Can the “nice guys” on Wall Street stop high frequency traders (HFT) from taking billions of dollars from the rest of us?
That’s the question Michael Lewis sets out to answer in Flash Boys: A Wall Street Revolt—a classic tale of good versus evil, the underdog’s effort to triumph over all.
Flash Boys purports to be the true tale of three electronic trading experts (and their earnest band of outsiders) who walk away from huge Wall Street salaries to start their own stock exchange, where investors will be protected from the predatory HFT outfits who supposedly steal billions from them every year.
As stories go, it’s a ripping good one. Lewis makes financial jargon and technological mumbo jumbo readable, understandable, even compelling. From the moment our heroes are introduced, they’re impossible not to root for—if you own even one share of stock, you’re invested (pun intended) in their cause, and you want them to take down those greedy shysters with their superfast computers, smarter-than-you algorithms and über-shady tactics.
Problem is, it’s a story. As such, it suffers from many of the same drawbacks as its author’s earlier work, which generally hinge on telling the story of a select few people as though it were indicative of a much more common practice. Pure anecdotal evidence. Just as Miguel Tejada and the Big Three pitchers had at least as much to do with the Oakland A’s 2002 success as Scott Hatteberg, Chad Bradford and Ricardo Rincon, several elements of Flash Boys seem embellished or whitewashed for dramatic effect. Provocative quotes are portrayed as Gospel, without apparent regard for factual underpinning. To a degree, it’s understandable: Good versus evil narratives work best when the cowboy hats are black and white. But reality isn’t black and white—it’s infinitely more complex, with a lot of grey area.
One glaring problem is in the portrayal of HFT. For the story to work, the reader has to believe HFT outfits—if not outright breaking the law—are behaving extremely unfairly. So the book focuses on one HFT tactic: identifying and capitalizing on tiny discrepancies in stock pricing across the 13 public stock exchanges in the US (and the 40-something off-exchange crossing networks, better and more theatrically known as dark pools of liquidity), and using their speed to trade around normal investors.
As described in the book, this is HFT firms’ way of exploiting Regulation National Market System, or Reg NMS, a 2007 rule change requiring brokers fulfilling trade orders to deliver “best price” instead of “best execution.” “Best execution” is vague by design—and in my view, appropriately so. Whether a trade is executed in a manner best for the investor depends on more than share price. There are a number of implicit costs, including liquidity and information leakage, all of which can determine whether the investor gets the best deal. Let’s say you submit an order to buy 1,000 shares of company XYZ, which your online brokerage says is trading between $99.89 (bid) and $99.95 (ask). Your broker gets it and sees 100 shares offered on BATS and 100 on Nasdaq for $99.90, 500 shares on the New York Stock Exchange (NYSE) for $99.91 and 2,000 shares on Direct Edge for $99.92. To get best execution, the broker could justify sending the order to Direct Edge only—it’s a higher price, but it’s one and done. No routing to multiple exchanges, signaling your intentions to the broader market, and risking other outfits trying to trade against you—effectively minimizing the implicit costs.
Under Reg NMS, however, brokers are required to route orders so they buy all shares available at the lowest price—so they’d buy those 200 shares at $99.90, the 500 shares at $99.91, and 300 more from Direct Edge at $99.92. This exposes you to more implicit costs and, according to the book, gives HFT an in. Because information travels to different exchanges at different speeds, depending on the infrastructure and the broker’s location, when HFT firms see the first slice of your order hit BATS, they can use their speed to snap up the shares on Nasdaq, the NYSE and Direct Edge and flip them to you at $99.93. All within microseconds.
The book rightly acknowledges this is fully legal—an unintended consequence of well-intended regulation. As hero-in-chief Brad Katsuyama surmises to a group of his new exchange’s backers toward the book’s end: “I hate [HFT] a lot less than before we started. This is not their fault. I think most of them have just rationalized that the market is creating the inefficiencies and they are just capitalizing on them. Really, it’s brilliant what they have done within the bounds of the regulation. They are much less of a villain than I thought.”
However, in the book’s other 270 pages, the tactic is still dressed up as being grossly unfair to the average investor: Predatory computers that can execute multiple buys and sells in the blink of an eye, that can move faster than humans can ever dream of, make tens of billions a year by trading against us. Exploiting us! Fleecing us, taking money that should otherwise be ours!
Perhaps, in a vacuum, that’s true. But life isn’t a vacuum. Nor is HFT, on balance, a giant sucking sound in your portfolio. In a way, it keeps more money in your pocket. In olden days, human exchange specialists and market makers filled orders. They’d buy from sellers at the going ask price, sell to buyers at the going bid price, and pocket the spread. In those days, spreads were a lot wider—humans fleeced far more per trade than HFT does today. Plus, by vastly increasing the number of players in the market, HFT’s rise made trading easier and cheaper. When trading commissions were deregulated in 1975, it wasn’t unusual to pay hundreds of dollars to execute a large trade in order to cover all the broker’s costs. That’s in 1975’s dollars—based on the change in CPI since then, it would be 4.5 times higher in today’s dollars. Charles Schwab, then an upstart discount broker, was considered dirt cheap at $70 a pop. Costs are far lower today. HFT isn’t the only factor here, but it’s a big one—a huge contributor to competition and technological advancement that reduced the market’s overall operating costs. If you ask me, a penny or so (or less) per share seems a pretty fair price to pay for these many benefits.
Not that every HFT player is pure of heart. Every industry has its share of cretins, charlatans and lawbreakers. Stock investing is no different, and allegations (and convictions) for corruption date to the earliest days of exchange trading. It seems a fair assumption at least some HFT outfits are behaving illegally, and to the extent they are—and that it can be proven—I say, fry ‘em. (Metaphorically.) But the illegal actions of a few shouldn’t taint the many who act within the bounds of the law and ethics, however superhuman their trading speeds.
But Flash Boys doesn’t aim to be a fair critique of HFT. Instead, it’s the tale of the white knights who decide to level the playing field by creating a new stock exchange that neutralizes HFT’s advantage. And here, to me, is the most compelling part of the story. You see, our heroes did what few believe American business people are capable of, especially if they come from Wall Street. They built a business based on values, believing principles are a superior guiding force to the raw pursuit of money. They knew they could make more if they stayed put and used all they’d learned about HFT to their own advantage, but they didn’t believe that was the right thing to do. Sure, they certainly hope to make some dough—they have families to feed—but they walked away from their high-paying, high-flying jobs at RBC because they believed they had a higher purpose. They wanted to put investors first. Fat salaries were nice, but these gents cared far more about bettering the investment universe. Even in creating their new exchange, IEX, their goal wasn’t to drive all trading to their venue and make a killing in execution fees—it was to dare all exchanges to follow their model and create a more transparent, equitable marketplace. No matter where you trade.
It’s a wonderful purpose even if the adversary is something of a straw man. But here, too, the book is a little too black and white. In its effort to convince readers the good guys are as good as can possibly be, the book ignores what some might consider grey areas. For example, it describes many of IEX’s features, including the 350 microsecond delay added to all orders routed to other exchanges (in accordance with Reg NMS), the fact it accepts only four trading orders (as opposed to the dozens of complex, exotic orders allowed on other exchanges), and its flat fee that doesn’t reward participants for taking liquidity. All simple, straightforward and designed to minimize loopholes and exploitable quirks. But the book doesn’t mention that IEX allows “broker preferencing,” which gives brokers first crack at filling orders that come from their own firm—or, in more nefarious terms, trading against their own order flow. So if a client of Big Broker, Inc. entered an order to buy 1,000 shares of Company XYZ, and there were already shares on offer, Big Broker, Inc.’s prop traders could cut in line and fill the order itself.
Broker preference has been a de facto no-no in US trading for over a decade—not technically illegal, but the SEC hasn’t approved new exchanges using it (IEX, still in its infancy, is officially a dark pool, though its founders plan to file for official exchange status in the future). One could reasonably suspect this is why Flash Boys avoids the subject. To the casual observer, the first-come, first-serve system seems fairest. Never mind that broker preference is the norm in Canada and a 1996 study by the SEC found the practice had no negative effect. It just sounds bad.
In my view, a more complete, accurate book would have acknowledged this little factoid—and explained why IEX allows it: They believe it increases transparency and makes pricing more efficient. Prop traders trading against their firm’s order flow is nothing new, and it’ll happen with or without broker preferencing. But the IEX crew believes its absence in the US prompts brokerage firms to execute orders inside their own dark pools instead of public exchanges, ultimately reducing the number of participants and liquidity available “in the light.” They believe broker preferencing is why only a small share of Canadian trading happens in dark pools (compared to roughly half in the US), and they believe it’s “a trade-off that seems to make sense for the good of the industry.” A fine hypothesis with honorable intentions—but a seemingly grey area all the same. In a black and white tale, grey ain’t ok.
Still, Flash Boys is well worth a read, provided you dive in with the right expectations: a reminder that there are good guys in finance, but a based-on-a-true-story, somewhat novelized version of an often messy, complex reality.
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