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Transcript: Inside the Traders’ Black Box


March 7, 2024

Ethan Wu speaks to Financial Times legal correspondent Joe Miller

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.

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