No one matches Michael Lewis' ability to take an arcane topic of finance and use it to build a narrative that is not only educational, but also a pleasure and a joy to read. In Flash Boys the arcane topic is the way that computer geeks have been able to game the newly computerized financial markets, extracting billions of dollars from investors large and small. As in his other books, he uses the experiences of real people to build the narrative, and his main character in this book is a Brad Katsuyama, who begins the story as a stock trader at the Royal Bank of Canada (RBC).
In 2006 Katsuyama noticed an anomaly in the market. He could see bids and offers in a variety of the different stock markets, but when he tried to make a trade, that stable market disappeared as if someone knew what he wanted to do before he acted. What the reader needs to know is that by 2006 the old world of individuals trading stocks on the floor of the stock exchange had disappeared, replaced by computers that matched buy and sell orders. Further, the market had fragmented, so that in addition to the old NYSE, NASDAQ, and American Stock Market, there were a dozen other markets, all matching orders with computers.
Brad Katsuyama and the reader gradually learn that high-frequency traders, doing all their trading using computer programs, had learned how to rig the new market where a few milliseconds, less than the blink of a human eye, was enough time for a computer to execute many trades. What the high-frequency traders discovered is that a buy or sell order did not arrive at all the computerized exchanges at the same time and the delay allowed for an opportunity to "front run" it. Suppose an investor wanted to buy a large block of stock and looking at the market saw that plenty of shares were offered at the various computerized exchanges. The high-frequency traders would offer a small block on the first exchange at which the order arrived and this would allow them to see what the trader wanted to do. The high-frequency traders would use this information to race to the other markets to buy up the stock before the investor's order arrived. They would then sell those shares at a higher price to the investor. Although this may sound fantastic and impossible, it became the main activity for the high-frequency traders.
To be able to game the market in this way, speed was everything. You wanted your trading computers to be as close to the market matching computers as possible, and the high-frequency traders paid the exchanges to allow their computers to be in the same building as the computers of the exchange. The price of having a company's computer in the building depended on how close it was to the computer that ran the market. The high-frequency traders also paid to get the fastest communications links because the time that it took light to travel a hundred feet could make the difference between making money and being too late to the deal.
Lewis explores all this from the view of traders trying to discover what was happening to their trades. It would have been even more interesting, perhaps, to have traveled with those who discovered how to rig the system, but they have an incentive to remain silent. After all, a reason for their success was that people did not understand what they were doing. (And even after the outsiders understood, they were often astounded that what was being done was even technically possible.)
Eventually RBC developed a software program that neutralized the high-frequency traders by sending orders to the various exchanges with time lags so that all the orders would arrive at the various exchanges simultaneously. This prevented the high-frequency traders from using their order information on one exchange to exploit them on other exchanges.
After the reader discovers that the markets are rigged, an expected reaction would be that the government needs to regulate more. Lewis dismisses this idea using one of the characters who researches scandals on Wall Street and finds "[e]very systemic market injustice arose from some loophole in a regulation created to correct some prior injustice....[T]he regulators might solve the narrow problem of front-running in the stock market by high-frequency traders, but whatever they did to solve the problem would create yet another opportunity for financial intermediaries to make money at the expense of investors." (p. 101) The current regulation that was being exploited was Regulation National Market System, passed by the SEC in 2005 and implemented in 2007 in response to abuses that surfaced in 2004.
The last part of the book describes the efforts of Brad Katsuyama to establish a new exchange, the IEX, that would be fair and constructed in a way that would not be gamed by the high-frequency traders. His main obstacle was that so many of the big players had a stake in the existing system. The exchanges made lots of money by selling fast access to the high-frequency traders. The big banks and brokerages with access to the markets made money both by establishing their own proprietary trading areas, called dark pools, and also by selling information to the high-frequency traders. However, large investors such as mutual funds were eager for this kind of exchange and by the end of the book the IEX has been launched. It had even attracted favorable attention from Goldman Sachs, where some executives thought a fairer market was in their long-term interest and who believed they could never really compete with the high-frequency traders.
Why does it all matter? The electronic markets in theory should be matching buyers and sellers so that all the benefits of the exchange accrue to them. However, the high-frequency traders have found a way to get between the buyers and sellers, extracting a bit of the gains for themselves while providing no benefit to anyone else. This is a tax on capital that takes billions of dollars from the financial markets and thereby make them less efficient in allocating capital to its most productive uses. (On the other hand, some of the fees to banks and exchanges may allow them to keep user fees lower than they would otherwise be, so some the money extracted from the investors may provide benefits.)
I highly recommend the book. Michael Lewis is an unique talent, one who can clearly explain difficult economic and financial concepts in an entertaining and engaging way.
Bonus Quotation of the Day…
6 hours ago