Book Reviews | Apr 14 2014
By Greg Peel
“Their new exchange needed a name. They called it the Investors Exchange, which wound up being shortened to IEX. In the interest of clarity, they hoped to preserve the full name, but they discovered a problem doing so when they set out to create an internet address: investorsexchange.com. To avoid that confusion, they created another.”
The most appealing element of reading a book by Michael Lewis is that despite the complexity of the subject matter, the reader is always guaranteed the odd belly laugh. At the very least, Lewis possesses an innate talent to deconstruct, even for the most financially inexperienced reader, perplexing and downright doing-my-head-in concepts such as subprime mortgage collateralised debt obligations, as he did The Big Short, and globally significant events such as the crisis in Europe, as he did in his last work Boomerang, to provide a readily accessible explanation. And Lewis’ books are simply stand-alone entertaining, even if the reader was never particularly interested in the subject matter in the first place.
Flash Boys (Cracking the Money Code) is, at its heart, an expose of the latest doing-my-head-in financial market practice known as High Frequency Trading. But Flash Boys is also the story of how a handful of disgruntled and morally disenfranchised Wall Street employees set about correcting what they saw as a glaring injustice.
“Once very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system up further, or to remain silent as they watch it being screwed up by others. The cost, in the end, is a tangled up financial system. Untangling it requires acts of commercial heroism – and even that fix might not work. There was simply more money to be made by the elites if the system worked badly than if it worked well.”
Lewis caused an uproar in the US and subsequent heated debate right across the financial industry when his Sixty Minutes interview was aired earlier this month to coincide with the release of Flash Boys. In the interview, Lewis claimed the US stock market was “rigged” in favour of the big financial houses and the HFT specialists, and at the expense of all legitimate investors, big and small. The furore continued when the “hero” of the book, mild-mannered Canadian Brad Katsuyama, appeared on CNBC in a face-off with a less than mild-mannered American HFT specialist, and stood his ground in support of Lewis’ assertion.
Flash Boys takes us on Katsuyama’s journey from noticing something rather strange going on in the electronic US stock markets to ultimately gathering a coterie of equally disillusioned Wall Street traders, computer programmers and telecommunications experts to create his own stock exchange, the above-mentioned IEX, which would eliminate the advantages HFT was providing the ever more wealthy few.
The irony inherent the twenty-first century stock market is its “back to the future” progression. In the twentieth century, stocks were traded through face-to-face transactions on physical trading floors. Broking houses were headquartered in stock exchange precincts (Wall Street in New York for example, and Bond Street in Sydney) because exchanges had to be physically attended. In order to access this market, investors could do no better than pick up the phone to their broker and hope the line wasn’t busy.
By the late twentieth century, stock markets had transitioned onto electronic platforms. The Nasdaq, for example, headquartered in Times Square, was only ever electronic. The ASX trading floor on Bond Street closed when the Australian stock market became fully automated and internet interfaced. The iconic New York Stock Exchange still maintains a trading floor to this day, but really it’s only for show (to give “Wall Street” a physical and psychological presence). The vast majority of NYSE trades occur over the internet.
But today the NYSE is only one of thirteen “public” US stock markets. And there are 45 broker-owned “dark pools”, or private exchanges (at which trading is undisclosed). All these clearing centres trade with US regulatory approval, and all of them, bar the symbolic NYSE, exist only in cyberspace.
The development of stock exchanges in cyberspace meant that physical location was no longer an issue. US investors in New York or Los Angeles or Kalamazoo, or Australian investors in Sydney, Perth or Yackandandah, could all access the exchange equally, and shares could be bought and sold in the blink of an eye. Indeed, what use were stock brokers anymore? Discount trading platforms allowed investors to cut out the middle man.
But just as once upon a time an investor would hope to be first to the phone to place an order with a broker, investors in cyberspace still needed to first to type their order into their computer to catch the price on the screen. Internet speed soon became a real issue, and in cyberspace the blink of an eye is equivalent to a century. Internet speed is now measured in microseconds. And the greatest barrier to speed is the physical distance an order has to flow down a cable, even a fibre optic cable.
Stock trading and broking thus had to turn full circle, and go back to benefitting from a physical location as close as possible to, if not actually in, a stock exchange. Exchanges may now be electronic, but they still require massive servers to run them, and these reside in physical locations. The majority of US “exchanges”, being their data centres, are located in New Jersey. The ASX data centre is located in Gore Hill, northern Sydney (having recently moved from Bondi).
The most successful stock market traders have always, throughout history, been the “first to move”. In the twenty-first century, “first to move” is all about shaving off the microseconds. Those who have the money to invest in “co-locating” their own servers near or inside exchange data centres, and to employ genius geeks to write complex algorithms, have gained a speed advantage that comes down to mere microseconds. In being able to trade at a speed that not only is indiscernible to the human eye, but faster than even an exchange’s own systems as well as the systems of genuine brokers and investors, smart trading houses can pick off trades, spot incoming volume, and jump from exchange to exchange before anyone else would ever notice. By trading only in minimum order sizes, but doing so thousands of times a day across all exchanges, high frequency traders can gain an almost foolproof advantage over “real” investors. HFT houses have been making billions while never risking anything but trivial order sizes and never carrying a position past one trading day. Those billions have been “skimmed” off the genuine investors.
And none of it is illegal. Indeed, none of it is any different to what stock market traders have been doing since stock markets began, it’s just that it happens so fast no one can see when they are the ones on the losing end. (“Losing” in this case, means paying the extra penny for a stock or selling at a penny less because an HFT trade, or hundreds of them, got in first to skim that penny.) HFT systems are so much faster than any other systems that HFT houses can have a look at orders coming into the market and decide how to respond, to the HFT house’s profitable benefit (which in up to 75% of cases means cancelling an order), long before the order can be transacted. “Long before” as measured in microseconds.
Is the US stock market thus “rigged”. Michael Lewis believes so. Brad Katusyama so fundamentally believed this to be the case he set up his own HFT-impenetrable exchange and dared the big broking houses to send their clients’ orders there. (While HFT is not itself illegal, brokers are legally required to operate primarily in their clients’ interest.) How Goldman Sachs, often seen from outside as the arch-villain of Wall Street, responded may surprise many readers.
Personally, I don’t believe “rigged” is the right word. HFT is not illegal and is merely a superfast adaptation of historical “real time” trading strategies and tactics. However HFT is clearly inequitable, and such inequity is being perpetuated by a flawed US financial structure and regulatory system that in promoting competition, and “weak hands to strong hands” economics, has inadvertently created a monster that allows the few to skim billions of risk-free profits off the many.
You might have a different opinion. But first, you must read Flash Boys. Trust me, you’ll have difficulty putting it down.
Michael Lewis: Flash Boys (Cracking the Money Code); Penguin Group, New York, 2014. 274 (large font) pages.
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