Scott Patterson is a financial journalist for The Wall Street Journal, best-known for writing the 2010 New York Bestseller The Quants, and the 2012 follow-up Dark Pools.
In episode 27 of Trend Following Radio, host Michael Covel invited Scott on his podcast to discuss his career writing on about the financial markets for Rolling Stone Magazine, the Financial Times and the WSJ among others.
They also delve into the topic of his books, tracing the history of high speed trading and electronic communication networks (ECNs), and discussing the murky subject of Dark Pools. Read below for some extracts from the interview, or listen to the full episode here...
The whole market has gone dark, no one knows what’s going on in the market anymoreScott Patterson
On the origins of his book on Dark Pools...
I started looking into this stuff a couple of years ago when I was a reporter at the Wall Street Journal. High Frequency Trading (HFT), which is something I look at a lot in this book, was becoming a really hot topic. And at first I was like, what’s wrong with this? There were some critics and it seemed that it was helping the market, and I really didn’t think there was much wrong with what was going on.
But the more I learned about how this stuff worked and what was going on across the market, I became more worried. As I started working on this book it really started to open my eyes, and I realised we have a major problem on our hands. When I was at the Journal before, (I left for a while to write this book), I covered the flash crash for the WSJ and that was a landmark event in the recent history of our markets and it just scared the bejesus out of everybody. It was a sort of warning sign of what could happen.
On Josh Levine...
Josh Levine is this totally fascinating character that I discovered in my research, who I would say is probably the most important figure in the history of modern day markets that people have never heard of. But Josh’s story actually starts in the 80's, when he was a 17-year-old college dropout working the streets of Wall Street as a computer programmer, selling his trading systems to giant hedge funds, and even firms on the NYSE, big market makers.
He was right there at the beginning when computers started moving into the trading floor. Then in the early 90’s he hooked up with this group of renegade day traders at a firm called Day Tech. Day Tech was basically a bunch of guys who had been market makers, but they figured out that they could make a lot more money by trading on this very new sort of computer system on the NASDAQ called the ‘Small Order Execution System’, or SOES. Eventually they became to be known as the ‘SOES Bandits’.
So Josh, this young idealistic computer programmer, teamed up with these day traders, and together they launched a revolution of computer trading. A completely amazing story. Josh slowly put together this computer system that became a powerhouse.
On the story behind The Island Network...
Basically these guys were trading the NASDAQ, with the SOES system, and they really hated how crappy NASDAQ was, and a lot of the market makers really didn’t like what they were doing, so they were getting a lot of ‘noise’. They wanted to do that (buy or sell fast) without the interference of the NASDAQ market makers. They would send an order to a NASDAQ market maker and a lot of times it was on this automated system. But they didn’t always go that way, they went through another system NASDAQ had that required the intervention of a human market maker to make the order work.
Because the NASDAQ market makers hated Day Tech, they would just not recognise the order, they did what is called ‘backing away’. They would just say that "that order was filled already" and just reject it. And at Day Tech, that was just infuriating because they were legitimate orders. Out of that frustration, they decided to create a method where their orders could interact with one another, they could bypass NASDAQ, and do it all in an automated way on a computer.
So Levine started to put together this system and slowly it evolved into a computer program called ‘Island’. He called it that because it was a sort of refuge from the NASDAQ cesspool that they hated so much. By the late 90’s, Island itself was accounting for 10% of all trading of NASDAQ stocks, and it was a huge revolution because these guys just came out of nowhere. It was the revolution happening, the big exchanges had no idea it was going on.
On Dark Pools...
The technical definition of a Dark Pool, is an alternative trading system that is set up away from the public markets. So the public markets are these so called "lit" exchanges where the prices are published, they are there for everyone to see and it’s all out in the open. But a dark pool is ‘dark’. The bids and the offers are not made public and they rose up in the early 2000’s because the big firms started getting concerned that these HFT’s and other computer firms were able to gain their big ‘whale’ orders, like a million share buys of IBM.
When those went out and hit the lit markets, it was a blood bath because prices would just run ahead of them and the funds would end up buying for a higher price or selling for a lower price. So a couple of places opened up these dark pools as a refuge essentially for the institutional firms.
Island was the most ‘lit’ exchange at the time. You could even say the floor of the NYSE was a dark pool because the buying and the selling that took place on the floor wasn’t public, it wasn’t available for everyday investors. It was too much out in the open for these firms, so to enjoy the advantages of electronic matching orders but do it in a place that is far more opaque than the new lit systems like Island, the dark pools started rising up.
On the Pipeline Trading Systems story...
One of the more popular dark pools was called Pipeline Trading Systems. This dark pool claimed that it was matching natural buyers and sellers, meeting together with no middle man. What actually was happening was Pipeline had set up a secret middle man which was established one floor above their office in mid-town Manhattan. And that secret trading operation was called Millstream, looking at the orders coming in and figuring out whether it was a buy or sell, what stock it was for, and they would go into the market.
So if it was a buy, they would go up and get a whole bunch of stock so they could sell to that order. And they would do the same thing for a sell order. They were secretly a middle man, and these are guys sitting at their computers doing this. The regulators had no idea that this was going on for years. Until a guy who had been a trader at Millstream went to the FCC in 2009 and blew the whistle on them. Now that whole thing has been shut down and Pipeline doesn’t exist anymore. But that’s an example of what happens with an industry that is "lightly" regulated let’s say, but not really regulated at all.
On the flash crash of 6th May 2010...
I was at the time covering Berkshire Hathaway at the WSJ. And the weekend before that I was covering Berkshire's annual meeting in Omaha. And I had really been wanting to meet this big dude in HFT called Dave Cummings. So I decided to drive out from Omaha to Kansas City to meet Dave at Tradebot, which is the high frequency fund he runs. I met him and we talked for a couple of hours.
I went back to the Journal a day later and on May 6th, I was sitting there on the desk, and we started to notice the market just going down a lot. This was around 2.30pm. We were just standing there and then it just started to completely collapse, this one editor next to me started screaming. Because it was down 600 points, 700 points, 800 points, and it just seemed like the whole thing was collapsing.
At the time I had just written The Quants, people looked at me and said “these are your guys Scott, they must be behind this”. We knew the Greek thing had been going on, but there was a lot of other stuff going on in Europe and I think people were worried it was Lehman all over again. So I was told to figure out what had happened, and I kind of laughed and was like "yeh right, I’m supposed to just pick up the phone and find out what happened".
So I picked up the phone and I called Dave, and called a few other high frequency firms that I knew. And they all told me that they had got out of the market because things had been crazy. I also called a broker that I knew who had a lot of HFT firms and he said almost all his clients just shut down around 2:30pm - 2:40pm that afternoon.
So I started writing up a story about how the high frequency firms pulled out of the market that afternoon and that may have added to the volatility because, you know, they are market makers. Without them there’s no liquidity. As much as people may hate them, they also need them. We wrote this story in the paper then next day and I think that kind of set the tone of the debate about high frequency from then on, because people realised that yes, they provide liquidity in the market, but when things get really hairy, they pull out. And that’s kind of a fatal flaw in the market structure that we have now. By getting out it makes things worse for everybody.