Flash Boys Chapter 4 - How Brad's Team Tracked Wall Street's Hidden Predators
By the end of 2010, Brad’s team had built a weapon. Thor worked. It protected investors from getting front-run by high-frequency traders. But here’s the problem. They had built a defense against an enemy they barely understood.
So Brad started interviewing people. More than a hundred employees from the big Wall Street banks. After the 2008 crisis, a lot of them were looking for new jobs and willing to talk. The scariest thing Brad learned? Most of them had no idea how their own electronic trading systems worked.
John Schwall, the Firefighter’s Son
One of the best characters in this chapter is John Schwall. His father was a firefighter on Staten Island. His grandfather too. He wanted something different. Got a master’s in engineering. Ended up at Bank of America with his desk on the eighty-first floor of the World Trade Center.
On September 11, 2001, he was late to work for the only time that year. Watched the first plane hit from a bus window. Colleagues died. He turned that guilt into fierce loyalty toward his employer.
Then Bank of America bought Merrill Lynch during the crisis. Merrill people awarded themselves massive bonuses before the deal closed. Then took over and started firing the loyal Bank of America employees.
Schwall’s exact words: “Wall Street is corrupt. There is no corporate loyalty to employees.”
The Man Who Went Down the Rabbit Hole
After Brad explained Thor to him, Schwall became obsessed. One Sunday night he started googling front-running scandals. By five AM Monday, he still hadn’t slept. Called Brad, said he wasn’t coming to work. “Trust me.” Disappeared to the Staten Island library for days. He traced every front-running scandal in American history back to the 1800s. Every scandal came from a loophole in a regulation created to fix the previous one. Like circus elephants linked tail to trunk.
His conclusion? Regulators would never fix this. But the technology now existed to eliminate middlemen entirely.
Reg NMS, the Regulation That Broke Everything
Here’s where it gets technical but stay with me. In 2005, the SEC passed Regulation National Market System (Reg NMS). Brokers had to find the best price for their customers across all thirteen stock exchanges. Good idea, right?
But here’s the thing. To know the “best price,” you needed a system called the SIP that collected prices from all exchanges. The SIP was slow. HFT firms built their own private, much faster version. So HFT guys saw current prices. Everyone else saw prices from milliseconds ago.
A Berkeley study found that for Apple stock alone, HFT prices and regular investor prices differed 55,000 times per day. Each one an opportunity to buy at the old price and sell at the new one. Reg NMS was supposed to create fairness. It created a system where speed was everything.
Rich Gates and the Dark Pool Tests
Rich Gates ran a mutual fund called TFS Capital out of West Chester, Pennsylvania. Almost $2 billion from 35,000 small investors. A math geek who didn’t trust Wall Street.
Banks kept pitching him algorithms with names like Ambush, Nighthawk, and Guerrilla. Credit Suisse’s Guerrilla came with a drawing of Che Guevara on the slides. Gates thought: why do I need protection? From whom exactly?
So he built a test. Pick a lightly traded stock. Say Chipotle at $100 to $100.10. Send a buy order into a dark pool at $100.05. Then send a sell order to a public exchange at $100.01. If the dark pool was honest, his buy should update to the new best price. He’d basically trade with himself.
That’s not what happened. Someone inside the dark pool front-run him. He lost 4 cents per share. He ran hundreds of tests. At first only Goldman’s dark pool was dirty. His Goldman broker said: “It’s not just us. It’s happening everywhere.”
Gates went to the Wall Street Journal. They wrote a piece but wouldn’t name Goldman. Fifteen comments, all Russian mail-order brides. Nobody cared. Later he tested again. Goldman was clean but everyone else was dirty. The predators had moved.
The Dark Pool Problem
The banks created dark pools and told investors: your orders are safe here. Hidden. Protected. But the banks were selling access to those same dark pools to HFT firms. The firms pinged pools with tiny orders, hunting for big investors’ hidden orders. When they found one, they front-run it.
Brad put it in a way I like. You could front-run an order in a dark pool on a bicycle. That’s how slow and predictable the orders were. A pension fund inside a dark pool was basically a deer in a clearing. HFT firms paid the banks for the right to hunt in that clearing.
Schwall Builds the FBI Board
Schwall took his obsession to LinkedIn. He mapped every major bank’s HFT connections. Found twenty-five “kingpins” at the top, thousands of engineers below. Brilliant people building systems they didn’t understand the purpose of.
He focused on Credit Suisse. They publicly said their dark pool Crossfinder had nothing to do with HFT. But their own employees wrote on LinkedIn about “building high-frequency trading platforms” and “on-boarding high-frequency clients to Crossfinder.” Schwall built their entire org chart. Brad said it looked like an FBI board with drug kingpins connected by strings. The head of their electronic trading? A guy who worked for Bernie Madoff for seven years.
“Let’s Just Create Our Own Stock Exchange”
By mid-2011, Thor’s growth had flatlined. Not because it didn’t work. Investors kept calling to say: “We love Thor, but we have to keep paying Goldman and Morgan Stanley.” RBC was rated number one broker in America but got only 2 percent of the market. A Citadel guy told Ronan: “What you’re doing is genius. But you are only two percent of the market.”
Then one day the team was trying to apply for some Wall Street Journal technology award. Rob Park said, “I just had a sick idea.” License Thor to an exchange. Brad’s response?
“Screw that. Let’s just create our own stock exchange.”
They stared at each other. Create your own stock exchange. What does that even mean?
Brad pitched it to big money managers. T. Rowe Price, BlackRock, Wellington. Hedge fund guys like David Einhorn and Bill Ackman. They all loved it. But they all said the same thing. For it to be credible, it can’t be run by a Wall Street bank. Brad would have to quit his job and do it himself.
My Take
This chapter is where Flash Boys shifts from “something is wrong” to “we’re going to fight this.” Rich Gates proved the manipulation with actual tests. A guy from suburban Pennsylvania figured out what the SEC couldn’t, or wouldn’t.
Schwall is my favorite character in this book. A firefighter’s son who spent days in a library tracing front-running back to the 1800s. Who built FBI-style org charts using LinkedIn. Zero political skills. Perfectly designed for this job.
The scariest part? When Brad went to the SEC, one staffer said: “What you are doing is not fair to high-frequency traders.” The people supposed to protect investors were protecting the predators. More than two hundred SEC staffers had left to work for HFT firms since 2007.
And that’s why Brad had to build his own exchange. The regulators wouldn’t fix it. The banks were profiting from it. The only option was to build something new.
This is part of my chapter-by-chapter retelling of “Flash Boys: A Wall Street Revolt” by Michael Lewis (ISBN: 978-0393244663). I’m retelling the story in my own words with my own thoughts mixed in.
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