Michael Lewis has written several great books about various marketplaces. Two standouts are Moneyball and The Big Short. These books extol the virtue of determining the true value of an item in an opaque market. How do you find the real value of a minor league baseball player or a securitized sub-prime mortgage bond fund, then exploit that knowledge to find a hole in the market?
Lewis’s most recent book, Flash Boys, takes the opposite tack. Here, the math oriented, technically superior high-frequency traders (HFT) who are exploiting the hole are the bad guys, even though they seem to have a lot in common with Oakland’s Billy Bean, or hedge fund manager Steve Eisman.
In Flash Boys Lewis takes on the innovators, the HFT, for their predatory behavior. He also goes after the big Wall Street banks and their so-called “dark pools,” where big trades are made but no official printed rules exist, and where the banks making the market assure buyers and sellers that they are both simultaneously getting the best price. But both sides can’t be winning, and this contradictory claim is one reason customers’ trust in the big banks has eroded in recent years.
Once upon a time, as many of us remember, if an investor wanted to buy or sell a stock he would call a broker who would find a way to execute the trade as efficiently as possible — talking to other human beings. The arrival of computerized exchanges eliminated many of the people from the process. Now bids and offers are matched by computers. In theory this means that markets should become more efficient and the cost of trading should fall. But the effects of technology are rarely so simple.
Today, if you place an order for 1000 shares of IBM, the order is supposed to ping from exchange to exchange claiming a few shares at each stop, seeking the best price until the order is complete. But the moment the order hits the first exchange the information is out, and the high-frequency traders (with ultra fast computers and shorter fiber optic cable) see your order (especially if it’s large), and race ahead of you to the other exchanges. They buy the stock you want, and then sell it back to you for a slight up-charge. All of this happens in a matter of milliseconds — millions of times a day.
High Frequency Traders execute a combination of two old Wall Street scams — first, insider trading (seeing your order), and second, front running the market. However, in this situation, it is entirely legal. It is an unintended consequence of SEC Regulation NMS passed in 2007, intended to protect the consumer from paying too much. But it opens the door for HFT to squeeze in between trades and create arbitrage opportunities worth billions.
The heroes of the book are the so-called “flash boys,” Brad Katsuyama and a team of talented oddballs who ferret out the schemes going on and create a HFT-proofed exchange called IEX, signifying “Investor’s Exchange,” where the price a trader sees is the price he gets.
The exchange is backed by some leading hedge funds and banks who felt they were getting bilked by the HFT. The average small investor is also being taken advantage of by HFT but likely doesn’t notice a penny or two per share on an occasional trade. But if the investor is invested in a pension fund or mutual fund, he is being hurt by HFT.
Currently, even though the new IEX exchange is well on its way to financial success, there doesn’t seem to be any evidence that high-frequency trading has declined. And, in reality, the villains of this story, the high-frequency traders are not quite villains. They are just smarter and faster than everyone else. Even Katsuyama comments, “It’s not their fault. It’s brilliant what they have done legally, within the bounds of the regulation.”
Lewis’s Moneyball revolutionized the way the market for baseball talent is evaluated from the major leagues to fantasy leagues. It will be interesting to see if Flash Boys has the same effect on the financial markets.
Question: Do you feel abused by financial institutions?
Jerry Levine is a writer for Today’s Machining World, and a retired engineer who worked in BP’s chemical division.