This is an audio transcript of the Unhedged podcast episode: ‘Inside the traders’ black box

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Ethan Wu
If you have bought or sold stocks in the US, you most likely have interacted with a high-frequency trader. Even if indirectly, these big trading houses make US stock markets work. But they’re a little bit of a black box. A recent lawsuit suggests that may be changing. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I’m reporter Ethan Wu here in the New York studio, joined today by legal correspondent Joe Miller to help us break open the black box. Joe, are you using like a crowbar or like, how are you cracking this one open?

Joe Miller
No, I’m using my ability to read 85 pages of dense legal filings without giving up or quitting.

Ethan Wu
You’re really selling your job to the audience.

Joe Miller
I know, right?

Ethan Wu
It sounds truly thrilling.

Joe Miller
I love this stuff, though.

Ethan Wu
So Joe, you’ve just written, you know, a really interesting, excellent column about a small little biotech company, the small little biotech company that could. And by could I mean sue the big high-frequency traders, the titans of Wall Street, about alleged spoofing. We need to walk through this because it’s technical and it’s granular, but I think it really gets to the heart of a big conflict that’s been going on for, I mean, at this point, a decade on Wall Street.

Joe Miller
Yeah. Ethan, as you know, I am a card-carrying nerd. But even for me, this is quite nerdy, but I think very interesting. So stick with me. In late 2022, a small Maryland biotech which is developing a vaccine for brain cancer, one of the most pernicious forms of cancer, filed this bombshell lawsuit. And this lawsuit named a bunch of companies known as market makers, including Virtu. And you may have heard of Ken Griffin’s Citadel.

Ethan Wu
Ken Griffin of Dumb Money fame, Citadel Securities.

Joe Miller
Citadel Securities, yes, correct. Yeah, thank you for that correction. And essentially, the allegation which we can get into in detail was that these enormous companies, you know, multibillion dollar companies who control more and more of trading on New York stock exchanges, that they were doing something called spoofing. And essentially what they were doing is they were targeting a stock, in this case, a small company, you know, trying to do good in the world. And they were putting in fake sell orders on those stocks, sending a signal to the market because there were all of these sell orders going in, that they were down on this stock, waiting for the stock price to plummet and then buying back that stock at a much cheaper price. This was a, you know, it’s fair to say this is an explosive allegation. And not very many people thought that this would go very, very far.

Ethan Wu
But the magistrate in the case seems open to it.

Joe Miller
Exactly. So I was following this, you know, without much hope of it ever going anywhere. And then I’m standing in the line, actually for one of the Trump hearings the other day and I’m just checking, you know, the latest orders that have been filed in various cases. And I see that this case has been dismissed. And usually that would be the end of that. But there was a long what’s called R&R, which is a report and recommendation from a magistrate judge on why it should be dismissed.

And as I’m reading this, it’s like he’s validating every single one of the allegations. When I say validating, it’s not going to the truth of those allegations but saying, hey, on the face of it, these allegations are at least plausible enough to proceed. And the only reason he dismissed the case was he said that he didn’t think that the plaintiffs had done enough to tie the stock losses on various days to specific trading. It’s a technicality which he urged them to fix and to refile. But all of a sudden this, for lack of a better word, conspiracy theory, which was what most people had been painting this lawsuit as. And it you know, it lit up the Reddit threads, the sort of Reddit threads that were behind the meme stock trading. Here you have a very sober magistrate in, you know, probably the most important commercial court in the world saying, look, this stuff is plausible enough to be able to be taken forward. And that’s what really caught my attention.

Ethan Wu
Let’s back up and go piece by piece, because there was a lot in your kind of high-level summary, Joe.

Joe Miller
I told you it’s nerdy.

Ethan Wu
Yeah, it is, it is, but again, interesting. So spoofing — let’s start with spoofing. This is, as I understand it, the idea that you dangle some sell orders to make it look like the market’s really bearish on the stock, right? So you’re not actually executing the sell orders. You’re displaying intent through the market, right? You can post limit orders in the marketplace and make it seem like, well, at a certain level, I might start selling. That signals to other traders in the market, yeah, there’s a lot of people bearish on the stock so maybe other people are like, well, I better sell quickly, right, if there’s a lot of intention to sell this. And, you know, maybe you pull back on the sell orders when the stock actually starts to get sold off. In the court order itself they call these baiting orders, right? You’re dangling it out there for somebody to bite on and then you yank it back at the last second.

Joe Miller
And you could do it the other way around. You could pump up the price by putting in buy orders. In this case, the allegation was there were sell orders. And this practice is obviously as old as the markets have existed. But it only really became illegal in the US after Dodd-Frank. It was put into the Dodd-Frank Act. And there’ve been a few successful prosecutions of individuals over spoofing, but there’s never been a successful civil case, which is why this case is, you know, particularly interesting, this and a bunch of others that have come along. And the problem at the heart of this is that the behaviour that you described there is also part of normal market-making, right? Because if you are someone like Citadel and Virtu — maybe we can explain for a second what these guys do, right, is that they take in enormous amounts of orders from brokers like, you know, Charles Schwab and Robinhood, etc. In some cases, they pay for those orders and they then make the market by buying and selling and always having liquidity to provide. And they say that they can then provide the retail investor at the end of this transaction with a better price as a result, right?

Ethan Wu
Yeah. Let’s do that next. So we have spoofing — dangling little orders in front of the market, pulling them back at the last second. Then you have market makers. And so you mentioned Virtu, Citadel Securities. And people may know these names from the big GameStop fracas of 2021, where, you know, they stand between retail investors and their stock brokers and then the market itself. And they’re like, you said, Joe, they’re trying to make little tiny bits of profit on a huge volume of trading orders by taking them in and finding small, little pricing discrepancies across all the venues that stocks are listed on, right? So this is a practice as old as time.

Joe Miller
And those discrepancies add up to billions and billions of dollars in profits.

Ethan Wu
Exactly. Yeah, I know that’s exactly right. And the practice of market-making, of standing between the people buying and the people selling, and facilitating those trades, that’s an old practice and in some ways it’s necessary to make markets function. But what’s different about market-making in 2024 versus, you know, 20, 30, 40 years ago?

Joe Miller
And that’s the high-frequency trading element, is that these are essentially tech companies for, you know, want of a better description, they hire a whole load of incredibly bright computer science graduates and programmers. And what they are trying to do is they’re fighting over the best algorithm, really. What they’re trying to do is work out the best way of placing orders at the right time, discovering the right price on the market, selling at the right level and making, you know, within split seconds, money off that spread.

Now, I can’t tell you in any greater detail how that works. I wish I could, and it’s not for lack of trying. It’s because, perhaps understandably, this is very commercially sensitive information for these firms and while they’ll, you know, make a good show of telling you this is how it works. Come to our website, come to our, you know, videos, and we’ll explain how high-frequency trading works. They only really explain how it works on the surface level. There are lots and lots of things that happen in that process, you know — how the orders are placed, when they are placed, how many of them are placed, when they are cancelled. These are all things that we have no real insight into and it’s lent itself to a lot of questions about the lack of transparency in this evermore powerful industry. And there’s a lot of people out there, including, you know, elected members of Congress who say we need to know a lot more about, you know, what’s going on behind the curtain.

Ethan Wu
But you can see why this gets a lot of attention on social media, on Reddit, etc, that you have a David player, a small little biotech company — in this case, it’s Northwest Biotherapeutics making a cancer drug. And then suddenly the stock crashes despite having actually good clinical results. People look into what went on in the market. Oh, there’s all these high-frequency trading orders that just disappeared. What’s going on here? Are they trying to dump on the stock? Are they trying to push it down? What do they have against Northwest Biotherapeutics?

And I think the the quote you had from r/WallStreetBets was hedge funds “want to bury this company”. And, you know, you can see how that thinking goes. The market makers, on the other hand, would probably say something to the effect of, listen, this is a competitive business. This is a really intense high-tech business. We have just as much chance to lose money on a given stock as we are to get money on a stock. If we make money, it’s because we’re good at this, because we have good algorithms. We’re improving liquidity, we’re shrinking the bid-ask spread — the difference between the selling and the buying price. You know, this is like a hard business and we compete. And there’s nothing untoward going on here and no one’s been able to prove it. And that’s why there have been no successful court cases about spoofing. And, you know, whatever may have happened specifically in this case, there’s no broader conspiracy. There’s nothing going on.

Joe Miller
Right. Let me elaborate on what Citadel Securities and the defendants’ position on all of this is. You know, Citadel Securities provided a statement in which they called this a malicious lawsuit and said that it just misrepresents how the market functions in an attempt to shake down the world’s leading liquidity providers, etc. That’s their front-of-house statement.

But some of the other people associated with the defendants will point to, you know, quite fairly, to the fact that there may have been perfectly reasonable reasons to dump Northwest Bio’s stock. This is a company that had been fined by the SEC over financial reporting oversights. This is a company that also there was actually a negative news report in a very important website that questioned the results of that trial. There have been some academic papers questioning the design of that trial. So they say, you know, this is just a company that’s on its uppers looking to blame the market makers.

And essentially, what they would say is because of the complexity of how the system works, you could take pretty much any stock, especially a penny stock like this, which isn’t heavily traded, which isn’t on any of the major indexes. And, you know, you would see that there was an enormous amount of order flow and then that drops off, etc. And then you can try and tie this to some form of conspiracy. But that’s just the ordinary process of market-making in that, you know, this is why, for example, you could argue you need companies like Virtu and Citadel because if you are a retail investor looking to buy this fairly obscure stock, there might not be any liquidity around if there weren’t people out there buying and selling, you know, frequently and making sure that there was, to borrow an analogy from, you know, the grocery store, that there wasn’t stock on the shelves for the retail investor when they come along. So, you know, that’s how the market makers would see all of this.

Ethan Wu
Well, Joe, I think this gets to the underlying issue, right? Which is, you know, you and I have just sat here and had a 10-minute conversation about high-frequency trading firms. But it’s hard for us or really any third party to understand quite what they’re doing, right? There have been a lot of like anomalous market events over the past 10 or so years as HFTs have gotten bigger — flash crashes, flash rallies, you know, sudden jumps in stock prices that in hindsight, HFTs appear to have played a big role. But it’s hard to tell contemporaneously like what they’re doing.

And I think that’s what makes this case so interesting, right, is that if this case is going to discovery, meaning that there’s a process by which Citadel Securities and Virtu and all these guys have to kind of, you know, open the kimono or, you know, show a little bit of their tradecraft, it’s going to tell us something about an increasingly influential part of Wall Street that still to so many people in the finance world remains a black box.

Joe Miller
Yes. I think it’s really important to point out that this isn’t interesting because we’re necessarily at a point where more credence has been given to Northwest Bio’s claims because the standard to survive to the point of a judgment or a trial is a lot, lot higher than to survive just the motion to dismiss. But we may get to the point, like you said there, of discovery, which is quite rare in securities cases because you have to survive a certain stage to get to that point. And the stance that’s been adopted by Citadel Securities and Virtu, you know, which is this sort of nothing to see here, guv kind of stance, you know.

That may finally fail and you may see these firms be forced to provide a little bit more meat on the bone as to what is going on behind the scenes. You know, what is behind the order placement at these particular times? What is behind the cancellation or reduction of these orders, you know. Give us some insight into how these algorithms work. And for that reason alone, you know, this case will be watched incredibly closely by nerds like us, but also by, you know, the entire army of Redditors who claim that there’s a grand conspiracy going on here and that these are these dark pools and these, you know, mysterious organisations that control the US stock market to the disadvantage of retail investors.

Ethan Wu
Yeah. The orders may allegedly be fake, but the intrigue is very much real.

Joe Miller
Exactly.

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Ethan Wu
All right, Joe, we’ll be back in a moment with Long/Short.

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Welcome back. This is Long/Short, that part of the show where we go long a thing we love, short a thing we hate. Joe, are you long or are you short something?

Joe Miller
I am short something called Trader Joe’s, which . . . 

Ethan Wu
Oh my God, all the worlds are colliding here.

Joe Miller
We should probably explain to non-American listeners.

Ethan Wu
It’s a grocery store.

Joe Miller
It’s a grocery store but, you know, I wouldn’t go so far as to call it a woke grocery store, but its marketing, its messaging, you know, is very much geared towards the alternative milk crowd, let’s put it that way. You know, this was started in California.

Ethan Wu
You’re really calling me out here, man.

Joe Miller
(Laughter) Hey, I shop there too. And the reason I’m short on Trader Joe’s is not because they charged me $2.29 for a cucumber the other day. The reason I’m short on Trader Joe’s is that it has this, you know, public-facing persona of being this progressive company. And the other day, it joined the likes of Elon Musk’s SpaceX and Amazon in calling the National Labor Relations Board unconstitutional. Essentially, Trader Joe’s has been fighting organised labour within its ranks. And, you’ve seen this backlash against this NLRB, which is a, you know, a pillar of the New Deal; was instituted by Franklin Roosevelt, you know, back in the 1930s; has, you know, been a bedrock of organised labour, protecting organised labour in the US. And here you have this company that on the one hand wants to signal to its consumers that it’s this, you know, progressive idyll and on the other hand, is joining with, you know, the most anti-union forces in this land in trying to get this, you know, storied body ruled unconstitutional. And I find that to be somewhat two-faced.

Ethan Wu
Well, Joe, I am short the Chinese upstart ecommerce company Temu. There’s a great piece in the FT by Dan McCrum recently looking into its rather suspicious balance sheet. You know, the revenues and the hard assets don’t quite match up. It also had like eight incredibly annoying Super Bowl ads with this like, terrible shop like a billionaire jingle. So bad Super Bowl ads, suspicious balance sheet — easiest short of all time.

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All right, Joe, thank you for being here.

Joe Miller
Thanks for having me on.

Ethan Wu
We’ll have you back very soon. Listeners, we’re back in your feed on Tuesday with another episode of Unhedged. Catch you then.

Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn, and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Ethan Wu. Thanks for listening.

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