A month after hitting the streets, Michael Lewis’ “Flash Boys” has sparked such outrage that the Securities and Exchange Commission is investigating, U.S. Attorney General Eric Holder told a Senate committee that his office is investigating, and New York Attorney General Eric Schneiderman is investigating.
The culprit? High-frequency trading, the heretofore mysterious method whereby stock market middlemen execute trades in milliseconds. Touted as a super-efficient evolution of the stock market, high-frequency trading, it turns out, is a high-tech mechanism that allows firms to perform stock transactions before anyone else and profit from it.
The firms, which place their computers close by the stock exchanges to get trade information faster, buy stocks just after large orders are placed and sell them to the buyers for slightly inflated prices. This happens in a fraction of a second and has allowed these middlemen to skim billions from investors.
Lewis, the bard of Wall Street’s dirty secrets, has blown the cover off this self-serving ecosystem, and reaction has been swift and fierce. Last week, the SEC fined the New York Stock Exchange $4.5 million for rules violations related to co-location of HFT computers near the stock exchange.
Lewis has done this before with his unflattering portrayal of his time as a rookie bond trader in “Liar’s Poker” in 1989. But while that book painted a humorous picture of shenanigans at Salomon Brothers, his latest effort points out a systemic kink that further rocks people’s belief in the market. And it raises the spectre of a very fragile system that no one may truly understand.
The high-frequency trading sector has lashed back at Lewis, charging that their efforts have helped make the stock exchanges more efficient and less expensive. But they have not refuted what his book says. And while trading for individual investors has become faster and cheaper, the question remains: Can it be better, and more fair?
Lewis has a genius for making the complicated understandable through great storytelling. His main character and hero in “Flash Boys” is Brad Katsuyama, a curious and remarkably honest trader from the Royal Bank of Canada. He sensed something was wrong with the market when he would place a client’s order, and immediately the listed price would vanish and reappear a moment later, slightly higher.
He set off in search of what was happening – building a team of people with different gifts, from puzzle masters to computer geeks.
In 2007, no one in the business seemed to know what was causing the price fluctuations. Giant mutual fund managers didn’t know. Stock brokers didn’t know. Some force was playing games with stock prices, and no one could explain it.
What Katsuyama discovered, and what he did, could transform the way Wall Street operates.
Lewis sets the book in motion describing how a company called Spread Networks dug a straight line trench from New York to Chicago and installed a fiber optic cable that transmitted information between the two cities in 13 milliseconds. The company kept the project secret – even the scattered teams of installers did not know what it was for – and when it was done, the company sold usage of the line to 200 companies in five-year blocks for $10.6 million each.
Why was that cable so valuable? Because it allowed high-frequency traders to exploit tiny price variations on stocks between the two cities and trade on that variance – essentially charge a toll.
High-frequency trading evolved after stock exchanges became public companies in 2005 and multiplied. By 2008, there were 13 exchanges competing to sell stocks. Some even paid brokers to place trades with them.
Katsuyama couldn’t fathom why an exchange would pay to take a trade, and he wondered where that money was coming from. In building his investigative team, he interviewed people from all over Wall Street, grilling them about how the system worked. People knew little bits, but no one had the whole picture.
The HFT firms emerged after an act called Regulation National Market System, passed in 2005 and was implemented in 2007. It required brokers to find the best market prices for their clients. One computer, called the Securities Information Processor, or SIP, was set up to gather all the prices for each stock and determine the national best “bid and offer” prices. But the HFT firms set up their own faster systems to determine those prices so they could trade ahead of them.
To make this process even more hidden, much of the trading goes on within the “dark pools” run by investment banks. How trades occur within these pools is not revealed.
The stock exchanges have embraced high-frequency trading because it drives up their trading volume, despite those trades not adding any value to the market.
The team at the Royal Bank of Canada wrote a computer program that beat the high-frequency traders by slowing the time their trades went to some exchanges, so that the trades arrived at each exchange at exactly the same time.
Katsuyama thought that would be the end of it, and all brokers would use his system to give their customers the best possible price. But with investment banks, exchanges, brokers and HFT firms making money off the system, little change followed.
When Katsuyama showed his findings to people at the SEC, they sided with the high-frequency traders. To explain this, Lewis notes that 200 staffers had left the SEC since 2007 to work for HFT firms or as lobbyists for them.
One of the biggest threats from high-frequency trading, Lewis points out, is the fragility it brings to the market. HFT firms make more money when the market is volatile, when prices suddenly jump higher and lower.
As to the market’s mysterious fragility, regulators cannot fully explain what caused the May 6, 2010, flash crash, when the Dow Jones industrial average dropped 600 points in minutes and bounced back just as fast.
Katsuyama left Royal Bank of Canada in 2011 and started his own stock exchange incorporating the delayed trading system that prevented HFT firms from front-running on the trades. The exchange, called IEX, opened and did a small amount of business.
Then, after a management shake-up at Goldman Sachs, two new leaders of the firm’s trading operations opted to move more of the giant bank’s trades to IEX. Since then, volume at IEX has grown steadily, with an average of 28.7 million shares trading each day in April, up from 18.9 million in March, Bloomberg reported.
Whether the podium thumping triggered by “Flash Boys” will lead to meaningful structural change remains to be seen. Powerful forces enjoying risk-free, bountiful profits are lined up in favor of the status quo.
Grove Potter is The Buffalo News business editor.
Flash Boys: A Wall Street Revolt
By Michael Lewis
288 pages, $27.95