by I.R. Mullin
Copyright©2014 I.R. Mullin. All Rights Reserved. No part of this book may be reproduced or retransmitted in any form or by any means without the written permission of the author.
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This unofficial guide to Lewis’s book begins with an overview of facts used to support Lewis’s ideas in his book. We categorize the facts in the way that supports our analysis and critique of Lewis’s book.
Please note that this unofficial guide does not include Lewis’s original expression of ideas and facts. If you wish to familiarize yourself with Lewis’s original expression of the ideas and facts presented in his book, then please read his book Flash Boys: A Wall Street Revolt.
II.1. A Review of Important Facts That Support Lewis’s Ideas in His Book
In March and April 2014, the Securities and Exchange Commission (SEC) and the FBI announced their intention to investigate high-frequency trading. This investigation was brought as part of the SEC/FBI investigation into insider trading on Wall Street. The announcement of the investigation coincided with the release of Michael Lewis’s book, Flash Boys: A Wall Street Revolt. In his book, Michael Lewis compares high-frequency trading to cheating at poker.
- The Nature of High-Frequency Trading
Financial markets are becoming increasingly computerized, and technology replaces humans in trading. The modern market operates through high-speed computers. In addition to large stock exchanges, trading takes place on many small exchanges. As a result, investors have no way of knowing exactly what happens to their money.
The U.S. stock market data displayed on the ticker tape running across the TV screens, as well as on the screens of the professional traders, is an illusion. The modern market offers massive opportunities for the market opacity, with opportunities for hidden fees, kickbacks and skimming. HFT is an example of the market’s unfair game.
HFT firms do not invest. They only trade. At the end of each day, they have no stock in their names. Unlike investors, HFT firms do not take any risks.
For example, Virtu Financial claims that in about five years, there was only one day when it did not make money, and that one day without profit was the result of “human error.”
HFTs are not human beings. They are computer algorithms that operate much faster than humans do. HFT firms use sophisticated computers with ultra-fast connections as well as HFTs, in order to take an advance peek at trading orders of other investors. Once an HFT firm’s computers receive such information, its HFTs quickly interpose themselves between sellers and buyers and execute transactions micro- and nanoseconds ahead of investors, buying the investors’ stock at lower prices or selling to them at higher ones and reaping risk-free profits at the expense of less technologically advanced competitors.
The HFTs’ trading advantage comes from two different strategies:
- When an investor presses a button to place buy or sell orders, a trading signal is sent to a broker or bank, who has to search various stock exchanges for the best price. It takes time for trading signals to travel, and, consequently, the orders arrive at different stock exchanges at different moments in time. The HFTs exploit such time differences. Repeatedly, HFTs place buy or sell orders for small amounts at each exchange. They monitor how those orders are filled in order to determine whether a large investor has a much bigger stake to sell or buy. Some of the HFTs’ orders are not designed to be filled. They are placed only to flush out which way the large investors are planning to trade.
- Another HFT strategy exploits “dark pools,” trading venues established typically by banks and designed to provide investors with anonymity. Banks have been allowing HFTs access to dark pools for a fee, thus letting them prey on unsuspecting investors.
HFT firms place their computers as physically close to the stock exchanges’ servers as possible. This is called co-location. By using co-location, HFT firms can have their orders placed microseconds ahead of non-HFT investors’ orders.
- HFTs and Their Impact on the Stock Market
In 2002, eighty-five percent of all U.S. stock-market trading was taking place on the New York Stock Exchange, and the rest of U.S. stock-market trading was done mostly on the NASDAQ. By the year 2008, there were thirteen different public exchanges in the U.S. Most of these exchanges were numerous computer servers located in secured buildings in New Jersey. The stock market now comprises over forty-five markets, and an investor who places an order, does not necessarily know which particular market the order is actually traded on.
Large investors are ripped off every time they buy or sell shares of stock. For example, if an investor places an order for 10,000 shares of Microsoft, the order pings from one exchange to another claiming a few shares at each exchange and seeking the best price. However, when it reaches the first exchange, the HFTs detect the order, and they run milliseconds or microseconds ahead of it to the other exchanges, buy the stock that the order is seeking, and sell it back to the investor who placed the order, for a fractionally greater price. They do that millions of times a day to millions of investors. Their tiny profitable trades add up to huge profits for such HFT firms as Citadel and Getco.
Front-running is the term that describes this process. Michael Lewis argues that HFT firms distort the market to their advantage by using this front-running technique.
Their HFTs obtain early information about investors’ orders, and then they execute stock orders by buying a stock before the investor does and then selling it to the investor for more than it would have cost if HFTs had not “front-run” the investor’s order.
Lewis estimates that HFT firms steal from five billion to fifteen billion dollars per year from investors, possibly more. Moreover, John Schwall, an IEX employee, tells Lewis that HFT is “ripping off the retirement savings of the entire country through systematic fraud” by front-running investors such as large mutual funds and pension funds. (IEX is an alternative trading system started in the US by Brad Katsuyama.)
Many of the biggest Wall Street institutions have their own stock markets called “dark pools.” Dark pools are basically mini-stock markets where companies like Credit Suisse and Goldman Sachs match buyers and sellers whose orders remain anonymous. Each of these companies controls only a small percentage of the stock market, and their customers do not know if these companies are getting the fairest possible price when the customers buy or sell. The temptation for these big investment companies to profit from HFT is too great and encourages them to put their own priorities above their customer’s priorities.
The stock market’s self-appointed middlemen have always made money by reaping a profit off of investors. Michael Lewis writes, “the entire history of Wall Street was the story of scandals linked together tail to trunk like circus elephants.” He emphasizes that the modern U.S. stock market is “a class system, rooted in speed.”
- HFT, Market Liquidity and Market Volatility
Markets work better when there are more buyers and sellers. Market liquidity describes a market’s ability to facilitate a financial instrument being sold quickly without having to decrease its price very much. Advocates of HFT propose that HFT adds liquidity to market. However, Michael Lewis disagrees with such a statement. He calls high-frequency trading “less a market enabler than a weird sort of market burden” as HFT firms use inside information to place themselves between buyers and sellers who are capable of doing a computerized trade without HFT firms.
Lewis proposes a hypothetical company, Scalpers Inc., which front-runs an investor every time the investor buys a share in stock. The company buys the shares the investor wants and then sells them to the investor at a higher price.
Scalpers Inc. does not take any risk. It buys or sells a stock only when it has the other end of the transaction already available. It interferes with trading that would have happened without Scalpers’ participation. It is obvious that Scalpers Inc. does not bring any real liquidity to the market. Besides, Scalpers Inc. has an incentive to intensify volatility in the market because it profits from movements in prices.
To illustrate the dangers of HFT, Lewis also mentions the Flash Crash that happened on May 6, 2010, when the Dow Jones industrial average plunged 600 points, and then recovered, in minutes.
HFT firms claim that their activity has a positive impact on “spreads,” the gap between the prices at which shares are bought and sold. A spread can be considered a kind of transaction fee on traders because it is guaranteed profit for the exchange that sells the shares.
HFT firms insist that HFT reduced spreads in the course of the last decade. However, HFT firms do not provide any data that would support their argument.
- HFT, Goldman Sachs and Sergey Aleynikov
Sergey Aleynikov used to work as a computer programmer for Goldman Sachs’s own HFT operation. Goldman Sachs purchased the core of its HFT system in 1999, when it acquired an electronic trading firm called Hull Trading. Sergey Aleynikov estimated that its software included about sixty million lines of code. It was Aleynikov’s responsibility to find and fix bugs in that code.
Aleynikov also designed HFT code for Goldman Sachs while he was employed there. When Sergey was leaving Goldman Sachs for another job, he took some HFT code with him.
On July 3, 2009, he was arrested by the FBI and convicted of stealing Goldman Sachs’s computer code and was sentenced to eight years in prison.
In December 2010, the Second Circuit Appeals Court overturned Aleynikov’s conviction. In its decision, the Court found that Aleynikov did not take any tangible goods from Goldman Sachs. The Court also found that Aleynikov did not steal a product involved in interstate commerce. Although Aleynikov’s conviction was overturned, Manhattan prosecutors continue to pursue their case against him.
Michael Lewis criticizes Goldman Sachs for its alleged involvement in the financial crisis. He points out that Aleynikov was “the only Goldman Sachs employee arrested by the FBI in the aftermath of a financial crisis Goldman had done so much to fuel.”
- Regulators, the SEC and HFT
HFT firms consistently stay ahead of the regulators. As soon as the regulators close one loophole, HFT firms seem to find another one. Every new law seems to provide a new opportunity for risk-free, high-speed profit for HFT firms.
Michael Lewis argues that the rise of high-frequency trading was the unplanned consequence of regulation that was introduced in 2005 in order to ensure that investors got the “best price” for trades and to weaken the monopoly of the New York Stock Exchange and NASDAQ by creating more competition. It brought into existence thirteen new public stock exchanges, as well as more than forty private dark pools. Moreover, it created the market structure promoting the enormous upsurge of front-running by HFT firms.
A nationally accepted standard for share prices, the NBBO or National Best Bid and Offer, was set by collating the official price for a share through all public exchanges. However, the technology that supports the NBBO turned out to be slow. It lags behind the HFT computers, and its slow performance makes possible the existence of much of the HFT industry because it assures that the official price will always be late.
Today, HFT firms are doing business on such a grand scale that they have become capable of influencing the operations of the exchanges. HFT firms pay fees to the exchanges for access to the flow of orders. They also pay the same kinds of fees to investment banks that run their own private exchanges, the dark pools. In return, exchanges twist their rules to accommodate HFT firms.
By the summer of 2013, financial markets around the world were restructured so that HFT firms could reap profits at the expense of non-HFT investors.
The exchanges added an extra decimal place to stock prices, for example, enabling HFTs to collect every fraction of a penny in price fluctuations.
- Proposed Solutions: IEX
One possible solution for the HFT-related problems would involve regulation. For example, it is illegal to trade on the basis of information that is not publicly available. HFT firms might be put on trial if it can be proven that they trade using information that is not publicly available.
However, Michael Lewis argues that the regulators have failed to resolve HFT-related issues. In his opinion, the market can act as a self-correcting system fixing its own problems.
Brad Katsuyama offers such a market solution in the form of an equity trading system called IEX. IEX is described as the trading venue for investors who want to place buy and sell orders without being front-run by HFT firms. In order to “neutralize” front-running, IEX uses a technological “speed bump” that delays incoming orders by 350 microseconds on its trading platform. This interval of time is thousands of times shorter than the time it takes a human eye to blink.
In Lewis’s opinion, if IEX becomes a success, then the other exchanges will have to change their strategies and prevent customers from being exploited by HFTs.
II.2. Critique of Michael Lewis’s Flash Boys: A Wall Street Revolt
In his book, Lewis explores the influence of high-frequency trading upon Wall Street. The most important message of the book is that high-frequency trading firms are working in tandem with the exchanges and big banks, and that they are ripping billions of dollars of investors’ profits.
Michael Lewis tells the story of the financial world’s insiders who decided to use private-sector innovation in order to solve problems created by HFT.
In October 1987, the stock market crashed. In response to that crash, regulators changed the rules in order to allow customers to connect directly to computers. Since that time, the computers have been gradually replacing human traders.
In 2007, Dan Spivey, a former broker, did research and found that most fiber-optics cables connecting the data center beside the NASDAQ stock exchange in Carteret, New Jersey and Chicago Mercantile Exchange followed complicated paths with many turns and twists. This affected the time required for electronic signals to travel. Dan Spivey and Jim Barskdale, the former CEO of Netscape Communications, founded a company called Spread Networks.
The first chapter of Lewis’s book describes the effort of Spread Networks to build a “straight” tunnel passing through mountains and under riverbeds between Chicago and New Jersey and to lay 827 miles of fiber-optic cable through that route. The cable would send financial data from Chicago to New Jersey in only thirteen milliseconds. In 2010, Spread Networks spent 300 million dollars on the project. The only purpose of this project was to reduce the time it takes to receive and respond to new trading information.
Whereas Lewis describes vividly the construction of the tunnel, we should mention that this fiber-optic cable became outdated within two years after its completion; a network transmitting microwave beams through the air replaced it.
Wall Street banks agreed to pay fourteen million dollars apiece per year for the right to use two lanes (one lane in each direction) of the original HFT “fiber-optic highway” built by Spread Networks. They were willing to pay such fees because the HFT highway would give them a few milliseconds advantage in trading, and this advantage would generate profits in the amount of approximately twenty billion dollars.
In his book, Michael Lewis argues that these profits come out of the pockets of non-HFT investors. With the rise of high-frequency trading, investors began to notice that every time they placed an order to buy or sell, the market price would move.
It seemed like someone had been running one step ahead of them. High-frequency traders (HFTs) or “algos” is the name for those front runners. They are sophisticated computer algorithms. Many HFTs have their own nicknames, such as Ambush, Dark Attack, Guerrilla and Slicer.
In Lewis’s book, the upsurge of HFT is depicted as Brad Katsuyama witnessed it. Katsuyama was trading U.S. energy stocks at Royal Bank of Canada before he moved to RBC’s New York office, where he became head of Global Electronic Sales & Trading. In 2007, after RBC bought Carlin Financial, a U.S. electronic stock market trading firm, Katsuyama noticed that something strange was happening on stock-trading screens. On the screen of his computer, he saw that another investor was selling 10,000 shares at 22 dollars per share. However, when he pushed the button to buy the shares, the offer disappeared, and then the price went up.
It looked like if someone else on the market was foreseeing his intention to buy shares and changing the prices just before he made the trade. In addition to this trading problem, RBC’s bills from the stock exchanges began to increase. These problems arose after RBC added the new electronic trading connection.
The IT people at RBC presumed that a software glitch caused the problem with orders. However, other firms were encountering the same problem. Katsuyama decided to learn more about this “fast trading.” He hired a few pros from the HFT industry with the expectation that they would help him understand what was going on. One of the people that he hired was Ronan Ryan, a telecommunications engineer. Hedge funds and banks were willing to pay Ryan huge money to build telecommunication systems that would allow hedge funds and banks to trim milliseconds from the time required to move orders and price data on the market.
Ryan began working for RBC as head of high-frequency trading strategies, although initially he had no idea of what he was supposed to do at RBC. Katsuyama and Ryan combined their expertise in trying to solve the mystery of the vanishing sell offers. When Ryan had worked as a telecommunications engineer, he did the wiring inside stock exchanges. From his own experience, he explained to Katsuyama that high speed played a crucial role in the trading process.
Ronan told Katsuyama about the latency charts used by the HFT firms. These charts allowed HFT firms to know the time when each exchange received information from certain hedge funds or brokerage firms. In this way, the HFT firms were able to figure out the time when hedge funds or brokerage firms were placing large orders and to use this information in order to outmaneuver them.
Rob Park, an algorithm specialist, was one of Katsuyama’s colleagues. Using funding provided by the Royal Bank of Canada, they conducted experiments. The experiments gave them the idea of how high-frequency traders were able to predict forthcoming stock movements and exploit them.
John Schwall figured out how the computerized trading system was secretly manipulated for the benefit of Wall Street insiders. Schwall did research about Regulation National Market System (Reg NMS). It was implemented in 2007, and it made it mandatory for brokers to seek the best market prices for their investors. Stock prices were provided via the Securities Information Processor (SIP), which was rather slow. Its sluggishness provided profit opportunities for HFT firms, who used their fast connections to front-run banks and brokerage firms.
Katsuyama and his team realized that traders with faster connections were able to spot Katsuyama’s orders on one exchange, and then move to another exchange to buy shares before Katsuyama and then sell the shares to him at a higher price. The traders who were doing this front-running turned out to be computer algorithms—HFTs. HFTs are constantly pinging the market with bids while “fishing” for large buy orders. Once they identify the orders, they buy the shares and resell them to a real buyer at a price that is a little higher than the original.
It turned out that HFT firms have many collaborators, including the exchanges that sell their order flow to HFT firms. The exchanges allow private firms to install their own computer equipment extremely close to the exchanges’ computers, so that the HFT firms can benefit from the tiny advantages in trading time.
In his book, Michael Lewis explains that SEC staffers have been reluctant or unable to regulate HFT firms. For example, Katsuyama, the main source for Lewis’s book, found from his meeting with SEC representatives that they were favoring HFT firms. They argued that HFT firms were necessary as an intermediary helping to match buyers and sellers in a computerized market. In Lewis’s opinion, though, the regulators fail to resolve HFT-related issues for fairness in the market.
In his book, Michael Lewis describes such HFT techniques as “slow market arbitrage” and “rebate arbitrage.” Slow market arbitrage takes place when HFT firms exploit extremely small lags in the movement of prices. For example, consider the situation when the market for P&G shares is 80.01. A big seller reduces the price down to 79.99 dollars on the NYSE.
HFTs buy shares on NYSE at a lower price and sell them on all the other exchanges at a higher price, before the public can see that the price has changed. By doing this every day, HFT firms make billions of dollars annually. Rebate arbitrage takes place because many exchanges pay kickbacks for traffic. HFT firms profit from this by directing trades to those exchanges.
In Katsuyama’s opinion, high-frequency trading is unfair to the general public because “anyone with a pension or retirement is an investor in the stock market.” Katsuyama and his team at RBC created a system that would “counteract” HFTs and level the playing field for ordinary investors. They called it “Thor.” HFTs depend on tiny delays in delivery times between exchanges, and Thor is capable of “blocking” the HFTs by delivering an order to all exchanges simultaneously.
In early 2012, Katsuyama left RBC. Together with a group of like-minded traders and IT specialists, he established a new trading venue, IEX, with the intention of outsmarting the HFT firms. IEX was built on the same principle as Thor. It was financed mainly by large mutual and hedge funds. To a certain extent, the success of IEX depends on the help of such hedge-fund billionaires as David Einhorn and Bill Ackman.
We would like to draw readers’ attention to the fact that it is not an accident that income inequality keeps rising in the US, and we propose that more research is needed in order to understand the motivation of the riches, who are involved in the creation of IEX. Lewis’s book does not elaborate on this question.
The book tells about the challenges that Katsuyama and his team encountered when trying to establish their trading venue and facing the opposition from numerous Wall Street power players. IEX opened for trading on October 25, 2013. Initially the big banks avoided sending their trades to IEX because they were profiting from the existence of HFT. On December 19, 2013, Goldman Sachs routed orders for about forty million shares to IEX. To Katsuyama and his team, that moment was very important because it meant that the other big financial firms would not be able to ignore IEX anymore.
Goldman Sachs was asserting that the U.S. stock market needed changes, and that IEX was capable of making the U.S. stock market more fair and stable. However, Goldman Sachs did not come back to IEX on December 20, 2013. Michael Lewis notes that Goldman Sachs is “a complex environment,” with its own internal politics.
In Lewis’s book, the motives for creating IEX were essentially selfless and idealistic. He writes that the founders of IEX “loved the idea of a stock exchange that protected investors from Wall Street’s predators.” Lewis’s book does not draw readers’ attention to the fact that IEX will bring a substantial profit to its founders and executives in case it attracts big fund companies such as Fidelity and Vanguard.
According to the Financial Industry Regulatory Authority, by mid-July 2014, IEX has become the seventh most used alternative trading system in the U.S. thanks to its trading strategy. However, a few months after Michael Lewis’s book was published, Brad Katsuyama said that, in July 2014, 17.7 percent of trading on IEX was done by proprietary trading firms, including HFT firms. (Proprietary trading firms is a general term for the firms that trade for their own account and have no clients.)
Whereas Michael Lewis’s book does a great job of bringing to light HFT front-running insider trading practices, it leaves out the big picture. The market is rigged by HFTs at the micro level. On a larger scale, the financial system is rigged by the Federal Reserve and global central banks. These issues cannot be resolved without a large-scale reform of the system. As long as the wealthiest keep getting profits from it, we leave to our readers to guess whether there is a chance that regulators and legislators will proceed with any real reforms.
Following the launch of Lewis’s book in April 2014, a few regulatory agencies disclosed that they were already addressing the issues associated with high-frequency trading. The FBI, the Justice Department, the Financial Industry Regulatory Authority, and the SEC had been investigating HFT firms, as well as exchanges, for violations of insider trading rules and some other Wall Street rules.
In the wake of this regulatory scrutiny, a number of security suits had been filed. For example, on April 18, 2014, a class-action lawsuit was filed on behalf of the City of Providence, Rhode Island. The filing was made by Robbins Geller Rudman & Dowd LLP, the law firm that played a crucial role in the securities class action against Enron.
The lawsuit was filed against:
- every major stock exchange in the U.S., including the New York Stock Exchange (NYSE), NASDAQ, Direct Edge, Bats Global Markets, etc.,
- major Wall Street firms and banks (Bank of America, Goldman Sachs, Citigroup, JPMorgan, UBS and Barclays),
- many HFT firms and hedge funds.
The complaint provided numerous references to Michael Lewis’s book, and it alleged that:
- some market participants received non-public information, which they could use to their advantage in order to manipulate the U.S. securities market;
- the Exchange defendants and the defendants, who controlled other trading venues, received generous kickback payments for providing the HFT companies with trading data via preferred access to exchange floors and special trading products;
- the Exchanges, brokerage firms, HFT firms “engaged in conduct that was designed to and did manipulate the U.S. securities markets …, diverting billions of dollars annually from buyers and sellers of securities to the defendants.”
The class-action lawsuits target essentially the entire global financial system, including such market players as large banks. However, one should keep in mind the words of Senator Dick Durbin who said that banks are “still the powerful lobby on Capitol Hill. And they frankly own the place.”
The investigation of HFTs indicates that it might be possible that the stock market’s insiders have unfairly benefited from the advantage of using faster and better information. Yet, Wall Street is trying to present high-frequency trading as a benign trading mechanism in order to preserve the illusion of equal access and market impartiality and to make certain that the market does not become heavily regulated.
In the end of Michael Lewis’s book, Katsuyama says that he hates HFT firms less than before he started his “battle” with them. He says, “The market is creating the inefficiencies and they are just capitalizing on them. Really, it’s brilliant what they have done.” One of his colleagues also says, “On the savannah, are the hyenas and the vultures the bad guys?… It’s not their fault. The opportunity is there.”
Their words tell us that the story of the rigged financial system is a never-ending story. One might hope that new regulations or private-market innovative solutions can resolve the problems of the financial system.
But the story of the rigged financial system will continue as long as we agree to believe that humankind can prosper only when greed, vanity and thirst for profit are placed above moral values.