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Is the U.S. stock market rigged?

The following script is from "Rigged" which aired on March 30, 2014, and was rebroadcast on Aug. 17, 2014. Steve Kroft is the correspondent. Draggan Mihailovich, producer.

This year marks the fifth anniversary of the current bull market on Wall Street, making it one of the longest and strongest in history. Yet U.S. stock ownership is at a record low and less than half of Americans trust banks and financial services. Some might argue with good reason. In the past few months, state and federal authorities have launched investigations into high frequency computerized stock trading that now controls more than half the market.

As we reported last March, the probes were announced just ahead of a much anticipated book on the subject by best-selling author Michael Lewis called "Flash Boys." In it, Lewis argues that the stock market is now rigged to benefit a group of insiders that have made tens of billions of dollars exploiting computerized trading. The story is told through an unlikely cast of characters who figured out what was going on and devised a plan to correct it. It's had a huge impact on Wall Street, with the top U.S. stock regulator, the Securities and Exchange Commission, vowing to take action. Michael Lewis broke the story here just before the book came out.

Steve Kroft: What's the headline here?

Michael Lewis: Stock market's rigged. The United States stock market, the most iconic market in global capitalism is rigged.

Lewis explains how the stock market is rigged 02:28

Steve Kroft: By whom?

Michael Lewis: By a combination of these stock exchanges, the big Wall Street banks and high-frequency traders.

Steve Kroft: Who are the victims?

Michael Lewis: Everybody who has an investment in the stock market.

"Stock market's rigged. The United States stock market, the most iconic market in global capitalism is rigged."

Michael Lewis is not talking about the stock market that you see on television every day. That ceased to be the center of U.S. financial activity years ago, and exists today mostly as a photo op. This is the stock market that Lewis is talking about; the one where most of the trades take place now, inside hundreds of thousands of these black boxes located at more than 60 public and private exchanges, where billions of dollars in stock change hands every day with little or no public documentation. The trades are being made by thousands of robot computers, programmed to buy and sell every stock on the market at speeds 100 times faster than you can blink an eye. A system so complex, it's all but invisible.

Michael Lewis: If it wasn't complicated, it wouldn't be allowed to happen. The complexity disguises what is happening. If it's so complicated you can't understand it, then you can't question it.

Steve Kroft: And this is all being done by computers?

Michael Lewis: All being done by computers. It's too fast to be done by humans. Humans have been completely removed from the marketplace.

"Fast" is the operative word. Machines with secret programs are now trading stocks in tiny fractions of a second, way too fast to be seen or recorded on a stock ticker or computer screen. Faster than the market itself. High-frequency traders, big Wall Street firms and stock exchanges have spent billions to gain an advantage of a millisecond for themselves and their customers, just to get a peek at stock market prices and orders a flash before everyone else, along with the opportunity to act on it.

Michael Lewis: The insiders are able to move faster than you. They're able to see your order and play it against other orders in ways that you don't understand. They're able to front run your order.

Steve Kroft: What do you mean front run?

Lewis: Rigged stock market is "bigger than a scam" 00:54

Michael Lewis: Means they're able to identify your desire to, to buy shares in Microsoft and buy 'em in front of you and sell 'em back to you at a higher price. It all happens in infinitesimally small periods of time. There's speed advantage that the faster traders have is milliseconds, some of it is fractions of milliseconds. But it''s enough for them to identify what you're gonna do and do it before you do it at your expense.

Steve Kroft: So it drives the price up.

Michael Lewis: So it drives the price up, and in turn you pay a higher price.

"If it wasn't complicated, it wouldn't be allowed to happen. The complexity disguises what is happening. If it's so complicated you can't understand it, then you can't question it."

Michael Lewis is not the first person to allege the stock market is rigged or that high-frequency traders are front running the market but he was the first to find Brad Katsuyama, who is the first to figure out how it was being done.

Michael Lewis: A very unlikely character, a trader at the Royal Bank of Canada, a young Canadian man named Brad Katsuyama realized that the market that he thought he knew had changed. The market seemed to be willing to sell a stock. But the minute he went to buy it, someone else bought it, the stock went up. It was as if someone knew what he was doing before he did it.

RBC trading floor in New York City

Back in 2008, Katsuyama was 30 years old and running the Royal Bank of Canada's stock desk in New York with 25 traders working for him. Every time one of them tried to buy a large block of stock for a client their order would only be partially filled and the price of the stock would go up. It kept happening over and over again.

Brad Katsuyama: The best analogy I think is that your family wants to go to a concert. You go onto StubHub, there's four tickets all next to each other for 20 bucks each. You put in an order to buy four tickets, 20 bucks each and it says, "You've bought two tickets at 20 bucks each." And you go back and those same two seats that are sitting there have now gone up to $25.

Steve Kroft: What'd you think the problem was?

Brad Katsuyama: I had no idea. I couldn't get answers.

At first, Katsuyama thought the technology at RBC was slow, until he went to Stamford, Conn., and paid a visit to one of the largest hedge funds in the world.

Brad Katsuyama: The same thing that I was experiencing as a trader, one of the most sophisticated hedge funds in the world was also having the same problem. Then the light bulb goes off. You say, "Holy cow, this is, this is a huge problem."

Steve Kroft: You were determined to get to the bottom of it?

Brad Katsuyama: Yeah.

Steve Kroft: Why?

Brad Katsuyama: 'Cause it just didn't feel right. It didn't feel right that people who are investing on behalf of pension funds and retirement funds are getting bait and switched every single day in the market.

Katsuyama suspected that the problem had something to do with plumbing, the way the trades were routed through fiber optic cables from his trading desk in lower Manhattan to the 13 public exchanges in northern New Jersey. But no one would tell him exactly what happened to his orders once he hit the buy or sell button. So he put together a team of technical experts, traders and most importantly, an Irish telecom guy named Ronan Ryan, who was an expert on high-speed fiber optic networks.

Ronan Ryan: I knew nothing about trading until my first day at RBC when I sat in that three hour meeting on algorithms. I called my wife afterwards. And I'm like, "Holy crap, I have no idea what they just said."

Ryan had done work for the high-frequency traders. He knew what they were building and he knew about the colossal amounts of money they were prepared to spend. He told Brad about a company called Spread Networks that had laid a high-speed fiber optic cable from the futures market in Chicago to the exchanges in New Jersey. They spent $300 million just to shave three milliseconds off the fastest route and were leasing access to high-frequency traders at $10 million a pop.

Michael Lewis: From Brad Katsuyama's point of view, when he heard they were willing to spend that kind of money for milliseconds it told him the sums involved were vast. That was one of the first questions he said he had. He says, "All right, I'm getting ripped off. Everybody's getting ripped off. But what does it add up to?" And I think when he heard the story of Spread Networks, he realized this is tens of billions of dollars we're talking about.

Ronan Ryan also knew where all the cable was buried and had detailed maps of the fastest routes from the financial district in lower Manhattan to the various stock exchanges in New Jersey, all calculated down to the millisecond.

Ronan Ryan: So I would sit there, roll out maps, and roll out this data center as a box and a line going through it. And they had no idea what I was on about. And then I'd be like, "Hey are you guys aware of where these data centers are located? Of course you're arriving there at different time intervals."

For Brad, the maps turned what had been an abstract idea into something he could actually see. The first place his orders were landing was the BATS Exchange across the river in Weehawken, N.J., and high-frequency traders were lying there in wait.

Michael Lewis: Brad realizes, "Oh my God, that's how I'm being front-runned. I'm being front-runned because my signal gets to the BATS Exchange first and they can beat me to all the, all the other exchanges."

It only took a tiny fraction of a second for Brad's trade to reach the next exchanges on the network, but the high-speed traders were able to jump in front of him, buy the same stock and drive the price up before his order arrived, producing a small profit of just one or two pennies. But it was happening to everyone's trades millions of times a day.

How ordinary investors are getting "screwed" 00:42

Ronan Ryan: That adds up.

Steve Kroft: You make it sound like a skim.

Ronan Ryan: What else would you call it?

Michael Lewis: One hedge fund manager said, "I was running a hedge fund that was $9 billion and that we figured that the, just our inability to, to make the trades the market said we should be able to make was costing us $300 million a year." That was $300 million a year in someone else's pocket.

Steve Kroft: Is this illegal?

Michael Lewis: No. That's the thing that's so shocking about all this. It should...

Steve Kroft: Well you used the word front running. Front running's illegal.

Michael Lewis: This form of front running is legal. It's legalized front running. It's crazy that it's legal for some people to get advance news on prices and what investors are doing. It's just nuts. Shouldn't happen.

Ronan knew the only way to beat the high-frequency traders was to take away their milliseconds advantage that allowed them to sniff out slower trades and beat them to the exchange. He had an idea how to do it.

Brad Katsuyama: And he said, "You're probably better off trying to go slower," which means send the order to the exchange located the farthest away first and send the order to the one that's located to you last. So stagger when you send them out with the goal of arriving at all places, as close to the same time as possible.

Katsuyama and his team developed software that did just that, allowing the orders of Royal Bank of Canada's customers to reach all of the exchanges at the same time, cutting the high-frequency traders out of the equation.

Brad Katsuyama: And essentially our fill rates went to 100 percent. We couldn't believe it when, when we actually figured it out.

Steve Kroft: So you beat speed by slowing it down.

Brad Katsuyama: Yeah, as crazy as that sounds.

Katsuyama and his team went out and began selling and explaining what they had discovered to the big mutual funds, pension funds and institutional investors, people who had suspicions that they were being front-run but didn't know how.

Steve Kroft: And nobody had really bothered or tried to figure this out until Brad Katsuyama came along...

Michael Lewis: It was in nobody's interest to, correct. I spoke to dozens of investors, big investors, famous investors who, who said that, "When Brad Katsuyama came into my office and laid out to me how the market was rigged, my jaw hit the floor. I mean, I knew something was wrong. I just didn't know what it was and no one had told us."

Brad Katsuyama: Part of those meetings led us to believe, "Holy cow, this is, this is really something." 'Cause some of the most sophisticated, largest asset managers in the world, this is the first time they were hearing this story.

And some of the most famous names in the American stock market heard the pitch...

Lewis: Investors, big and small, are "prey" 00:58

Michael Lewis: The Capital Group, T. Rowe Price, Fidelity, Vanguard, I mean, it, one after another. He was in their offices. They said, "This man walked in. Why is he gonna know how the stock market operates?" And, and at the end of the hour they said, "Oh, my God, he understands."

Hedge fund titan David Einhorn of Greenlight Capital is one of the believers.

Steve Kroft: Was he able to show you how your orders were being front run?

David Einhorn: Oh yeah. They had, they, they got the marker and the white board and started drawing maps and boxes, and wires and locations. And yeah, we went through it in some detail.

Steve Kroft: Did you find it interesting?

David Einhorn: It was. It was.

Clients like Einhorn encouraged Brad and his team to do something bigger. That's when Katsuyama, a conformist even by Canadian standards, decided to do something radical. In 2012, he quit his high-paying job as head trader at RBC and went off with some of his team to start their own exchange.

Steve Kroft: You were making good money at Royal Bank of Canada?

Brad Katsuyama: Yeah, right.

Steve Kroft: Millions of dollars?

Brad Katsuyama:: Right. I guess, I guess everybody know that now? Right, yeah.

Steve Kroft: Why did you wanna go off and walk away from that job and start a stock exchange?

Brad Katsuyama: Yeah, wasn't an easy conversation to have with my wife, that's for sure. It almost felt like a sense of obligation to say, "We found a problem. It's, it's affecting millions and millions of people. People are blindly losing money they didn't even know they're entitled to. It's a hole in the bottom of the bucket.

They set out to build an exchange funded exclusively by large traditional investors. They called it IEX, the investor's exchange, and quietly launched it in October with the support of some of the biggest players on Wall Street. And it comes with built in speed bumps to eliminate the advantage of high-speed predators.

Michael Lewis: And the way they did it was they coiled 60 kilometers of fiber optic cable between themselves and the high-frequency traders computers. They call it the magic shoe box and it looks like it's got fishing line in it. But essentially, a high-frequency trader, if he tries to react on the IEX exchange, his trade goes (makes noise) for 60 kilometers until, so he's, he's in east Jesus.

Steve Kroft: So it gets there the same time as everybody else.

Michael Lewis: It gets there same time as everybody else's.

Steve Kroft: Do you think they can game you?

Ronan Ryan: I think that they'll try to game us. I think the fact, though, that we've gone and met with the majority of the biggest high-frequency firms to explain what the magic shoebox is doing and that people haven't said, "Oh that's rubbish. That won't work." We've had many ask us for a backdoor, to be honest. So that says something that it'll work.

The exchange is off to a strong start, although it is still very small with lots of powerful enemies that like the status quo and are trying to starve IEX by discouraging customers from using them. Greenlight Capital's David Einhorn is one of the investors.

Steve Kroft: Do you think IEX will survive?

David Einhorn: I think it's gonna succeed. I think it's gonna succeed in a very big way.

IEX received a strong endorsement from Goldman Sachs, whose top executives cited it as a model for a more stable and less complicated stock market.

Brad Katsuyama: We're selling trust. We're selling transparency. And, and, and to think that trust is actually a differentiator in a service business, it's kind of a crazy thought, right?

Michael Lewis: Why is this kid, why is he able to all of a sudden sit at the center of the American stock market? And the answer is, when someone walks in the door who is actually trustworthy, he has enormous power. And this is the story, story of trying to restore trust to the financial markets.

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