Secaucus, N.J.
A SUBSTANTIAL part of all stock trading in the United States takes place in a warehouse in a nondescript business park just off the New Jersey Turnpike.
Few humans are present in this vast technological sanctum, known as New York Four. Instead, the building, nearly the size of three football fields, is filled with long avenues of computer servers illuminated by energy-efficient blue phosphorescent light.
Countless metal cages contain racks of computers that perform all kinds of trades for Wall Street banks, hedge funds, brokerage firms and other institutions. And within just one of these cages — a tight space measuring 40 feet by 45 feet and festooned with blue and white wires — is an array of servers that together form the mechanized heart of one of the top four stock exchanges in the United States.
The exchange is called Direct Edge, hardly a household name. But as the lights pulse on its servers, you can almost see the holdings in your 401(k) zip by.
“This,” says Steven Bonanno, the chief technology officer of the exchange, looking on proudly, “is where everyone does their magic.”
In many of the world’s markets, nearly all stock trading is now conducted by computers talking to other computers at high speeds. As the machines have taken over, trading has been migrating from raucous, populated trading floors like those of the New York Stock Exchange to dozens of separate, rival electronic exchanges. They rely on data centers like this one, many in the suburbs of northern New Jersey.
While this “Tron” landscape is dominated by the titans of Wall Street, it affects nearly everyone who owns shares of stock or mutual funds, or who has a stake in a pension fund or works for a public company. For better or for worse, part of your wealth, your livelihood, is throbbing through these wires.
The advantages of this new technological order are clear. Trading costs have plummeted, and anyone can buy stocks from anywhere in seconds with the simple click of a mouse or a tap on a smartphone’s screen.
But some experts wonder whether the technology is getting dangerously out of control. Even apart from the huge amounts of energy the megacomputers consume, and the dangers of putting so much of the economy’s plumbing in one place, they wonder whether the new world is a fairer one — and whether traders with access to the fastest machines win at the expense of ordinary investors.
It also seems to be a much more hair-trigger market. The so-called flash crash in the market last May — when stock prices plunged hundreds of points before recovering — showed how unpredictable the new systems could be. Fear of this volatile, blindingly fast market may be why ordinary investors have been withdrawing money from domestic stock mutual funds —$90 billion worth since May, according to figures from the Investment Company Institute.
No one knows whether this is a better world, and that includes the regulators, who are struggling to keep up with the pace of innovation in the great technological arms race that the stock market has become.
WILLIAM O’BRIEN, a former lawyer for Goldman Sachs, crosses the Hudson River each day from New York to reach his Jersey City destination — a shiny blue building opposite a Courtyard by Marriott.
Mr. O’Brien, 40, works there as chief executive of Direct Edge, the young electronic stock exchange that is part of New Jersey’s burgeoning financial ecosystem. Seven miles away, in Secaucus, is the New York Four warehouse that houses Direct Edge’s servers. Another cluster of data centers, serving various companies, is five miles north, in Weehawken, at the western mouth of the Lincoln Tunnel. And yet another is planted 20 miles south on the New Jersey Turnpike, at Exit 12, in Carteret, N.J.
As Mr. O’Brien says, “New Jersey is the new heart of Wall Street.”
Direct Edge’s office demonstrates that it doesn’t take many people to become a major outfit in today’s electronic market. The firm, whose motto is “Everybody needs some edge,” has only 90 employees, most of them on this building’s sixth floor. There are lines of cubicles for programmers and a small operations room where two men watch a wall of screens, checking that market-order traffic moves smoothly and, of course, quickly. Direct Edge receives up to 10,000 orders a second.
Mr. O’Brien’s personal story reflects the recent history of stock-exchange upheaval. A fit, blue-eyed Wall Street veteran, who wears the monogram “W O’B” on his purple shirt cuff, Mr. O’Brien is the son of a seat holder and trader on the floor of the New York Stock Exchange in the 1970s, when the Big Board was by far the biggest game around.
But in the 1980s, Nasdaq, a new electronic competitor, challenged that dominance. And a bigger upheaval came in the late 1990s and early 2000s, after the Securities and Exchange Commission enacted a series of regulations to foster competition and drive down commission costs for ordinary investors.
These changes forced the New York Stock Exchange and Nasdaq to post orders electronically and execute them immediately, at the best price available in the United States — suddenly giving an advantage to start-up operations that were faster and cheaper. Mr. O’Brien went to work for one of them, called Brut. The N.Y.S.E. and Nasdaq fought back, buying up smaller rivals: Nasdaq, for example, acquired Brut. And to give itself greater firepower, the N.Y.S.E., which had been member-owned, became a public, for-profit company.
Brokerage firms and traders came to fear that a Nasdaq-N.Y.S.E. duopoly was asserting itself, one that would charge them heavily for the right to trade, so they created their own exchanges. One was Direct Edge, which formally became an exchange six months ago. Another, the BATS Exchange, is located in another unlikely capital of stock market trading: Kansas City, Mo.
Direct Edge now trails the N.Y.S.E. and Nasdaq in size; it vies with BATS for third place. Direct Edge is backed by a powerful roster of financial players: Goldman Sachs, Knight Capital, Citadel Securities and the International Securities Exchange, its largest shareholder. JPMorgan also holds a stake. Direct Edge still occupies the same building as its original founder, Knight Capital, in Jersey City.
The exchange now accounts for about 10 percent of stock market trading in the United States, according to the exchange and the TABB Group, a specialist on the markets. Of the 8.5 billion shares traded daily in the United States, about 833 million are bought and sold on Mr. O’Brien’s platforms.
As it has grown, Direct Edge and other new venues have sucked volumes away from the Big Board and Nasdaq. The N.Y.S.E. accounted for more than 70 percent of trading in N.Y.S.E.-listed stocks just five years ago. Now, the Big Board handles only 36 percent of those trades itself. The remaining market share is divided among about 12 other public exchanges, several electronic trading platforms and vast so-called unlit markets, including those known as dark pools.
THE Big Board is embracing the new warp-speed world. Although it maintains a Wall Street trading floor, even that is mostly electronic. The exchange also has its own, separate electronic arm, Arca, and opened a new data center last year for its computers in Mahwah, N.J.
From his office in New Jersey, Mr. O’Brien looks back across the water to Manhattan and his former office on the 50th floor of the Nasdaq building at One Liberty Plaza, and he reflects wistfully on the huge changes that have taken place.
“To walk out of there to go across the river to Jersey City,” he says. “That was a big leap of faith.”
His colleague, Bryan Harkins, the exchange’s chief operating officer, sounds confident about the impact of the past decade’s changes. The new world is fairer, he says, because it is more competitive. “We helped break the grip of the New York Stock Exchange,” he says.
In this high-tech stock market, Direct Edge and the other exchanges are sprinting for advantage. All the exchanges have pushed down their latencies — the fancy word for the less-than-a-blink-of-an-eye that it takes them to complete a trade. Almost each week, it seems, one exchange or another claims a new record: Nasdaq, for example, says its time for an average order “round trip” is 98 microseconds — a mind-numbing speed equal to 98 millionths of a second.
The exchanges have gone warp speed because traders have demanded it. Even mainstream banks and old-fashioned mutual funds have embraced the change.
“Broker-dealers, hedge funds, traditional asset managers have been forced to play keep-up to stay in the game,” Adam Honoré, research director of the Aite Group, wrote in a recent report.
Even the savings of many long-term mutual fund investors are swept up in this maelstrom, when fund managers make changes in their holdings. But the exchanges are catering mostly to a different market breed — to high-frequency traders who have turned speed into a new art form. They use algorithms to zip in and out of markets, often changing orders and strategies within seconds. They make a living by being the first to react to events, dashing past slower investors — a category that includes most investors — to take advantage of mispricing between stocks, for example, or differences in prices quoted across exchanges.
One new strategy is to use powerful computers to speed-read news reports — even Twitter messages — automatically, then to let their machines interpret and trade on them.
By using such techniques, traders may make only the tiniest fraction of a cent on each trade. But multiplied many times a second over an entire day, those fractions add up to real money. According to Kevin McPartland of the TABB Group, high-frequency traders now account for 56 percent of total stock market trading. A measure of their importance is that rather than charging them commissions, some exchanges now even pay high-frequency traders to bring orders to their machines.
High-frequency traders are “the reason for the massive infrastructure,” Mr. McPartland says. “Everyone realizes you have to attract the high-speed traders.”
As everyone goes warp speed, a number of high-tech construction projects are under way.
One such project is a 428,000-square-foot data center in the western suburbs of Chicago opened by the CME Group, which owns the Chicago Mercantile Exchange. It houses the exchange’s Globex electronic futures and options trading platform and space for traders to install computers next to the exchange’s machines, a practice known as co-location — at a cost of about $25,000 a month per rack of computers.
The exchange is making its investment because derivatives as well as stocks are being swept up in the high-frequency revolution. The Commodity Futures Trading Commission estimates that high-frequency traders now account for about one-third of all volume on domestic futures exchanges.
In August, Spread Networks of Ridgeland, Miss., completed an 825-mile fiber optic network connecting the South Loop of Chicago to Cartaret, N.J., cutting a swath across central Pennsylvania and reducing the round-trip trading time between Chicago and New York by three milliseconds, to 13.33 milliseconds.
Then there are the international projects. Fractions of a second are regularly being shaved off of the busy Frankfurt-to-London route. And in October, a company called Hibernia Atlantic announced plans for a new fiber-optic link beneath the Atlantic from Halifax, Nova Scotia, to Somerset, England that will be able to send shares from London to New York and back in 60 milliseconds.
Bjarni Thorvardarson, chief executive of Hibernia Atlantic, says the link, due to open in 2012, is primarily intended to meet the needs of high-frequency algorithmic traders and will cost “hundreds of millions of dollars.”
“People are going over the lake and through the church, whatever it takes,” he says. “It is very important for these algorithmic traders to have the most advanced technology.”
The pace of investment, of course, reflects the billions of dollars that are at stake.
The data center in Weehawken is a modern building that looks more like a shopping mall than a center for equity trading. But one recent afternoon, the hammering and drilling of the latest phase of expansion seemed to conjure up the wealth being dug out of the stock market.
As the basement was being transformed into a fourth floor for yet more computers, one banker who was touring the complex explained the matter bluntly: “Speed,” he said, “is money. “
THE “flash crash,” the harrowing plunge in share prices that shook the stock market during the afternoon of May 6 last year, crystallized the fears of some in the industry that technology was getting ahead of the regulators. In their investigation into the plunge, the S.E.C. and Commodity Futures Trading Commission found that the drop was precipitated not by a rogue high-frequency firm, but by the sale of a single $4.1 billion block of E-Mini Standard & Poor’s 500 futures contracts on the Chicago Mercantile Exchange by a mutual fund company.
The fund company, Waddell & Reed Financial of Overland Park, Kan., conducted its sale through a computer algorithm provided by Barclays Capital, one of the many off-the shelf programs available to investors these days. The algorithm automatically dripped the billions of dollars of sell orders into the futures market over 20 minutes, continuing even as prices started to drop when other traders jumped in.
The sale may have been a case of inept timing — the markets were already roiled by the debt crisis in Europe. But there was no purposeful attempt to disrupt the market, the regulators found.
But there was a role played by some high-frequency machines, the investigation found. As they detected the big sale and the choppy conditions, some of them shut down automatically. As the number of buyers plunged, so, too, did the Dow Jones Industrial Average, losing more than 700 points in minutes before the computers returned and prices recovered just as quickly. More than 20,000 trades were ruled invalid.
The episode seemed to demonstrate the vulnerabilities of the new market, and just what could happen when no humans are in charge to correct the machines.
Since the flash crash, the S.E.C. and the exchanges have introduced marketwide circuit breakers on individual stocks to halt trading if a price falls 10 percent within a five-minute period.
But some analysts fear that some aspects of the flash crash may portend dangers greater than mere mechanical failure. They say some wild swings in prices may suggest that a small group of high-frequency traders could manipulate the market. Since May, there have been regular mini-flash crashes in individual stocks for which, some say, there are still no satisfactory explanations. Some experts say these drops in individual stocks could herald a future cataclysm.
In a speech last month, Bart Chilton, a member of the futures trading commission, raised concerns about the effect of high-frequency trading on the markets. “With the advent of ‘Star Trek’-like, gee-whiz H.F.T. technology, we are witnessing one of the most game-changing and tumultuous shifts we have ever seen in financial markets,” Mr. Chilton said. “We also have to think about the myriad ramifications of technology.”
One debate has focused on whether some traders are firing off fake orders thousands of times a second to slow down exchanges and mislead others. Michael Durbin, who helped build high-frequency trading systems for companies like Citadel and is the author of the book “All About High-Frequency Trading,” says that most of the industry is legitimate and benefits investors. But, he says, the rules need to be strengthened to curb some disturbing practices.
“Markets are there for capital formation and long-term investment, not for gaming,” he says.
As it tries to work out the implications of the technology, the S.E.C. is a year into a continuing review of the new market structure. Mary L. Schapiro, the S.E.C. chairwoman, has already proposed creating a consolidated audit trail, so that buying and selling records from different exchanges can be examined together in one place.
In speeches, Ms. Schapiro has also raised the idea of limiting the speed at which machines can trade, or requiring high-frequency traders to stay in markets as buyers or sellers even in volatile conditions. just as human market makers often did on the floor of the New York Stock Exchange. .
“The emergence of multiple trading venues that offer investors the benefits of greater competition also has made our market structure more complex,” she said in Senate testimony last month, adding, “We should not attempt to turn the clock back to the days of trading crowds on exchange floors.”
MOST of the exchanges have already eliminated a controversial electronic trading technique known as flash orders, which allow traders’ computers to peek at other investors’ orders a tiny fraction of a second before they are sent to the wider marketplace. Direct Edge, however, still offers a version of this service.
The futures trading commission is considering how to regulate data centers, and the practice of co-location. The regulators are also examining the implications of so-called dark pools, another product of the technological revolution, in which large blocks of shares are traded electronically and without the scrutiny exercised on public markets. Their very name raises questions about the transparency of markets. About 30 percent of domestic equities are traded on these and other “unlit” venues, the S.E.C. says.
For Mr. O’Brien, the benefits of technology are clear. “One thing has surprised me: people have looked at this as a bad thing,” he says. “There is almost no other industry where people say we need less technology. Fifteen years ago, trades took much longer to execute and were much more expensive by any measure” because market power was more concentrated in a few large firms. “Now someone can execute a trade from their mobile from anywhere on the planet. That seems to me like a market that is fairer.”
For others who work at the company or elsewhere in the financial ecosystem of New Jersey, it has been a boon.
“A lot of my friends work here or in this area,” says Andrei Girenkov, 28, one of Direct Edge’s chief programmers, over lunch recently in Dorrian’s restaurant in Direct Edge’s building. “It changed my life.”
But some analysts question whether everyone benefits from this technological upending.
“It is a technological arms race in financial markets and the regulators are a bit caught unaware of how quickly the technology has evolved,” says Andrew Lo, director of the Laboratory for Financial Engineering at M.I.T. “Sometimes, too much technology without the ability to manage it effectively can yield some unintended consequences. We need to ask the hard questions about how much of this do we really need. It is the Wild, Wild West in trading.”
Mr. Lo suggests a need for a civilizing influence. “Finally,” he says, “it gets to the point where we have a massive traffic jam and we need to install traffic lights.”
High-Frequency Trading: Security Risk 