In 1999, CEO Hank Paulson, who later served as Treasury secretary during the financial crisis, bought a stake in Archipelago Holdings LLC, a relatively new trading platform beginning to gobble up market share. Six months later he spent $500 million for Hull Group Inc., a Chicago-based options broker and early proponent in a new strategy using algorithms. In 2000 he spent billions more for Spear, Leeds & Kellogg LP, a big employer of human market makers on the floor of the New York Stock Exchange. The Spear purchase included a stake in a small electronic-trading system called REDIBook.
Then, in 2001, the SEC took another whack at profit margins and further tipped the scales in favor of automation when it ordered all exchange trading to quote prices in pennies rather than fractions. Six years later, regulators demanded that trades take place on whichever venue offered the best price at a given time, sparking a proliferation of venues, which now number more than 80.
For a few years after the Spear purchase, Goldman was a top player in electronic trading as it steadily added capabilities. But the ever-shifting landscape would prove to be fertile ground for a new market inhabitant that would erode Goldman’s standing: the high-frequency trader.
In the following years, a battle would rage within Goldman about what to make of high-speed traders and their cousins, the quants. (Quants deploy strategies that are different from those of HFT companies, but they have similar technology requirements.) It often pitted men who’d made fortunes in personalized, or “high-touch,” trading against technologists who arrived at Goldman through its acquisitions.
Senior equities executives including Brian Levine were convinced that Goldman should stick to its historic strength of wielding risk capital for clients, according to people with knowledge of the situation. They questioned whether the returns generated by servicing quants, who use leverage to amplify returns from thousands of bets on tiny price movements, were adequate. Levine was also troubled by structural changes that he felt were weakening markets. Glitches, such as Goldman’s options mistake, and numerous others in the cash equities market were symbols of the market’s vulnerability. (By 2013, Levine had seen enough that he agreed to sit down with Michael Lewis for his 2014 book, Flash Boys: A Wall Street Revolt, and the company later wrote a Wall Street Journal op-ed calling for changes to the market.) It was because of this confluence of concerns that Goldman failed to anticipate how much the quant client base would grow. That decision looks unwise in hindsight, but Goldman had generated $13 billion in stock revenue in 2008, a high-water mark for the industry. By some accounts, they were fat and happy. “I just don’t think we were as concerned about electronic trading,” Levine recalls in December, his voice hoarse after holiday parties.
Part of Goldman’s weakness in automated trading was by design. Following the Spear purchase in 2000, Goldman had kept the electronic-trading unit in New Jersey, separate from the rest of the operations. Goldman’s penchant for proprietary trading was well-known, so clients fearful that their trades would be visible asked the company to keep the technology at arm’s length. But the separation prevented Goldman from developing the ability to do principal trades in the electronic unit, meaning they couldn’t offer what quants needed: equity swaps that bundle financing and execution costs together.
The company finally merged its broker-dealers in 2013—almost a decade after Morgan Stanley pioneered electronic swaps trading. Goldman had dithered too long.
In February 2013 it was announced that electronic-trading head Greg Tusar was leaving for a high-frequency trading company. Ronnie Morgan, a senior equities executive with years of serving clients in a high-touch capacity, was put in charge of “low-touch,” or electronic, trading. Decisions such as this reflected a cultural bias for risk takers over technologists, says Michael Dubno, a retired Goldman Sachs partner and chief technology officer. “They lagged for a long time simply because they really didn’t put their front-office tech leaders in ownership positions,” he says. “They weren’t comfortable doing that.”
It didn’t help that some in the company were devoted to doing as much as possible within its risk management platform, known as Securities DataBase, or SecDB. Years earlier, executives had decided that trading algorithms should reside inside the system. And for good reason: The strength of it was that every trading desk fed into the all-seeing program in real time, giving Goldman executives companywide views of risk. The system’s reputation grew during the financial crisis when it helped Goldman outperform rivals. So for some inside the bank, building a system outside of it seemed like sacrilege. But the platform wasn’t engineered to handle the data rates of hundredths or thousandths of a second needed to compete in the low-latency game.
Goldman continued to struggle with its place in the rapidly changing market. As Morgan Stanley’s rise became apparent, Morgan and Levine invited employees of Goldman’s rival in for job interviews, according to Lewis’s book. In the process, one of the things the Goldman execs learned was that Morgan Stanley was minting money with its high-speed offerings.