The story of how a start-up is making money for itself and its clients through NASDAQ's Small-Order Execution System.
Their aim: move fast, make money, have fun. Who knew they would threaten a whole industry in the process?
Block Trading's office on the third floor of a Houston shopping mall exudes the dimly lit quiet of a pool hall, suggesting an activity that is as purposeful as it is questionable. Twenty-eight customers sit in high-backed leather chairs, staring at the dance and flicker of numbers across computer screens. Stephanie Clark is one of them. Picking at a piece of cold pizza and sipping a can of Mr. Pibb, Clark speaks in code as she eats lunch and keeps an eye fixed on the screen. "Load to buy PAIR at 71 and a half...cancel the short on Cascade...offer Robotics at 63 and 11 teenies." Across the desk, a broker enters her rapid-fire orders to buy and sell stock in 1,000-share blocks.
Thin, blond, and getting richer by the minute, Clark only 18 months ago was a 28-year-old secretary at Oppenheimer & Co. in Houston, where she grew tired of watching men make money while she answered the phones. Now, thanks to the alternative created by Block Trading cofounders Chris Block and Jeff Burke, she's a "SOES bandit"--SOES (pronounced sews) standing for the Small-Order Execution System, which gives individual investors both direct access to stock prices and near-instantaneous executions on NASDAQ, the computerized system that trades over-the-counter stocks. "Bandit" is the epithet conferred by the established market makers who create and support markets in stocks, and who want to keep individual traders out--off their turf and away from their profits.
But it's too late for that. For Clark and the other bandits who've been given a place at the market's table by Block Trading, this has become their day job. They arrive daily before the market opens, sit in their regular seats, and trade stocks from bell to bell. On a good day a SOES trader might make a grand or two. On a bad day he or she will give it back. The only sure thing is this: no matter how much their enemies huff and puff, the bandits are here to stay.
In the past three years Block and Burke, by building a company that wires SOES bandits directly into the stock market, have conspired to turn the securities industry on its ear. And the establishment has set off an alarm. The Stephanie Clarks of the world, say the market makers, are unsophisticated speculators who will undermine the securities markets and may even cause them to collapse. Less often mentioned is the reality that the SOES bandits have cut into market makers' profits and have helped produce fairer pricing for the average investor.
Block and Burke couldn't care less what others think. They're too busy having fun and making money. SOES has caused such a dustup, says Block, because "some of the wealthiest people in the world are getting screwed, and they don't like that." And NASDAQ is just the first front of a looming war. It's only a matter of time, Block argues, before the New York Stock Exchange's proprietary information, still moved by people wielding pencils and paper, leaks into cyberspace, where it will become public property. "They'll turn the exchange into a museum," he vows. Meanwhile, Block Trading's revenues continue to soar--they've gone from $1 million in 1995 to $18 million in 1996--and the firm, now with 13 offices in five states, is busy opening new locations at the pace of one a month, as the two founders happily gather the spoils.
Block and Burke nod approvingly as, by noon on this day, star customer Clark makes a flurry of 120 commission-generating trades and carves up the market makers for another $3,000 in gains. But it isn't just Clark's swelling bank account, or even the clash between the SOES bandits and the securities-industry old guard, that makes Block Trading's story worth watching. Block's deeper significance is that it is doing what countless start-ups before it have done in numerous other businesses: flouting the rules, threatening the status quo, and altering forever how an industry works. Chris Block and Jeff Burke could fail long before turning their firm into the Wal-Mart, Southwest Airlines, or Dell Computer of stock trading. But by then it wouldn't matter. They already will have sown their own brand of market-changing chaos. Theirs is the story of how change really happens in the new economy.
The corporate offices of Block Trading, near the apex of the atrium in Houston's tony Galleria Mall, convey a baronial splendor that hardly suggests a company that has sprung up overnight and may not last more than another season or two.
Chris Block and Jeff Burke themselves, both 30, look like the Felix and Oscar of SOES trading. Block is beefy and voluble, given to rapid-fire thoughts and big ideas. He's quick to reach for his hard pack of Marlboro Lights and Cricket lighter. He wears suspenders imprinted with the currencies of the world.
Burke is a leaner, edgier Tom Cruise knockoff, a cowboy in pinstripes. Block is from Staten Island; Burke is a fourth-generation Houstonian. They both drive Ferraris.
The two met at Lehman Brothers in Houston, where the management put them in the same room, perhaps to see who would first kill whom in the race to build a customer book. They ended up becoming good friends and partners, bound by the soul-numbing cold-calling grind that all young brokers must endure.
Then, in early 1991, Block happened to cold-call an investor in New Jersey, Harvey Houtkin. But it was Houtkin who did the pitching. "Your firm hates my firm because I'm a SOES trader," Houtkin bellowed into the phone. "You guys are like mushrooms. They keep you in the dark and feed you crap." Block didn't know what Houtkin was talking about, and he didn't care. "I was looking for a sale, not a new vision of life."
Block got the vision anyway.
The Small-Order Execution System was created in 1984 by the National Association of Securities Dealers (NASD) to ensure that small investors had better access to NASDAQ, a system largely controlled by professional market makers. But Houtkin, like many others, didn't know much about it until the crash of 1987, when small investors, desperate to sell stock, called their brokers, and no one picked up the phone. Market makers--traders specifically charged by the exchanges with maintaining a "fair and orderly" market--had "stepped away" from their positions, sending stocks into a free fall.
In the wake of the crash, Houtkin's small investment firm went belly-up when, as he puts it, some heavy-margin customers "rolled over on me." He ventured back into the market, this time trading for his own account as an individual investor. As a former professional insider he now discovered that he "couldn't get a trade off at a reasonable price." Market makers often ignored his offers to buy stock. He started using SOES, which forced market makers to trade up to 1,000 shares on NASDAQ at their quoted price, or "bid." Houtkin, a student of NASDAQ, realized that SOES gave him a window into the workings of the market itself, and if he paid close attention and moved quickly, he could spot small movements in stocks, which he could trade on and profit from.
Houtkin has since become an evangelist for SOES--and, incidentally, for his own firm, All-Tech Investment Group, of Montvale, N.J.--complete with claims of late-night-infomercial proportions. "My former bookkeeper has made at least $1 million for the last six years," says Houtkin. He charges $5,000 for people to make the life-changing pilgrimage to New Jersey to take his course and learn how to trade on SOES for fun and profit.
Houtkin asserts that his trading method simply signals the advent of the stock market of the 21st century: people trading in cyberspace from the comfort of home and with the click of a mouse. It also offers sweet revenge against market makers, who, able to see one another's prices and execute their trades faster than the public, have, critics say, held an unfair advantage and charged excessive markups on stocks sold to the public. "For all too long the markets have been the exclusive domain of the moneyed few," Houtkin asserts. "But the markets belong to the public, not them. They've always made up the price and sold what they want, when they want. Now all of a sudden they're not calling the shots. They want you to feel bad for them. It's comical. I'm surprised these guys are not in jail; they've stolen billions from the public."
When business at Lehman Brothers slowed for Block and Burke in 1992, they called Houtkin back and asked if they could come for a visit. After a couple of trips to Houtkin's operation in New Jersey, Block and Burke were sold--not just on becoming bandits but on building a business like Houtkin's that catered to them. They flew home on a Sunday. On Monday they quit their jobs and bailed out of their apartment leases. By Friday they had driven back to New Jersey, prepared for Houtkin's tutorial the following week.
Over the next three months Burke, with lightning-quick instincts and an eye for price movements, honed his trading skills at Houtkin's shop, while Block returned to Houston to set up an office.
As Burke's trading success mounted he would phone home to Houston. "Chris, you won't believe it. I made another $1,000 today." Block, meanwhile, was thumbing through the yellow pages to look for a securities firm that would deign to give a lowly SOES outfit some floor space and back-office support, finally striking a deal with Texas Securities. When Burke had collected sufficient trading profits to start the company ($10,000), Block flew back to New Jersey on a Friday. The next morning at 11 they drove back home to Houston. "Twenty-four hours straight, 6-hour shifts," Burke recalls. They slept the trip off on Sunday afternoon and were in their seats in Houston in time for the stock market's opening bell on Monday morning.
THE FOURTH WAVE
Block and Burke believe their firm fills a burning need by in effect selling ordinary people "seats" on NASDAQ, an exchange that exists only in cyberspace. Their customers are in the front row; they see pricing information at the source. Block Trading represents what Chris Block labels "the fourth wave" in brokerage, which in the last 20 years has passed from full service to discount to deep discount. Now along comes Block, which the partners label "do-it-yourself." Block charges dirt-cheap commission fees, which range from $15 to $25 per trade, depending on a customer's volume. And, more important, the firm offers rapid access to critical information, which translates into the best stock prices, free of the market makers' rip-off tribute.
Block's customers become traders--just like the market makers. They must first train with the firm, which suggests certain techniques to improve the odds for success. Block's methods are aggressively opportunistic. It recommends that customers never hold a position overnight. "Then you're an investor, not a speculator," explains Burke. It recommends that customers sell both short and long to take full advantage of the market's action. In fact, Burke, a seasoned trader, prefers to go short because while buying, he reasons, is calculated, selling is emotional. Stocks fall faster than they rise. That means more profit sooner.
"All that matters is movement," says Burke. His biggest day in the market resulted in a $50,000 gain when the Dow plummeted 250 points, then recovered. "One day I lost $10,000. I didn't want the market to close. I was mad at myself. I was up pacing that night. I came in at 6 the next morning, even though the market didn't open until 8:30."
NASDAQ in theory belongs to the public, but trading on it has always passed through a select group of market makers who sit in front of what are known as Level II screens. The screens display all the market makers' prices on a given stock, as well as recent trades of it. Hence, they provide clues to future price movements.
Chris Block contends that the vast majority of retail brokers have never heard of a Level II screen, much less seen one. Moreover, he adds, "if a broker said he wanted a Level II screen on his desk, his firm would laugh at him." The firm's market makers, usually the big studs in the shop, would never allow it. He says this hoarding of vital pricing information arises from the single fact that at the large brokerage houses, the trading desk accounts for as much as 40% of a firm's operating profit. Says Block: "They don't make money on retail brokerage. That's just a distribution system for the stock they're hawking."
The SOES bandits at Block Trading are too busy making money to notice that they're restructuring an industry and eating into its old guard's profits.
"The other traders call my style 'radical,' " says Stephanie Clark with a laugh, describing her own--so far successful--approach. She favors high-flying high-tech stocks that carry wider spreads and produce wider swings in price. Clark has an equity stake of $300,000, borrowed at 15% from a friend, against which she might be carrying 12 open positions worth $1 million or more at any one time. In September, the month I visited Block Trading, Clark netted $25,000 after commissions and paid $3,000 in interest. October started off with a bang. In the first two days she made $14,000; the next three, she lost $12,500. "The market got real jiggy on me," she recalls. "I'm looking for a trend one way or the other. That's how you make money." When the trend's not there she takes a day off or even a short vacation to Cozumel. After the three-day losing streak in early October, she went shopping. Her next day back she netted $9,000. She made $60,000 for the month.
At 2 p.m. on the day of my visit Clark has already made 80 "round-trips"--80,000 shares bought and sold. She's up $6,000. She'd like to go to the bathroom, but she can't get "flat," or close out her positions. "Why is Intel going down?...Nice, PAIR just downticked," says Clark, transfixed by the screen. "Hamquist is really a buyer, but he acts like a seller. I'm not going to fall for that."
In the last hour she has made three-quarters of a point and a "stick and three-quarters" (one and three-quarters) by twice shorting PairGain Technologies, a stock that has gyrated between 74 and 79 since the opening. Now she thinks it will strengthen toward the close, so she'll go long.
"You've got to stay flexible and have a sense of humor about this," she says. It's also a good idea not to let details muddy the process. To Clark a stock is nothing more than a four-letter symbol describing its own peculiar trajectory across her screen. PairGain Technologies is one of her favorite stocks because it jumps around so much, but to Clark it's simply "PAIR." "Are they a big supplier of copper wire?" she asks. "I don't know."
In the Wall Street hierarchy SOES bandits rank somewhere between outcast and untouchable. That amuses Burke and Block. "What we're doing for the first time is exposing the corruption and collusion that's been going on in the markets for years," says Burke. "We're not the bandits. They're the bandits."
Last August the Securities and Exchange Commission filed a lengthy report that confirmed what many people had suspected. It stated that there was, effectively, collusion and price-fixing by market makers, with a consequent cost to the public of billions of dollars. In a consent decree the NASD, while not admitting guilt, agreed to spend $100 million to police itself.
Burke and Block find such a move laughable. They say that the NASD could spend nothing and clean up the markets simply by allowing the SOES bandits to continue to trade without restriction. "We're the stock cops," says Block. "We're the ones who keep the market makers honest." Block Trading offers a check on professional market makers' abuses by letting the common folk in. "We allow our customers to come right in," says Block. "Go to Goldman Sachs and ask them to let you into their trading room. It'll never happen. This has been a monopoly situation, and all of a sudden the business has been invaded by guys like us."
THE OLD GUARD
Getting a comment from established brokerages about SOES is akin to inquiring about an errant family member who, if ignored, might be forgotten. Our phone calls to Merrill Lynch, Smith Barney, and Morgan Stanley seeking comment about SOES all went unreturned.
But Meyer Berman, who heads his own New York and Florida-based investment firm, M. A. Berman, will fill your ear. "This is the biggest story of the financial world in the 20th century," says Berman. He says that SOES-created volatility has lured hordes of unsophisticated investors into the market and pushed stock prices up to unsustainable levels. When the bubble bursts, Berman predicts, SOES traders will then drive the market down through massive short selling. That drop will dovetail with the market makers' backing away from holding stock (and thus maintaining the fair and orderly market with which they are charged) because "they've been SOES'ed to death." Adds Berman: "They [the SOES bandits] say they're for the little people, but they have really screwed the little people. SOES is the ruination of the market makers, who are now afraid to hold stock."
Berman recently sparred with Block over SOES on CNBC. Their "debate" turned into a shouting match, after which Berman sent Block the following letter: "Dear Chris, You seem like a lovely guy. I wouldn't mind having you as a friend or neighbor. I could probably beat your ass in tennis even though I'm sixty-three and fat. Take my advice. Don't try to defend the SOES bandits. The regulators will be forced to change by Congress, and then there will be a bounty out for you....Don't be among the pigs that get caught."
CUTTING OUT THE FAT
Chris Block sloughs off such slurs. "This is a business where people lie all the time to make money," he says. He adds that the simple truth is that numerous studies of SOES have been done, and none has suggested the system would destabilize the market.
Robert Battalio, a professor of finance at Notre Dame, Robert Jennings at Indiana University, and Brian Hatch at the University of Delaware studied SOES's effect on the market with data provided by the NASD. "We found, in fact, that volatility causes SOES trading as much as SOES trading causes volatility," says Battalio. Moreover, an NASD internal study turned up no evidence that SOES bandits had reduced the number of market makers supporting individual stocks. Battalio, rather, came away with two firmer truths: "SOES makes the market more informationally efficient. The NASD doesn't like SOES, so it will look for any reason to get rid of it."
Courtland Huber, a professor at the University of Texas who studies the relationship between price and information in securities markets, provides a deeper understanding of what's really going on in the debate over SOES. He says Berman's comments are representative of an industry old guard that sees itself under assault in a time of profound and rapid change. "I see this as a similar phenomenon to changes in retailing that have come about through Wal-Mart. The old channels of distribution that are smaller and more fragmented required greater markups to bear the costs," says Huber. "As Wal-Mart came in, there were winners and losers. The winners were customers; the losers were the people in the old distribution channels. We are not surprised to see resistance in the old channels. It's amusing to hear those who don't want change. They're really wondering out loud, 'How will I get paid in the future?' "
THE NEXT ARMY OF ANTS
Block and Burke's sudden rise to success has taken many in the industry by surprise. When Burke started at Lehman Brothers, he was making all of $5 an hour. "I wasn't even making cold calls," he recalls. He was simply dialing the phone and "shooting" the calls to brokers. "When I left Lehman, the managers told me, 'You guys are crazy.' "
Block's old boss at Merrill Lynch, where he'd worked before going to Lehman, was even less encouraging. "He called me a whore and said I'd never make it in this business," says Block.
It hasn't worked out that way. Not only have Block and Burke prospered, but Lehman has had to close its Houston office. And Block has had a laugh at Merrill Lynch's expense as well. When Block was looking for quarters for the company, he was shown the Galleria space the firm now occupies. Merrill Lynch was a major tenant and had been successful in barring all discount brokers from the premises. Block Trading sneaked in by classifying itself as a "day trading" firm--and ended up renting space that happened to face Merrill Lynch's right across the atrium. Recalls Block, "I told them I'd pay double for the opportunity to be up here and wave across at my old boss at Merrill Lynch every day."
Asked what a giant like Merrill Lynch will do to a gnat like Block Trading, Block waves the question away. "They're not going to do anything." What he and Burke spend their time worrying about is the next army of ants ready to steal their lunch at the picnic. Who is the next Block Trading and what technology will it leverage to grind Block's profits to dust?
Block and Burke have already been down to Mexico City, studying the technologically challenged Bolsa. When Block thinks of other foreign exchanges, he fires up another Marlboro and starts orating. "Do you realize in Israel they have little kids posting the prices, who all of a sudden disappear for lunch every day at 11?" He and Burke have asked themselves, Why not trade stocks using decimal points instead of fractions? That would give customers even better prices and steam the market makers all the more. Says Block, "After we're done with the United States or have gotten kicked out because they've made a rule or we can't make a profit, then we'll go to the foreign markets."
Then they'll worry about Merrill Lynch, where across the mall, office manager Roger Kinghorn stresses that "Block Trading has absolutely no impact on our business."
To which Chris Block responds: "Roger's not up on this. He's a retail sales manager with tunnel vision."
And then he adds: "Someday Block Trading will be a household name like Merrill Lynch. Then they'll buy us--or we'll buy them."
Movers and shakers
One of the great economic myths of the late 20th century is that radical economic change is ultimately the work of global forces beyond our control. Crafty overseas competitors have undercut and outmaneuvered us. Their cunning has crippled the Fortune 500 and brought the dread of downsizing to Main Street America.
In fact, what most threaten large established companies are small new ones. The upstarts keep finding more efficient ways to do things, producing two outcomes. First, customers receive a better price. Second, established businesses find their cost structures under attack.
Block Trading's franchise is built on simple concepts. The company exploits technology to get more accurate information--in this case, the pricing of securities--into the customer's hands more quickly. That gives the customer the ability to trade more quickly and at less cost. The price he or she sees is not marked up, trades are executed within two seconds, and Block Trading charges just $15 to $25 per trade in commissions.
Block Trading, though in and of itself not a startling story, is the latest example of an innovative company blowing up an industry model and offering the customer a better deal. Wal-Mart has done it in retailing, Nucor in steel, and MCI and Sprint in telecommunications. Southwest Airlines, People Express, and ValuJet have reconfigured air travel. The list goes on to include such by-now well-known names as Charles Schwab, Federal Express, Dell, and Gateway 2000, and about 100 other makers of personal computers, most of which have gone extinct.
Block Trading may never get close to the pantheon, but that doesn't matter. Even companies that flame out fast can trigger irreversible change. These new companies attack--and sometimes even trash--their markets. They create jobs for people, and headaches for slow-to-respond competitors. They destroy the status quo, and often themselves in the process. Call what they do kamikaze capitalism.
Whether they survive or not, the insurgents leave widespread economic upheaval in their wake. Wal-Mart is credited (discredited?) with annihilating whole downtown shopping districts. Airlines such as People Express were accused by rivals of undermining the commercial aviation industry--and indeed, 200 carriers have failed in the last 15 years. Meanwhile, thousands of middle-management jobs in almost every industry have been eliminated in the forced march toward lower costs. A whole corporate management premise has been destroyed: companies now know that to win against the upstarts, they have to create assets, not just manage them.
Adrian Slywotzky, a partner at the strategic consulting firm Corporate Decisions, in Boston, says the upstarts are the crown princes of disintermediation. (That's a fancy term for taking the fat out.) "They restructure the value chain, with the customer's best interest being the driving point."
Large companies, Slywotzky says, are wide-awake to the threat posed by small businesses like Block Trading, which wield technology like a chain saw. But their terror freezes them. "It's very difficult for big companies to cannibalize themselves, despite knowing that the smart mind-set would be 'It's better for me to attack my own business model than to wait for someone else to.' But then they see how many assets they have locked up in the old way of doing things, and they resist change."
News was once local and slotted at 6 and 11. Then came Ted Turner, whose fortune originated with billboards. He put news in front of people around the clock--and around the globe. The result was CNN, now being copied by Microsoft and NBC, and Rupert Murdoch's News Corp.
WOULD YOU BUY STOCK FROM THIS MAN?
When brokerage commissions were deregulated, in 1975, Charles Schwab launched his discount firm--which became the first to use a personality to sell its services. Today many discounters and fund managers are stars, but Schwab's firm commands 51% of the discount market.
SURE BEATS THE BUS:
The major airlines used to compete just against one another--until Herb Kelleher's Southwest Airlines (and Don Burr's People Express soon after) took on the car, the bus, and the train. With no-frills service, Southwest became the most profitable U.S. carrier--and a model for most airline start-ups today.
BIGGER THAN A BREAD BOX:
The first portable personal computer was the brainchild of Adam Osborne. Weighing in at a retrospectively obese 25 pounds, the Osborne sank once Apple and IBM portables followed it into the market. Now everyone makes laptops, and Osborne Computer, which soared briefly in the early 1980s, is no more.
ROOM TO ROAM--AND READ:
Books by the baleful and the aroma of coffee remind us of modern-day megastore chains Borders and Barnes & Noble. But the trend began with a 26-year-old independent, the Tattered Cover, whose two easy-browsing emporiums in Denver draw readers from all over the region. Size and selection are now what book buyers expect.
Edward O. Welles is a senior writer at Inc.