Flash Boys: A Wall Street Revolt
Michael Lewis (W. W. Norton & Company, 2015, 2014)
My grandmother used to say that her favorite grandchild was whichever one she was looking at. I feel that way about Michael Lewis's books. They are generally great, and Flash Boys is amazing. It tells a story that could very easily have gone unreported, but which has undeniable implications for the whole financial world. (I'm being a tad hyperbolic: in footnotes, he mentions a couple of other books that I know I'll want to look for.)
Flash Boys is structured around the story of Brad Katsuyama, a trader with the Royal Bank of Canada. His job was to take large institutional blocks of stock that a client wanted to trade and break them up so that they could meet the market at a fair price. In 2007, he noticed that the price information he saw on his computer screen wasn't stable enough to work with. As soon as he hit 'Buy', most of the offers at the price he was looking at disappeared, and he'd wind up paying more than he intended.
Was it a problem with his hardware? No. With his software? No, again. It was with the markets themselves; and that plural noun is a telling detail. The New York Stock Exchange and Nasdaq became public, for-profit corporations in 2005. “Once competition was introduced, the exchanges multiplied. By early 2008 there were thirteen different public exchanges, most of them in Northern New Jersey.” All this activity was mediated by computers, of course. Fiber optic cables carried signals at two-thirds the speed of light, and trades were executed in a few thousandths of a second, with no further human intervention.
What Katsuyama, and Lewis, learned is that some traders ('high frequency traders', or HFT) were working so much faster than the official average price that showed up in RBC's offices that they could run ahead like the big bad wolf reaching Grandma's cottage. They'd find out about RBC's need for ten thousand shares of AnyCorp at forty dollars each by offering to sell one hundred shares at $39.99; within a fraction of a second, they could corner the market on any shares under $40.05 and sell them to RBC with a nice little premium of a few hundred dollars for themselves. When the HFT computers are in the same room in New Jersey as the exchange's computer, they can easily trade rings around a brokerage on Wall Street whose information is always fifteen thousandths of a second slow. And even if their margins are measured in a few pennies or dimes per hundred dollars, this adds up to billions of dollars a year.
The proliferation of markets, including 'dark rooms' or private exchanges set up within brokerages, only encouraged this scalping. As the name implies, dark rooms operate under rules that are opaque to investors, and indeed to regulators. That would be fine if they were truly honest brokers, but the evidence is clear that they usually aren't. Worse yet, “[E]ven if the Wall Street bank resisted the temptation to trade for itself against its own customers, there was virtually no chance they resisted the temptation to sell access to the dark pool to high-frequency traders.”
The people who helped Brad Katsuyama figure this out came up with a high-tech solution. They wired their computers to transmit orders to arrive at all the public exchanges at the exact same moment, depriving the scalpers of their time advantage. This system, dubbed 'Thor', put the RBC traders back in the position of making the trades that appeared to be on offer.
In a meeting with an arm of the Securities and Exchange Commission, Katsuyama had a startling experience: an SEC staffer told him there was something wrong with his new system: “What you are doing is not fair to high-frequency traders. You're not letting them get out of the way.” In other words, Thor was forcing traders to honor bids that had not been offered in good faith. Another staffer, an older man, argued back: “If they don't want to be on the offer they shouldn't be there at all.” The SEC hardly ever argues like that in public, but clearly they were not going to take the lead in finding a solution to this problem, especially considering how many people move from the SEC into lucrative jobs with high frequency trading outfits.
The game is well and truly rigged, and we hardly dare to know how much; the HFT business works in response to the last set of regulations, from 2007, but that's just the latest in a seemingly infinite series. Every new regulation makes new loopholes. In 2012, Katsuyama and his team had a radical idea: start their own exchange, with a simpler and more transparent structure. He left RBC and assembled a crew of people with expertise on all sides of the business. By the end of 2013, IEX was taking orders, and they are now processing about one per cent of the market.
After reading Flash Boys, I can see why index funds are so much likelier to make money than actively managed funds – every single time a fund manager goes into the market, he's the prey. You can't win, you can't break even, and you can't get out of the game. Now, however, there is literally one honest broker out there. My individual trades weigh nothing, but I dare to hope that the people who run my IRA funds are getting fair prices on IEX. If not, why not?
Emailed July 1, 2015