Haim Bodek began his trading career at Hull Trading before moving into key roles at UBS and Goldman Sachs. After founding high-frequency trading firm Trading Machines in 2007, he made headlines when he uncovered secretive order types being used by certain rival algorithmic trading firms, giving them an unfair advantage to front-run the orders of other participants.
In this interview with Aaron Fifield in Chat With Traders episode 49, the trader famously featured in the documentary The Wall Street Code (watch it below) discusses his early days in trading, how he uncovered the undocumented order types, and how his whistleblowing led to one of the most sophisticated and complex investigations ever carried out by the SEC.
Read below for some extracts from the interview, or listen to the full episode here...
I didn’t go up against a small part of the industry, I went up against the dominant practices in the industry.Haim Bodek
On Hull Trading...
I was doing credit card fraud detection using machine learning algorithms. So I was really orientated around large data, detecting patterns and I had some good successes with that project with Visa. At the time, there was a lot of hype with using those methods in finance. It was kind of funny, there was actually an advertisement that said "wanted: individual to use machine learning algorithms to forecast markets". So I applied and got the job.
Hull really focused on taking scientists and other technical types and grooming them. I was probably, in the financial engineering group, one of the stronger programmers. Eventually this led into a role where I was one of the few people that focussed on the intersection between what we think of as the three disciplines in the field. At Hull the financial engineering group was the quants, technology group with the developers, and then you had trading. Hull traded on the floor and also traded electronically. My role evolved to be the guy that sat in-between those groups.
Eventually in the early 2000s, the role at Hull started to have a name, people had a hard time about what I did. We call it ‘strategy’ now, it’s basically the algorithmic trading part of this type of business. So I started to focus on quite literally the intersection in terms of how those three functional areas are all bound into a system that could execute trades, strategically on the exchanges.
On forming Trading Machines...
In 2007 the options market in the US had what was known as the ‘Penny Pilot’. And there were 13 names that were quoted in pennies instead of the nickel increments that had existed beforehand. When I looked at how those names where trading I thought to myself these products are actually quite similar to how the Korean market traded. And I came to the conclusion that the way that market-making would operate in the US would necessarily have to change. So basically the margins would be so thin, that options market makers wouldn’t be able to do traditional bid/offer capture, or spread captures.
So I came the conclusion that I had to re-build. We were fast at the time but I felt we really needed to pursue the low latency game harder than maybe what was possible at a bank. At that time there were many high-frequency trading firms (HFT) in the equities universe that were really pushing the arms race there. You’ve got all this stock market HFT tradition moving into the options space. And then you also had some of these HFTs, who were doing very well, start up option operations and compete in the options space. So in this period of transition, I felt that I needed to be ahead of the game and needed to go build an entirely new business model.
Originally we were going to go to a hedge fund affiliated with an investment bank, but then it kind of evolved and I realised I could go independent. So we set up Trading Machines, basically a HFT for options. We hired from all the major operations, we tried to get people who had that kind of expertise, I think at peak we were 25 people. So we launched into the market, we traded pretty consistently, about half a percent of the US options market, spread over a lot of small trades. We would basically opportunistically provide liquidity or take liquidity in names when we identified mis-pricing, we centred a lot of the business over short-term intraday volatility forecasting, that was our bread and butter.
On spotting a 'bug'...
What happened in May 2009 is that the last exchange in the US basically modified its order handling to accommodate HFT. That was Direct Edge. They introduced an order type called ‘hide and slide’. What I try to explain to people is when you introduce a particular order type, it doesn’t just have features intrinsic to itself and how it operates, but the code, the actual code, has to be modified and has to define: how does that order type interact with other order types? And that’s something I’ve tried to explain in my book The Problem with HFT, it’s not just that they metaphorically introduce a queen to the chequers board, they’re also defining how that queen interacts with other pieces.
And it turned out that the pieces or order types I was using were heavily disadvantaged in the interaction of the ‘hide of slide’ order type. So really what happened is we started bleeding, and it looked like my guys rolled out a bug. I was actually gone for a week, and I came back, the stock trading had changed to a point where we were basically making money in the options and haemorrhaging it all into the stock market. It was quite perplexing, because a change like that is usually triggered by a software release or a mistake that the trading firm does.
I’d been in the business for over a decade at that time and it was not clear to me, there wasn’t any type of information delivered to me specifically that had indicated that that exchange had changed their market structure. There’s somewhat of a paper trail but it was such an extreme change, it wasn’t really communicated to the members of the exchange in the way it should have been. So I’m sitting there and it just didn’t occur to me that what really looked like a bug that was haemorrhaging money, was actually just the exchange redefining how my orders interacted with HFT orders.
On blowing the whistle...
That’s a long story, I didn’t really know what I was getting into! First of all I’ll say there’s a tradition. Blair Hull, founder of Hull Trading, he went on the record and called out the NASDAQ market maker collusion, which was known as the Christie-Schultz scandal. That was an episode in stock market history where the NASDAQ market makers were colluding and keeping spreads artificially wide. A pair of academic researchers discovered this and wrote a paper on why these market makers avoid odd prices really. Where they're skipping every other price and keeping the spreads artificially wide because of that. It turned out they were colluding and the industry was actually fined close to a billion dollars because of this activity. And Blair was one of the few first insiders to go on the record.
Another example is one of the great kind of leaders in the options industry, Tom Peterffy, who for five years was lobbying and very vocal about eliminating a loophole that allowed queue jumping, the same kind of stuff I turned in, there was actually a queue jumping loophole in the options market. Basically professional traders learnt that they could masquerade as retail traders and get customer priority and leap ahead of the other market makers. He was very vocal and deserves a lot of the credit for what eventually happened, which was in 2010 the options market basically created a solution for this problems and eliminated it by creating what’s known as the ‘professional customer designation’. So here are two big names in my industry are both associated with significant market reform.
Of course both of them were able to do that because they had very successful operations, and I think what was different about me was that I decided to call out these issues, maybe in the same style I thought, but I called them out after my firm failed! So I wasn’t in the same kind of position as they were and I didn’t realise how important it was, I mean this has taken up five years of my life now and no way did I think that was going to happen.
On his reputation after whistle blowing...
I was kind of insulated, I didn’t realise how insulated I was from other parts of the industry by getting that experience in the ivory tower. I didn’t realise how prevalent it was across the industry to exploit the grey and to often cross into the black lines from let's say unethical behaviour and illegal behaviour. Hull Trading was all about being smarter than the other guy, and I kind of grew up on that. It was actually a former colleague who said to me "it ruined us, we weren’t ready for the real world where it’s shadier". I guess I didn’t realise what I was going up against until I had already disclosed this stuff to Scott Patterson who started reporting on it in the WSJ. The information I gave resulted in extensive investigations that took four years.
The Direct Edge case eventually fined the largest fine against an exchange which was $14m for inadequately disclosing their order types. This long path, which was successful in the end, I was informed that it was the most sophisticated case the SEC had ever done in terms of complexity and sophistication of the abuses. So this whole process and my opponents, it started out that I thought I was going up against a small segment of the industry that was taking advantage of the system and I was convinced at the time that it would have been discovered by the regulators. Half way in I realised I didn’t go up against a small part of the industry, I went up against the dominant practices in the industry.
Again when you do something like this you take a shot, metaphorically you’re throwing a fist out there, you don’t actually know who you’re hitting. And you’re right that as you get feedback, in my case I went against some very powerful entrenched people, you look at this and think did I make the right move, did I do the right thing? And you get a little nervous and anxious. You get more heat and negative feedback the more significant the issue is. If you’re right, you’re going to get trapped for five years, that’s a very common thing for whistle blowers. If you’re wrong or if it doesn’t matter that much, you might report it but it doesn’t result in any big action.
I provided so much detail and accurate information that needed to be looked at carefully by regulators. What I believe happened is that it created so much heat on the practices that they weren’t really able to mount any kind of opposition to me. Other whistle blowers will get heavily smeared, that didn’t really happen to me. It was definitely done privately, but I didn’t have to go through a big public battle where exchanges were saying statements to try and disprove me publicly.
On the outcome...
Lots of things I work on, it’s not actually clear where that line is between unethical and illegal, and that takes a lot of talented people which securities law to determine. And the thing is, the SEC enforcement division is only going to be pursuing violations of securities law. So if the law is not violated or maybe the law is not defined well enough to address the issue, then it basically becomes a policy issue. So a lot of the things I turned in, ended up becoming a policy issue and everything really involved around disclosure.
You had the office of Compliance, Inspections and Examinations do an audit where they had all the exchanges submit very extensive information of how they made order types, how they disclosed them, the prices, which ones existed. And that was a complete separate initiative from the enforcement investigation. And then about a year ago, Chairman Mary Jo White mandated that all the exchanges needed to assess their regulatory filings and determine if their order types were accurately disclosed and to also assess if the order types were operating as intended. It was a very significant initiative.
Most of the exchanges were extremely responsive and put out a lot of revisions and clarified how their order types worked, changes certain features. Many of the issues that I was concerned about were addressed through disclosure.
Follow Haim on Twitter at @HaimBodek