The Fervor Around Flash Boys

Michael Lewis explains what led him to write his new book on the abuses in high frequency trading:

This NYT Magazine excerpt from the book gives you a general sense of its arguments:

Technology had collided with Wall Street in a peculiar way. It had been used to increase efficiency. But it had also been used to introduce a peculiar sort of market inefficiency. Taking advantage of loopholes in some well-meaning regulation introduced in the mid-2000s, some large amount of what Wall Street had been doing with technology was simply so someone inside the financial markets would know something that the outside world did not. The same system that once gave us subprime-mortgage collateralized debt obligations no investor could possibly truly understand now gave us stock-market trades involving fractions of a penny that occurred at unsafe speeds using order types that no investor could possibly truly understand. That is why Brad Katsuyama’s desire to explain things so that others would understand was so seditious. He attacked the newly automated financial system at its core, where the money was made from its incomprehensibility.

In an NPR interview, Michael makes his core case:

There is this perception that Wall Street insiders understand how Wall Street works — and it’s false. It’s especially false right now. Here you have this young man, this kid [Katsuyama] at the Royal Bank of Canada who’s engaged in this kind of science experiment in the market. He figures out at least one angle the predators are taking ,and he goes and talks to not just ordinary investors … the biggest investors, the smartest investors in the world, and their jaws are on the floor. … Even these people have no idea what’s going on in the market and are being educated by this Canadian who has basically just arrived on the scene and has decided to make understanding [this] his business.

It’s a riveting book, but it has its critics. Matthew Philips claims that Lewis gets much wrong about high frequency trading (HFT):

HFT doesn’t prey on small mom-and-pop investors. In his first two TV appearances, Lewis stuck to a simple pitch: Speed traders have rigged the stock market, and the biggest losers are average, middle-class retail investors-exactly the kind of people who watch 60 Minutes and the Today show. It’s “the guy sitting at his ETrade account,” Lewis told Matt Lauer. The way Lewis sees it, speed traders prey on retail investors by “trading against people who don’t know the market.”

The idea that retail investors are losing out to sophisticated speed traders is an old claim in the debate over HFT, and it’s pretty much been discredited. Speed traders aren’t competing against the ETrade guy, they’re competing with each other to fill the ETrade guy’s order.

Felix Salmon agrees that “Lewis goes to great lengths to elide the distinction between small investors and big investors” and argues that it’s “big investors who get hurt by HFT.” Another criticism:

This vagueness about time is one of the weaknesses of the book: it’s hard to keep track of time, and a lot of it seems to be an exposé not of high-frequency trading as it exists today, but rather of high-frequency trading as it existed during its brief heyday circa 2008. Lewis takes pains to tell us what happened to the number of trades per day between 2006 and 2009, for instance, but doesn’t feel the need to mention what has happened since then. (It is falling, quite dramatically.) The scale of the HFT problem — and the amount of money being made by the HFT industry — is in sharp decline: there was big money to be made once upon a time, but nowadays it’s not really there anymore. Because that fact doesn’t fit Lewis’s narrative, however, I doubt I’m going to find it anywhere in his book.

Mark Gorton, who “makes his living running a high-frequency trading firm,” criticizes the book for “conflating what high-frequency trading firms do with what exchanges and brokers do”:

The biggest conflicts of interest and problems in the market have to do with how brokers treat orders. Have you heard of payment for order flow? If you order through eTrade or TD Ameritrade, that order doesn’t get sent to one of the stock markets. There are firms out there that pay eTrade and the other firms to have their orders routed to them, and then they execute the orders. This payment obviously creates incentives for brokers to do things that aren’t in the customer’s interest.

The problem that exists is small. The amount you’re talking about in any of these cases is fractions of a penny. So even if you do have this payment for order flow, it’s a fairly small amount. And again, I think it’s a practice that should be banned. But it’s not a giant amount of money. And it’s a broker practice.

Matt Levine thinks that there “are two ways of characterizing high frequency trading”:

In one, HFTs are front-running big investors, rigging the game against them and making the stock market illusory. In the other, HFTs are reacting instantly to demand, avoiding being picked off by informed investors and making the stock market more efficient.

In my alternative Michael Lewis story, the smart young whippersnappers build high-frequency trading firms that undercut big banks’ gut-instinct-driven market making with tighter spreads and cheaper trading costs. Big HFTs like Knight/Getco and Virtu trade vast volumes of stock while still taking in much less money than the traditional market makers: $688 million and $623 million in 2013 market-making revenue, respectively, for Knight and Virtu, versus $2.6 billion in equities revenue for Goldman Sachs and $4.8 billion for J.P. Morgan. Even RBC made 594 million Canadian dollars trading equities last year. The high-frequency traders make money more consistently than the old-school traders, but they also make less of it.

You don’t have to be absolutist about this either way. Whether or not HFTs’ behavior of quickly adjusting quotes to market conditions is “predatory” in some moral sense — and whether or not it ultimately makes markets more or less efficient on balance — it is clearly annoying to a lot of institutional investors. So those investors like having the option of trading on IEX. And there’s no obvious reason to think that the current market structures and rules are the “right” rules, or that high-frequency traders aren’t sometimes gaming those rules in not-so-socially-optimal ways.

What Levine sees as the real danger of HFT:

There are two competing forces:

  1. High-frequency trading quickly propagates information across markets, reducing the need for fundamental investors to do research and make capital allocation decisions.
  2. High-frequency trading drives down the rewards to fundamental investors, by making prices react instantly to their activity so that they can never make a profit by buying (selling) undervalued (overvalued) stocks.

If force 1 outweighs force 2 then markets will be more efficient: The David Einhorns of the world will make less money finding undervalued companies, but their work will have more effect on market prices and capital allocation. If force 2 outweighs force 1, then … well, you could imagine a world where high-frequency trading is so speedy and efficient that there’s no way for fundamental investors to make any money: As soon as David Einhorn even thinks about buying a stock, its price snaps up to what he’d consider a fair price, so he can’t profit from buying it.

In this world, where high-frequency trading firms could instantly capture all of David Einhorn’s profits, he’d just quit investing and go play poker. And so would everyone: No one would invest in investment research, because any information advantage you could obtain by research would disappear instantly the minute you tried to buy stock. The market would be left to no one but the hobbyists and the high frequency traders, neither of whom are much good at the fundamental analysis that in theory should go into allocating capital.

Back in 2012, Felix Salmon identified another problem with HFT:

The more obvious problem with exchanges run by computers is that computers don’t have any common sense. We saw this on the 6th of May, 2010 — the day of the so-called “flash crash”, when in a matter of a couple of minutes the US stock market plunged hundreds of points for no particular reason, and some stocks traded at a price of just one cent. It was sheer luck that the crash happened just before 3pm, rather than just before 4pm, and that as a result there was time for the market to recover before the closing bell. If there hadn’t been, then Asian markets would have sold off as well, and then European markets, and hundreds of billions of pounds of value would have been destroyed, just because of a trading glitch which started on something called the e-mini contract in Chicago.

In a more recent post, Salmon wonders about HFT regulation:

Brad Katsuyama, the founder of IEX and the hero of Lewis’s book, is no white-hat absolutist: he doesn’t like the way in which the term “HFT” is used to cover a multiplicity of different behaviors, and in fact he is all in favor of computerized trading. (Which makes sense, seeing as how he runs a dark pool.) And BATS president Bill O’Brien is happy to concede that the market has become too complex. He said only that the complexity needs to be “managed”, rather than simplified, but in reality simplification is by far the most effective way to manage complexity. A market with only three or four order types, for instance, is a lot simpler and easier to manage than a market with hundreds.

Can the market be fixed? Michael Lewis says he would like to see that — but at the same time he says that he welcomes the way in which the FBI and the New York attorney general are launching investigations into HFT, to see whether anything in that world can be considered criminal insider trading or market manipulation. My feeling is that if you want prosecutions, then law-enforcement should launch investigations — but that if you really want to fix things, then creating a highly adversarial relationship between HFT shops and the government is not going to help and is in fact almost certain to hurt.

Zachary Karabell makes a related argument:

We should welcome the current debate and the negative spotlight cast on high-frequency trading. But that doesn’t mean that behavior that was previously deemed acceptable should be suddenly criminalized just because the pendulum shifts. The behavior can be unacceptable and be curtailed without the attendant use of state power to prosecute, fine, and potentially incarcerate. Let’s end this system of high-frequency trading that makes it possible for a few firms to profit unfairly and at times distort markets, but let’s do it in a way that avoids the bread-and-circuses spectacle of hunting for villains.

Our regulatory framework in general, whether in finance or any other aspect of life, has become too focused on punishment, often at the expense of meaningful societal reform. Since change and reform are what benefits us all, that is where our energies should go. Trials and scalps may garner media attention and act as proxies for reform, but they are a pallid alternative to the structural changes we actually need.

Finally, Justin Fox looks at the debate from 10,000 feet:

Yes, “the stock market is rigged,” as Lewis said on 60 Minutes. But it’s always been rigged, and that hasn’t prevented it from delivering pretty impressive returns to long-run investors. Yes, we should strive toward a market that’s rigged in the least expensive, most transparent, most efficient, most stable way possible. I don’t think we’ll ever get rid of the people (or computers) in the middle making money off the customers, though. And there may even be something to be said for letting them do it the old way, out in the open, with cartels and fixed fees and Cadillacs to drive home to Long Island.

I find this world-wear capitulation to rigging to be a little like the journalism pundits who say of fake articles: “nothing new here, walk on by.” The fact that some traders operated in a market milliseconds ahead of everyone else, and did so by subterfuge and flying below the radar is a reminder, once again, that Wall Street’s insiders simply cannot be trusted. They have one goal: to make as much money as possible by whatever means possible. They have close to zero interest in the integrity of your investments or mine. That they felt able to do this after all but destroying the lives of countless human beings through their addiction to complexity they didn’t fully understand makes it all the more shocking to me. Almost as shocking as the blase attitude of so many toward these unrepentant, greednik vandals.