There have apparently been some reviews sniping at Flash Boys, the latest book by Michael Lewis on the financial markets, not that he will care given how well it’s selling. The grumpy reviews are wrong. It’s an excellent book. Lewis writes like a dream, and brings characters to life as well as any novelist. There are laugh out loud moments. And he explains as clearly as it is possible for a general reader the way today’s super-super-fast US equity market functions, or rather malfunctions.This is a great achievement, as it is very complicated.
I’ve not read other reviews of the book, but I gather from Twitter that some people accuse Lewis of exaggerating and making out all high frequency trading to be bad when it has cut commissions and increased liquidity. They’re wrong. Maybe there are one or two good guys doing HFT. But when there are frequent crashes and spikes in prices, and when the HFT firms do not make losses on any day, these traders are not taking on risk and enhancing liquidity; they are tax farming and increasing volatility through massive amounts of ultra-fast trading activity.
I got interested in HFT early in 2012 when I was preparing for my Tanner Lectures. It seemed the most extraordinary example of performativity, the shaping of reality by economic theory, as the options pricing formula devised by Black, Scholes and Merton had ended up causing a tunnel to be drilled through the Allegheny Mountains so a new fibre optic cable from Chicago to New Jersey could send information at something closer to the speed of light. Flash Boys starts with the same new line, built by Spread Networks. Lewis writes about the contract Spread Networks offered the Wall Street banks, whereby they could use the line for their own proprietary trading but not for their brokerage customers: “The whole point of the line was to create inside the public markets a private space.”
The HFT markets serve the HFT firms and the big banks, which operate “dark pools”, or private markets in which they execute customers’ trades. Even giant hedge funds get a worse deal than the proprietary traders. Indeed, HFT firms pay Wall Street firms for access to their dark pools – to prey on the orders in there. No matter how big the investor, they would know nothing about how their orders were routed or when executed once they had issued the buy or sell order.
The market dysfunction had come about because of Regulation NMS, a stock exchange rule issued by the SEC with the intention of making sure investors got the best prices but with the unintended consequence that it created a spaghetti junction of orders moving around exchanges, with delays that HFT firms could use to their advantage. It isn’t just Lewis who says the rule backfired: here is a Wall Street Journal write-up questioning the benefits of the regulation. The regulation created short-term profit opportunities from gaming it, and the proliferation of exchanges it encouraged. As one character says, “It’s hard to be forward thinking when the whole of corporate America is about next quarter’s earnings.” High frequency traders, including those in big Wall Street banks, give themselves an information advantage over investors (including the funds looking after your money and mine); once an investor asks its broker to buy or sell shares, the information about the order belongs to the broker.
The solution to complexity that can be gamed and privileged information lies in simplicity and transparency, and the narrative thrust of Flash Boys is the creation of a simple, transparent exchange, IEX, by good cowboy Brad Katsuyama, who left Royal Bank of Canada to found it once he started to uncover the absolute scandal of the way high frequency trading was operating. Unexpectedly, Goldman Sachs emerges heroically, being the first major institution to route large volumes of orders through IEX. Lewis speculates that its senior people had come to realise: (a) Goldman is not very good at HFT because it has an old computer system; (b) one day, the highly complex and unstable equities market created by HFT will cause a huge, but huge, market crisis and they don’t want Goldman to get the blame. Goldman Sachs also emerges as villain for getting the FBI to arrest a Russian programmer, Sergey Aleynikov, for “stealing” some of their computer code – although found guilty and imprisoned, he had sent himself – openly – some mainly open source code when he quit the firm.
The book ends with a puzzle: the FCC license number 1215095, fixed to a microwave tower in Pennsylvania. The license application was filed in July 2012. Follow the lead, Lewis says, and you will find “another incredible but true Wall Street story, of hypocrisy and secrecy and the endless quest by human beings to gain a certain edge in an uncertain world.” Naturally, a lot of people have already done so.
As this ending suggests, he doesn’t argue that high frequency traders are evil. But the book does make a powerful case that the financial system is a dangerously complex system that creates damaging incentives. Like all complex systems, there will be a straw that breaks the camel’s back, a grain of sand that causes the whole pile to collapse. The world is uncertain in the sense that the specific straw or grain – which one, when - is unpredictable, but the collapse is inevitable. There is an interesting question as to why innovation in finance – unlike in any other sector of the economy – so often works against the interests of consumers, not in their favour.
Lewis cites some others who have written about HFT: Sal Arnuk and Jospeh Saluzzi in Broken Markets; Eric Hunsader, founder of Nanex, a stock market data company; researcher Adam Clark-Joseph (pdf), whose work on HFT led the CFTC to shut its programme giving researchers access to data. There is also a book, Dark Pools, by journalist Scott Patterson. Publications like Automated Trader are well worth a look too.