Flash Boys: A Wall Street Revolt
By Michael Lewis
(W.W. Norton, 288 pages, $27.95)
Michael Lewis is one of America’s most successful storytellers. But the bombastic conclusions in his new book, Flash Boys, a superficial one-sided discussion of High Frequency Trading, and his repeated pronouncements that the stock market is “rigged” and a “fraud,” are as harmful as they are overstated.
High Frequency Trading (HFT) is a term widely used—and misused—by people who know little of financial markets. It can describe so many things as to be nearly meaningless, since almost anything a trader can do with a computer is much faster than what traders (like me) did in pits in years past. Compared to even recent trading history, nearly everything seems high frequency these days. Among the HFT strategies that can be implemented by computer, some—such as “stat arb,” which involves crunching data to find relationships between the movements of dozens or hundreds of stocks—are unobjectionable.
Others are more controversial, such as using high-speed exchange data feeds to try to “front run” large orders in the stock market. Lewis suggests that HFT firms see your order coming down the pipe, outrun you to the exchange, and buy the stock you want in order to sell it back to you seconds later at a higher price. But this is misleading because it implies that a firm is trading based on knowledge of an existing large order. In fact, this strategy so detested by Lewis and others involves no such knowledge, but rather the use of clever logic and fast computers to guess whether a large order exists, and then to try to profit from that guess. Other than the compressed time frame, this is no different from what has happened in markets throughout centuries of trading history.
Flash Boys skims HFT like a surfer, thrilled by the ocean’s waves but not understanding the depths or the currents that really define it. Following the career paths of several people involved on the edges of HFT, particularly programmers and other technologists rather than traders, the book turns its primary focus on Brad Katsuyama, whose work in the brokerage arm of the Royal Bank of Canada (RBC) caused him to conclude that something nefarious was afoot: “I realized the markets are rigged.…That the answer lay beneath the surface of the technology. I had absolutely no idea where.”
Katsuyama’s team concluded that the ability of certain market participants to access stock price data faster than others allowed behavior that he (and Michael Lewis) find offensive. So like Robin Hood and his Merry Men, claiming to seek justice for investors (and hopefully profit from it), Katsuyama and crew left RBC to create a new exchange, now operating as IEX, which aims to defeat such behavior and thereby offer customers lower execution prices. (Despite the persistent use in Flash Boys and elsewhere of the word “exchange” to describe IEX, it is actually an Alternative Trading System that arguably has as much in common with the demonized “dark pools” as with a true exchange.)
The villains in the story include not just the firms engaged in HTF, but also large investment banks and stock exchanges that, per Lewis, sacrifice the interests of investors for their own gain.
There are legitimate questions here: It is one thing for a clever Russian programmer to try to guess whether there will be a buyer of stock in the market, and then profit from anticipating the demand. It is another thing entirely for a brokerage firm to send orders into a system if the firm’s own profits can be boosted by lowering the chance of its customer getting the best possible price. We can reasonably to wonder whether the many new “order types” that Lewis describes as created solely to benefit HFT traders do indeed put exchanges knowingly opposite the interests of many investors. Remember, however, that HFT firms’ strategies rely on publicly available information.
Most skeptics imagine that HFT offers large and consistent profits, a never-ending skimming of billions of dollars from ongoing trades—an entirely unreasonable assumption in our intensely competitive financial markets. Indeed, HFT profits were already massively eroding while Lewis wrote his story and prepared to sell this old news as a breaking headline. Nearly a year before the publication of Flash Boys, trading firm Getco, which Lewis calls “easily one of the smartest” (and most active) high frequency trading shops, reported a 90 percent drop in net income from 2011 to 2012. In April 2014, analysts at the TABB Group reported that the HFT industry’s annual earnings plunged from about $7 billion in 2009 to $1.3 billion last year. The massive decline in profits is no surprise, and Lewis was certainly aware of the numbers. But the real story isn’t nearly as good for book sales.
Beyond its superficiality, Flash Boys contains errors that raise doubts about Lewis’s reputation as a sage of his subject matter. For example, Lewis says that in 2008, “You could still buy and sell Intel on the New York Stock Exchange, but you could also buy and sell it on BATS, Direct Edge, Nasdaq, Nasdaq BX, and so on.” In fact, Intel was never listed on the NYSE, and could not be traded there in 2008 or today.
While the parallel stories in Flash Boys are modestly interesting (modestly because very little of what Michael Lewis tells us is surprising or particularly new), the real issue is the furor and fear being caused by Lewis’s repeated claims—in the book, on 60 Minutes and CNBC, in front of myriad other cameras—that the stock market is “rigged” (a thought he attributes to Brad Katsuyama).
On Wall Street, even outside of firms whose business is HFT, the outlook is more sanguine. “The SEC…was seeking a more democratic market. Now they’ve got it,” says Keith Ross, CEO of the PDQ Alternative Trading System that competes with IEX. “They busted the monopoly of NYSE specialists. There are new market participants, and the costs of execution and bid-ask spreads are much lower. I would argue there is not a major problem in the marketplace.” Executives at a large capital management firm (which does not employ any HFT strategies) stressed to me something that Mr. Lewis casually breezes over: The environment in which HFT became possible was created by evolutions in both technology and regulation: “The irony is that not by design but through a confluence of changes (electronification, significant new SEC market structure rules), HFT is unambiguously better for those trading in small size. There is no rational argument that it isn’t easier and cheaper to trade 100 shares of stock today, though we can debate whether it’s easier to trade a million.” Yet the unintended consequences of the government regulation Lewis seems to want are absent from the discussion.
Furthermore, HFT firms “have largely replaced the function of specialists in a monopolistic environment,” the executives argued. “Because these guys are competing, that results in lower spreads and lower costs for us.” Thus, once they figure out how to adjust to the new situation, the biggest players also gain.
Similarly, in 2012 a senior executive of Vanguard, the world’s largest mutual fund company, while noting that certain HFT strategies were “abusive,” emphasized on CNBC that “the bulk of them are creating liquidity and reducing spreads for us, which has dramatically reduced costs.”
In other words, HFT is more likely benefiting investors than harming them, allowing tighter spreads and lower commissions. The profits of HFT firms are now much lower than the profits of the specialists and market makers they have largely replaced. Again, Michael Lewis failed to mention these things that he must have known.
The stock market is, over a long horizon, generally the best investment available to the average American. So talking people out of investing, as Lewis seems intent on doing, harms their financial futures—and harms the rest of us when federal welfare spending is required to care for senior citizens who were frightened out of stock investment during their working years.
Michael Lewis (like Al Gore) knows that screaming about crisis is a much better way to reap profits and influence than gently explaining reality. Because attacking secretive organizations with scary-sounding strategies and lots of employees with foreign names is a sure way to score cheap political points, Lewis’s overwrought claims are causing the usual suspects, such as New York Attorney General Eric “Shakedown” Schneiderman, to go after HFT firms.
The city of Providence, Rhode Island, whose connection to HFT is even more unclear, has (no doubt egged on by contingency-fee attorneys) filed a class action suit against multiple parties, including exchanges and trading firms, seeking a presumably enormous amount of money on behalf of “public investors who purchased and/or sold shares of stock in the United States between April 18, 2009 and the present” on the premise that they “employed devices, contrivances, manipulations and artifices to defraud in a manner that was designed to and did manipulate the U.S. securities markets…”
The winners in this uninformed feeding frenzy will be attorneys, gullible reporters, regulators, and Michael Lewis; the losers are the rest of us.
Flash Boys could have been an interesting story. Instead, by his poor analysis and outrageous public charges of a “rigged” market, Michael Lewis has begun a witch hunt that could end up hurting tens of millions of American investors.