed to the rest of the market—to attract high-frequency trading firms.
To be sure he had it right, Mr. Bodek recalls, he sketched on a napkin how he understood it to work. The next morning, Mr. Davidovich emailed thanking him for attending the party and saying “I want to continue on our conversation about…our order types,” according to documents seen by The Wall Street Journal.
Regulatory guidelines generally require stock exchanges to honor the best-priced buy and sell orders, on whatever exchange they were placed, and to execute them in the order in which they were entered. Together, these principles are known as “price-time priority.”
Mr. Bodek says he realized the orders he was using were disadvantaged, compared with Hide Not Slide orders. He says he found that in certain situations, the fact that a Hide Not Slide order was hidden allowed it to slip in ahead of some one-day limit orders that had been entered earlier. He also learned that other stock exchanges had order types somewhat like Hide Not Slide, with different twists.
“Man I feel like an idiot. Never grasped the full negative alpha embedded in a normal day limit,” Mr. Bodek emailed Mr. Davidovich several days later. “Negative alpha” is trader jargon for poor performance.
Direct Edge declined to comment on details of how Hide Not Slide orders work. Direct Edge CEO William O’Brien says Mr. Davidovich, who declined to comment, doesn’t recall details of the conversation at the party. In any case, the CEO notes that Direct Edge had communications with Mr. Bodek’s firm about the order type prior to the party, which Mr. Bodek confirms.
Mr. O’Brien says one reason Direct created Hide Not Slide orders was to let fast-moving traders operate more efficiently. “It’s about giving people as many options as possible,” he says.
Mr. Bodek says he began using Hide Not Slide orders himself, and his firm’s performance quickly improved. But the firm was dogged by other problems, including a loss of key employees, and shut its doors last year.
Mr. Bodek began delving into order types, reading regulatory filings and asking others in the industry about them.
He came to believe these sometimes interacted with other orders in ways the exchanges hadn’t completely disclosed to investors or regulators. Exchange officials generally say that the way their order types work is fully disclosed.
Mr. Bodek also came to suspect that exchanges gave detailed instructions in how the orders worked to certain trading firms while leaving other investors in the dark. Asked about that, Direct Edge’s Mr. O’Brien said that the “notion of who knows what when—it’s not uniquely different than any other aspect of life.”
Mr. Bodek filed his concerns with the SEC’s enforcement division in July 2011, working through the Hagens Berman law firm. A month later he met with agency officials and described how the orders worked and could be filled before orders placed sooner, in what he called “queue jumping,” attendees say. Mr. Bodek says he was nervous and unsure whether he was doing the right thing. His wife worried he could harm his career.
Though the SEC was already looking narrowly at certain order types and at high-frequency trading practices, Mr. Bodek’s complaints expanded its effort into a much broader inquiry into thousands of variations, according to the people with knowledge of the probe.
About six months later, on Feb. 24, 2012, the head of the SEC enforcement group’s market-abuse unit, Daniel Hawke, said at a law conference that the SEC was examining computer-trading practices and the use of order types. He told the group the agency also was looking into ties between exchanges and high-speed firms and was interested in the firms’ ownership structure. Mr. Hawke declined to comment for this article.
A day before his speech, BATS disclosed in a regulatory filing that the SEC had asked it about the “use of order types, and our communications with certain market participants.” BATS said the probe focused on communications it had with “certain of our members affiliated with certain of our stockholders and directors.” High-frequency trading firms are among the BATS exchange’s owners. The same is true of Direct Edge.
Mr. Bodek, meanwhile, has been testing trading strategies and advising investment firms on high-frequency trading practices.
While he waits on the inquiry, he says he may hit the lecture circuit. One title he has toyed with for his speech: “Trick of the Trade: The Rigging of the United States Stock Market.”
Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved
This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit