There can’t be many authors who have managed to anger the President of one of the major US stock exchanges to such an extent that they induce them to lie live on CNBC resulting in the Attorney General no less asking them to take back what they said. In what started out as a Wall St detective story , Michael Lewis has taken his uncanny ability to use stories to explain away complexity (think Moneyball) and applied it to high frequency trading in his book Flash Boys.
I beat the crowd of suits to secure a ticket to hear him talk to John Lanchester at LSE about the shit storm that this book has created. In person he is just as cool as you would expect - rememberimg that I think weird people are cool. He is California slick, articulate and funny in a self-deprecating way. Trying to explain high frequency trading in terms of technicalities is hard - really hard. But the technicalities aren’t the interesting bit. Flash boys is a study in human behaviour. That’s the interesting bit.
In honour of Michael’s style, very simply, I would explain the story thus: a nice Canadian trader working on wall street trying to buy and sell stock on behalf of his clients realised that every time he hit enter to buy , the price of the stock would change on his terminal. At first he thinks he is going crazy or there is some IT glitch or that he has an insider trading problem. He becomes obsessed with solving the problem and it doesn’t take long for him to realise that it is his trades that are the event causing the price to jump. In essence, high frequency traders were using his buy order as a jump off point for them to use their faster systems to buy up all of the available stock on each of the exchanges and then fulfill his order at a very slightly inflated price. This front running of the market allowed these firms to keep the profit from the slightly inflated price for themselves. It’s a little like insider trading, except you actually know the price that is being offered to buy the stock first!
They were able to do this because when you hit a buy order for stock, you do not buy it from one exchange. There are 13 public exchanges in the US and numerous other private exchanges or dark pools selling stock to the market. So when a buy order is sent, the order arrives at the exchanges at different times based on where the servers for the exchanges physically sit relative to the server from which the buy order was sent - where the servers are located matters so much that some exchanges started leasing the space right next to their servers to the high frequency traders for them to park their own servers.
It’s hard to imagine these increments of time being valuable. It takes 100 milliseconds to blink your eye and only a quarter of that to front run the market.
The loophole that the high frequency traders are taking advantage of was, in part, created by a well-intentioned regulation that forced brokers to go to the market to buy at the best price for their clients. So yes, this is a loophole and the SEC knows about it. The nice Canadian guy(lets call him NCG) told them that when he built some software to ensure that his trades arrived at the exchanges at the same time to prevent the high frequency traders using their superior speed and location to their advantage. But, and ths is where the human behaviour aspect starts to come into play, there were people within in the SEC who did not think that what the high frequency traders were doing was wrong or bad for investors, even if they ended up paying more for their stock.
Lewis suggests this is because quite a few people from the SEC join the industry at some point. I think it’s more complicated than that. It’s nigh on impossible to fix such an insanely complex, highly secretive system from the outside. You have to work from the inside out. Just like the NGC.
People from across the industry knew that this was happening. But many investors, even the serious professional investors, did not. With 13 public exchanges and any number of dark pools it is bordering on impossible for investors to find out how and where their money is being handled. After speaking to the SEC, NCG decided to go out and start telling investors what he had found out. Most were equal parts shocked and weirded out that this guy from inside the system was sharing this information, just because it was the right thing to do. Lewis claims that NCG even had to pretend to have an ulterior motive of being ‘long term greedy’.
I’d also make sure to say that Lewis is not anti-electronic trading. In fact the opposite is true. To his mind it was a good thing for the world to get the brokers out of the middle. Getting people out of the middle actually eliminated many of the middle manager jobs on Wall Street, returning money to investors. But electronic trading and the regulations that followed also served to make the market far more complex and fragmented, ripe for very smart people focussed on and rewarded for gaming the system. Lewis believes that much of the regulation today is focussed on catching people out, making them feel like criminals, rather than encouraging them to be more trustworthy or interested in acting in the best interests of their customers.
Despite all this, Lewis claims to have written a hopeful book. Perhaps it is. Certainly the events that followed have been hopeful. NCG has used the credibility he gained telling investors the truth about how their orders were being executed to set up his own exchange that intentionally slows down orders and does not allow anyone who will invest on the exchange to invest in the exchange. The IEX is now used by many of the major brokers including Goldman Sachs who have gone so far as to endorse the exchange, despite being a major investor in other exchanges including the BATS Exchange. The reasons why I think that they have done this are worth a whole other blog post. Apparently, the book has also encouraged the Attorney General to launch an investigation into the claims of front running
The infamous CNBC interview that allegedly stopped Wall St and inspired spontaneous applause from the faux trading floor behind the CNBC newsdesk was the first time the nice Canadian guy Brad Katsuyama had ever been on TV. What a debut! Alongside Michael Lewis explaining to the furious President of the BATS exchange and the audience why they believe the stock market is rigged.
The straw poll that Michael took in the room of suits at LSE seems to support that view with 70% voting that they believed the market to be rigged. Michael describes how a friend of his was watching the CNBC interview from the floor at Goldman Sachs, standing next to one of their ‘old timers’. The old timer says to his friend: the angry guy, so we own £150m of his exchange? The friend replies yep. And the smart, little Canadian guy, we don’t own any of his exchange? Nup the friend says. We’re fucked the old guy replies. Indeed.