Flash Boys: A Wall Street Revolt

If you have been watching economic news this week, you will have heard that the British pound collapsed in a “flash crash.” Most news stories leave it at that. (I suspect that’s because they don’t know what a flash crash really is.) Put simply (and in Flash Boys Michael Lewis explains this recurring phenomenon quite simply) a flash crash is how high frequency traders use computers, multiple exchanges and time to abuse the rules. Now that I’ve summarized that, let me back up a second and deconstruct the sentence. First, what are the rules? In 2007, after brokers were found to have been abusing customers’ trust once too often, the government came out with what’s called Reg NMS. This regulation (and here I am just going to quote Michael Lewis directly because I don’t think I can say it any better than he did). Reg NMS mandated that brokers buy shares at the best price. “To define best price, Reg NMS relied on the concept of the National Best Bid and Offer. If an investor wished to buy 10,000 shares of Microsoft, and 100 shares were offered on the BATS exchange at $30 a share, while the full 10,000 listed on the other twelve exchanges were offered at $30.01, his broker was required to purchase the 100 shares at Bats before moving on to other exchanges.” This meant that anyone with a computer can see where a purchase is going to be made and for how much. So if you have a faster connection (and several exchanges where you can sell a few shares of a stock, you can already see how you can make money.) Sure, you won’t make a lot of money from any one trade. Maybe less than half a cent here and half a cent there. But that adds up. I know this from first-hand experience. The other day at work, I was trying to calculate what would the cost be of a service was excluded from a package of services. And my calculation kept being almost a billion off. I did it and re-did and re-did it every which way I could think of. I even pulled down my stats book to see if my math was off. Nothing. I got up and went for a cup of coffee just to take a break from this ridiculous problem and when I sat down again, I saw it. It was a rounding error. To be exact it was a rounding error in the one/thousandth decimal place. But I was dealing with billions of dollars and that rounding error made quite a difference. So yes, parts of pennies add up. But wait, there’s more. The way the best price is computed is when an exchange computes all the bids and offers on a particular stock. This computation is done by a government computer and if you know one thing about government, you will know that it takes years to upgrade computers. That means that if you have your own, faster computer you can “front-run” the official best price and sell and buy 100s of shares at the “real” best price. Sure it will be a “rounding error” but as I said before, those rounding errors matter. So a rule that was intended to create equity and transparency in the market in fact institutionalized inequality between the traders who had access to the super-fast computers and those who did not. Only the former would make money from these rounding errors. But wait, there is yet more. To make full use of Reg NMS you also need many different exchanges or dark pools and dark cables. And guess what, both exist. Dark cables are cables that are optimized for speed of transaction. Sure it’s a millisecond difference or even less but in that time you can get a lot of rounding errors. Dark pools are, in essence, proprietary exchanges. They exist to make it easier for institutional investors (like the folks to whom you entrust your pension and mortgage, for example) to trade in large blocks. So, for example if you have one million shares of Microsoft you want to sell (or buy) but don’t want your identity known, you would rather sell/buy those shares away from the glaring eye of the public transaction. Here’s the problem, if your are a high frequency trader, you (by definition) have a super-fast computer and access to dark cables. That means you can “ping” the many, many dark pools that have been set up. By some estimates, 40% of all trading is now done inside dark pools. And that in turn means you can know, well before the government-issued slow computers have finished calculating the best price what the real selling price is. That’s one heck of a rounding error in your pocket. And finally, to make all this work, you need volatility. All volatility means is that the price of something moves up and down a lot. And obviously if it does that, there is a lot more room for a high-frequency trader to essentially insert him/herself in the middle of that trade. Basically here’s the way it works. You want to buy those 10,000 shares of Microsoft for $30. There’s a dark pool that will sell 100 of them to you for that price. I, as a high-frequency trader, ping that dark pool, know what the price you’re willing to buy for is and all the other prices out there and where you will buy from next. So I go and buy the next batch of Microsoft shares that are selling (as you will recall at $30.01). Now, your broker, by law, has to come and buy the shares from me. Except I sell the shares now at $30.1001. And right there, in less than the blink of an eye I have made almost $10. And that’s from a mere 9,900 shares—a small trade. So what high-frequency traders do in effect is charge a tax for trading. And that tax (like most taxes) makes economic activity, in this case people’s willingness to trade to decrease. It also means that flash crashes, caused when a front-running computer algorithm gets too clever by half, are inevitable. In Flash Boys, Lewis explains all of this a little at a time. In some ways, the book reads like a great detective story. And like a great detective story, it is eminently readable because at its heart is a kind of hero: Brad Katsuyama. Brad sets out to hire a lot of computer programmers to beat the system. First he introduced Thor. This was a platform that enabled you to trade more slowly and then a brand new exchange called IEX (an exchange—and yes, it got the license to be an actual exchange) that did the same thing. The idea behind Thor and IEX seems counter-intuitive but in a high-frequency world it works. If you trade many thousands of shares per trade, then it makes sense that your order should arrive at all the exchanges/dark pools at the same time. That way no-one can ping/front-run you. You will not, in other words, be paying a tax on your trade. So to get the high-frequency traders out of the loop, you need to trade just slowly enough that your orders arrive at all exchanges at the same time. This is the story of how Brad and the motley crew he gathered around him came up with that idea, the push-back they initially got from the industry and how they eventually sold the industry, including Goldman Sachs, on the concept. It is a story well worth reading. I highly recommend it.

Michal Lewis is a national treasure. He is able to take complex things and make them accessible to people like your mom - if you want to be condescending to your mother. In a way, he is one of the best nonfiction writers in English working today. I'd put him up there with Bill Bryson. But you know that already. This is a Michael Lewis book. You know: the guy who wrote Liar's Poker, Moneyball, The Big Short, and that other book you like. What Lewis does is take a look at an issue, but he does this thing where instead of boring you with a lot of details, he tells the story of a person (For real - this book has no index, no endnotes) and the problem they face and the cool things they do. The person isn't really usually that far removed from what we imagine ourselves to be, but perhaps a better version than the self we really are. In Flash Boys, that person is Brad Katsuyama. Katsuyama was a worker on the exchange for the Royal Bank of Canada. He noticed that there were issues with trading. Namely that the trades that his traders were trying to make basically disappeared in front of him when they tried to execute them. This lead the reader to go on a journey led by Lewis as the reader follows along with Katsuyama as everyone learns what the issue was and why those trades were disappearing. Mainly the story is computers, software, and companies using their smarts to insert themselves in the middle of a trade. Eventually Brad and the reader learn all about this and is disenchanted with the system as it exists so he sets out to change this. His mission is to create a new exchange that disarms the smart "High Frequency Trading" and levels the playing field for everyone. It's a good story, and Lewis tells it well. My issue with it is that with the structure of the story, where it focuses on Katsuyama and his team, is that it is one-sided. The implicit message is that they are the good guys and the HFT guys are the bad guys. If you don't know much about the world that Lewis describes then you take it for granted that he is right. The last third of the book becomes an advertisement for the exchange that was started. It has started a lot of conversations amongst finance and economic people about the value of HFT, but that is nowhere in the book. Does it help price discovery; does it provide liquidity; does it make trading more efficient ? Or is HFT just predatory; is it pure rent as Lewis quotes someone "The market is all about algos and routers. It's hard to figure this stuff out. There's no book you can read ." (209)? I don't know, but thankfully this book is bringing those issues. Ultimately, I have to hoist a footnote that Lewis writes that sums up the whole book for me: "'Glitch' belongs in the same category as `liquidity' or for that matter, `high frequency trading.' All terms used to obscure rather than to clarify, and to put minds to early rest."(203). Lewis lets in his editorial voice come in to show that even though he has written a whole book there is an inexactness to defining what HFT is - you have to get to the nitty-gritty to really know (He recommends a couple of books in the text but I didn't highlight them). Because in the end, this book is only tangentially about HFT. It is really about Brad Katsuyama. All I wonder is who is going to play him in the movie

Muy buen libro.

Micheal Lewis non si smentisce mai, ottimo scrittore, ennesimo suo libro "must read". La storia é agghiacciante in quanto stiamo parlando di alta finanza istituzionale negli stati uniti condotta dai migliori laureati di università Ivy League, ma potrebbe essere tranquillamente ambientata in qualche paesiello della nostra penisola dove si studia e si lavora solo ai fini di manomettere e aggirare regole e istituzioni per monetizzare. Racconto pazzesco che mi ha fatto pensare che la finanza abbia davvero toccato il fondo, più in basso di cosi non si può scendere (ma sarò smentito). Scritto benissimo, intrigante con molti aneddoti interessanti e personaggi che coinvolgono il lettore, un "page turner" che si legge velocemente. Descrive una realtà che lascia l'amaro in bocca e che per certi versi conferma che tutto il mondo é paese; le cose da sistemare nella nostra società sono ancora molte e in tante parti del globo.

The thrust: Over the past 20 years, and particularly in the past decade, the stock market has undergone some significant changes. The most visible change is that much of the action has now become computerized. For example, whereas stock markets used to consist of trading floors (pits), where floor traders swapped stocks back and forth, we now have computer servers where sellers and buyers are connected automatically. Now, on the one hand, this automation has led to some substantial efficiencies, as once necessary financial intermediaries have now largely become obsolete (this has led to savings not only because the old intermediaries earned an honest commission for their dealings, but because their privileged position sometimes led to corruption). It is not that the new stock market has done away with intermediaries entirely. Take brokers, for example. Brokers are still used by large investors to help them move large chunks of stock where the market may not be able to fill the order immediately. The brokers take some risk in this action, and provide liquidity in doing so, since they help move capital to its most useful location, and thus brokers still provide a very useful service. While brokers have always existed, the new stock market has also added a new breed of intermediary. This new breed of intermediary is known as the high frequency trader (HFT). The high frequency trader operates on speed, relying on location and advanced communications technology to learn about the movement of the market before others, and uses this knowledge to make winning trades. To give you an indication of how important high frequency trading has become, consider that at least half of the trades now being made in the United States are coming from high frequency traders. Those who defend high frequency trading argue that these quick trades actually help move money through the stock market, and thus add liquidity to the system (the way brokers do); and that, therefore, high frequency traders provide a valuable service. However, just how high frequency trading works has largely remained a mystery to anyone outside of the industry itself; and many have become concerned that high frequency trading is not so much a liquidity-contributor as a way of scalping money off of trades that would have happened anyway. In 'Flash Boys: A Wall Street Revolt', Michael Lewis follows one man who made it his mission to find out what was going on at the heart of HFT. That man is one Brad Katsuyama, a broker from the sleepy Canadian bank RBC. Katsuyama’s interest in the mystery began back in 2007, when he found that the trades he was trying to make from his desk at RBC were not being executed in the way they once had. In short, Katsuyama was being ripped off. And that’s not all. Katsuyama soon found that other brokers were also being ripped off—and even the investment firms were being ripped off. And since the investment firms manage your money and mine, we were being ripped off too!! This was big. Katsuyama’s dogged persistence eventually led him (and a growing band of fellow mystery-solvers) to find that it was indeed the high frequency traders who were ripping him (and everyone else) off (though the HFTs were not the only culprits involved). What’s more, Katsuyama’s team also discovered just how the HFTs were doing it. The long and the short of it is that the HFTs are just gaming the technology. And in a way that is not only ripping others off, but making the system more volatile, and prone to errors and disasters as well (witness the flash crash of May 6, 2010). Rather than deciding to join the HFTs at the trough (which would have been easy enough to do), Katsuyama and his team decided to fix things. Specifically, the team decided to start their own stock exchange: a stock exchange (called the IEX) that was designed to be immune to advantages in technology, and hence fundamentally fair to all (it was either that or wait around for the SEC to do something—which may take forever). Now, you would think that a stock exchange that is fundamentally fair to all would be a big hit. But then again, a whole heck of a lot of people have no interest in making things fair to all. Which side will win? The fate of the IEX (which opened in October of 2013) has yet to be determined... This book is fantastic. The story will confirm your suspicious that truth is stranger than fiction. Lewis writes beautifully, unpretentiously, and makes the characters jump right off the page (that wouldn’t have been that difficult here—these are some brilliant characters). My only objection is that Lewis’ explanations of the technical side of things, while very good, could have occasionally been slightly more clear. Still, an enlightening and wonderful read.

Awesome book on HFT trading. A must read for any trader of any experience

The book is engaging in its writing style but sobering in its substance. I wish, however, to remark that despite the informality of its style, the book is conceptually dense and nuanced - and at least for me intellectually taxing - while its author emerges as a personality imbued with morality, possessing a brilliant, incisive, and penetrating intellect which goes to the heart of the matter revealing things in all their sinister clarity and importantly impeccably documented. If the characters of the actors in the book appear somewhat overdrawn, this is to stress their remarkable traits. The hero, Brad Katsumaya, emerges both as a paragon of morality and brilliance. When I consider the substance of the book words like sobering, chilling, and Kafkaesque come to mind while when I think what High Frequency Traders (HFT) and dark pools have done to Wall Street Exchanges and Finance, the first word that crosses my mind is travesty. Regarding the substance of the book, for the benefit of brevity and clarity, I shall in the ensuing simplify and confine myself to the gist of the matter. The specific mode for market manipulation and extracting money from investors which is the focus of discussion in the book is 'front-running' while the people practicing it and profiting from it are called ' High Frequency Traders'; an ancillary tool are 'dark pools' which are private stock exchanges, run by the big brokers, which are not required to reveal to the public what happened inside them. The mode and pattern of front running is revealed when a trader interacts 'simultaneously' with different exchanges: when bids and offers for shares sent to the exchanges arrived at precisely the same moment,the markets acted as they should. If they arrived a millisecond apart, the market vanished, and all bets were off. Brad Katsumaya knew that he was being 'front-run' - that some other trader, was in effect, noticing his demand for stock on one exchange and laying it on others in anticipation of selling it to him at a higher price. Brad identified a suspect: 'High-Frequency Traders'. And indeed that is what precisely happened, a small clan of insiders with the resources to create speed were now allowed to preview the market and trade on what they had seen. They were ripping off the retirement savings of the entire country through systematic fraud and people did not even realize it. The initial response of Katsumaya when still employed with the Royal Bank of Canada was to construct Thor which had built in delays so that orders could arrive at different exchanges at the same time (the window of opportunity was 465 microseconds). It was possible to obtain an estimate of the windfall for financial intermediaries which was somewhere between $10 billion and $22 billion a year. Subsequently Katsumaya resigned from RBC and with a team of experts built a fair and transparent exchange, IEX, which proved a success. The first to back it was Goldman Sachs which changed its former policies due to its long term interests. Among the considerations was the instability into the system when its primary goal was no longer stability but speed. Another the billions by financial intermediaries. It has to be appreciated that that the profits of the HFT was 85% with only 15% gained by the banks. I regret that I have to conclude the review in a pessimistic tone considering that since the late 1800s the entire history of Wall Street was the story of scandal. Every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice. No matter what the regulators did, some other intermediary found a way to react, so there would be another form of front-running.