As HFT shops begin to turn on each other, it seems appropriate to reflect on the impact that Michael Lewis' Flash Boys book had on exposing the ugly truth that many have been discussing for years in US (and international) equity (and non-equity) markets. As Lewis concludes, after explaining the attacks he has suffered from the HFT industry, "If I didn't do more to distinguish 'good' H.F.T. from 'bad' H.F.T., it was because I saw, early on, that there was no practical way for me or anyone else... to do it. ... The big banks and the exchanges [have] been paid to compromise investors’ interests while pretending to guard those interests. I was surprised more people weren’t angry with them."
When I sat down to write Flash Boys, in 2013, I didn’t intend to see just how angry I could make the richest people on Wall Street. I was far more interested in the characters and the situation in which they found themselves. Led by an obscure 35-year-old trader at the Royal Bank of Canada named Brad Katsuyama, they were all well-regarded professionals in the U.S. stock market. The situation was that they no longer understood that market. And their ignorance was forgivable. It would have been difficult to find anyone, circa 2009, able to give you an honest account of the inner workings of the American stock market—by then fully automated, spectacularly fragmented, and complicated beyond belief by possibly well-intentioned regulators and less well-intentioned insiders. That the American stock market had become a mystery struck me as interesting. How does that happen? And who benefits?
By the time I met my characters they’d already spent several years trying to answer those questions. In the end they figured out that the complexity, though it may have arisen innocently enough, served the interest of financial intermediaries rather than the investors and corporations the market is meant to serve. It had enabled a massive amount of predatory trading and had institutionalized a systemic and totally unnecessary unfairness in the market and, in the bargain, rendered it less stable and more prone to flash crashes and outages and other unhappy events. Having understood the problems, Katsuyama and his colleagues had set out not to exploit them but to repair them. That, too, I thought was interesting: some people on Wall Street wanted to fix something, even if it meant less money for Wall Street, and for them personally.
Of course, by trying to fix the stock market they also threatened the profits of the people who were busy exploiting its willful inefficiencies. Here is where it became inevitable that Flash Boys would seriously piss off a few important people: anyone in an established industry who stands up and says “The way things are being done here is totally insane; here is why it is insane; and here is a better way to do them” is bound to incur the wrath of established insiders, who now stand accused of creating the insanity. The closest thing in my writing life to the response of Wall Street to Brad Katsuyama was the response of Major League Baseball to Billy Beane after Moneyball was published, in 2003, and it became clear that Beane had made his industry look foolish. But the Moneyball story put in jeopardy only the jobs and prestige of the baseball establishment. The Flash Boys story put in jeopardy billions of dollars of Wall Street profits and a way of financial life.
Two weeks before the book’s publication, Eric Schneiderman, the New York attorney general, announced an investigation into the relationship between high-frequency traders, who trade with computer algorithms at nearly light speed, and the 60 or so public and private stock exchanges in the United States. In the days after Flash Boys came out, the Justice Department announced its own investigation, and it was reported that the F.B.I. had another. The S.E.C., responsible in the first place for the market rules, known as Reg NMS, that led to the mess, remained fairly quiet, though its enforcement director let it be known that the commission was investigating exactly what unseemly advantages high-frequency traders were getting for their money when they paid retail brokers like Schwab and TD Ameritrade for the right to execute the stock-market orders of small investors. (Good question!) The initial explosion was soon followed by a steady fallout of fines and lawsuits and complaints, which, I assume, has really only just begun. The Financial Industry Regulatory Authority announced it had opened 170 cases into “abusive algorithms,” and also filed a complaint against a brokerage firm called Wedbush Securities for allowing its high-frequency-trading customers from January 2008 through August 2013 “to flood U.S. exchanges with thousands of potentially manipulative wash trades and other potentially manipulative trades, including manipulative layering and spoofing.” (In a “wash trade,” a trader acts as both buyer and seller of a stock, to create the illusion of volume. “Layering” and “spoofing” are off-market orders designed to trick the rest of the market into thinking there are buyers or sellers of a stock waiting in the wings, in an attempt to nudge the stock price one way or the other.) In 2009, Wedbush traded on average 13 percent of all shares on NASDAQ. The S.E.C. eventually fined the firm for the violations, and Wedbush admitted wrongdoing. The S.E.C. also fined a high-frequency-trading firm called Athena Capital Research for using “a sophisticated algorithm” by which “Athena manipulated the closing prices of thousands of NASDAQ-listed stocks over a six-month period” (an offense which, if committed by human beings on a trading floor instead of by computers in a data center, would have gotten those human beings banned from the industry, at the very least).
On it went. The well-named BATS group, the second-largest stock-exchange operator in the U.S., with more than 20 percent of the total market, paid a fine to settle another S.E.C. charge, that two of its exchanges had created order types (i.e., instructions that accompany a stock-market order) for high-frequency traders without informing ordinary investors. The S.E.C. charged the Swiss bank UBS with creating illegal, secret order types for high-frequency traders so they might more easily exploit investors inside the UBS dark pool—the private stock market run by UBS. Schneiderman filed an even more shocking lawsuit against Barclays, charging the bank with lying to investors about the presence of high-frequency traders in its dark pool, to make it easier for the high-frequency traders to have the pleasure of trading against the investors. Somewhere in the middle of it all a lawyer—oddly, named Michael Lewis—who had devised the successful legal strategy for going after Big Tobacco, helped file a class-action suit on behalf of investors against the 13 public U.S. stock exchanges, accusing them of, among other things, cheating ordinary investors by selling special access to high-frequency traders. One big bank, Bank of America, shuttered its high-frequency-trading operation, and two others, Citigroup and Wells Fargo, closed their dark pools. Norway’s sovereign-wealth fund, the world’s largest, announced that it would do what it needed to avoid high-frequency traders. One enterprising U.S. brokerage firm, Interactive Brokers, announced that, unlike its competitors, it did not sell retail stock-market orders to high-frequency traders, and even installed a button that enabled investors to route their orders directly to IEX, a new alternative stock exchange opened in October 2013 by Brad Katsuyama and his team, which uses technology to block predatory high-frequency traders from getting the millisecond advantages they need.
On October 15, 2014, in a related development, there was a flash crash in the market for U.S. Treasury bonds. All of a sudden the structure of the U.S. stock market, which had been aped by other markets, seemed to implicate more than just the market for U.S. stocks.
In the past 11 months, the U.S. stock market has been as chaotic as a Cambodian construction site. At times the noise has sounded like preparations for the demolition of a hazardous building. At other times it has sounded like a desperate bid by a slumlord to gussy the place up to distract inspectors. In any case, the slumlords seem to realize that doing nothing is no longer an option: too many people are too upset. Brad Katsuyama explained to the world what he and his team had learned about the inner workings of the stock market. The nation of investors was appalled—a poll of institutional investors in late April 2014, conducted by the brokerage firm ConvergEx, discovered that 70 percent of them thought that the U.S. stock market was unfair and 51 percent considered high-frequency trading “harmful” or “very harmful.” And the complaining investors were the big guys, the mutual funds and pension funds and hedge funds you might think could defend themselves in the market. One can only imagine how the little guy felt. The authorities evidently saw the need to leap into action, or to appear to.
The narrow slice of the financial sector that makes money off the situation that Flash Boys describes felt the need to shape the public perception of it. It took them a while to figure out how to do this well. On the book’s publication day, for instance, an analyst inside a big bank circulated an idiotic memo to clients that claimed I had “an undisclosed stake in IEX.” (I’ve never had a stake in IEX.) Then came an unfortunate episode on CNBC, during which Brad Katsuyama was verbally assaulted by the president of the BATS exchange, who wanted the audience to believe that Katsuyama had dug up dirt on the other stock exchanges simply to promote his own, and that he should feel ashamed. He hollered and ranted and waved and in general made such an unusual public display of his inner life that half of Wall Street came to a halt, transfixed. I was told by a CNBC producer that it was the most watched segment in the channel’s history, and while I have no idea if that’s true, or how anyone would even know, it might as well be. A boss on the Goldman Sachs trading floor told me the place stopped dead to watch it. An older guy next to him pointed to the TV screen and asked, “So the angry guy, is it true we own a piece of his exchange?” (Goldman Sachs indeed owned a piece of the BATS exchange.) “And the little guy, we don’t own a piece of his exchange?” (Goldman Sachs does not own a piece of IEX.) The old guy thought about it a minute, then said, “We’re fucked.”
Thinking, Fast and Slow
That feeling was eventually shared by the BATS president. His defining moment came when Katsuyama asked him a simple question: Did BATS sell a faster picture of the stock market to high-frequency traders while using a slower picture to price the trades of investors? That is, did it allow high-frequency traders, who knew current market prices, to trade unfairly against investors at old prices? The BATS president said it didn’t, which surprised me. On the other hand, he didn’t look happy to have been asked. Two days later it was clear why: it wasn’t true. The New York attorney general had called the BATS exchange to let them know it was a problem when its president went on TV and got it wrong about this very important aspect of its business. BATS issued a correction and, four months later, parted ways with its president.
From that moment, no one who makes his living off the dysfunction in the U.S. stock market has wanted any part of a public discussion with Brad Katsuyama. Invited in June 2014 to testify at a U.S. Senate hearing on high-frequency trading, Katsuyama was surprised to find a complete absence of high-frequency traders. (CNBC’s Eamon Javers reported that the Senate subcommittee had invited a number of them to testify, and all had declined.) Instead they held their own roundtable discussion in Washington, led by a New Jersey congressman, Scott Garrett, to which Brad Katsuyama was not invited. For the past 11 months, that’s been the pattern: the industry has spent time and money creating a smoke machine about the contents of Flash Boys but is unwilling to take on directly the people who supplied those contents.
On the other hand, it took only a few weeks for a consortium of high-frequency traders to marshal an army of lobbyists and publicists to make their case for them. These condottieri set about erecting lines of defense for their patrons. Here was the first: the only people who suffer from high-frequency traders are even richer hedge-fund managers, when their large stock-market orders are detected and front-run. It has nothing to do with ordinary Americans.
Which is such a weird thing to say that you have to wonder what is going through the mind of anyone who says it. It’s true that among the early financial backers of Katsuyama’s IEX were three of the world’s most famous hedge-fund managers—Bill Ackman, David Einhorn, and Daniel Loeb—who understood that their stock-market orders were being detected and front-run by high-frequency traders. But rich hedge-fund managers aren’t the only investors who submit large orders to the stock market that can be detected and front-run by high-frequency traders. Mutual funds and pension funds and university endowments also submit large stock-market orders, and these, too, can be detected and front-run by high-frequency traders. The vast majority of American middle-class savings are managed by such institutions.
The effect of the existing system on these savings is not trivial. In early 2015, one of America’s largest fund managers sought to quantify the benefits to investors of trading on IEX instead of one of the other U.S. markets. It detected a very clear pattern: on IEX, stocks tended to trade at the “arrival price”—that is, the price at which the stock was quoted when their order arrived in the market. If they wanted to buy 20,000 shares of Microsoft, and Microsoft was offered at $40 a share, they bought at $40 a share. When they sent the same orders to other markets, the price of Microsoft moved against them. This so-called slippage amounted to nearly a third of 1 percent. In 2014, this giant money manager bought and sold roughly $80 billion in U.S. stocks. The teachers and firefighters and other middle-class investors whose pensions it managed were collectively paying a tax of roughly $240 million a year for the benefit of interacting with high-frequency traders in unfair markets.
Anyone who still doubts the existence of the Invisible Scalp might avail himself of the excellent research of the market-data company Nanex and its founder, Eric Hunsader. In a paper published in July 2014, Hunsader was able to show what exactly happens when an ordinary professional investor submits an order to buy an ordinary common stock. All the investor saw was that he bought just a fraction of the stock on offer before its price rose. Hunsader was able to show that high-frequency traders pulled their offer of some shares and jumped in front of the investor to buy others and thus caused the share price to rise.
The rigging of the stock market cannot be dismissed as a dispute between rich hedge-fund guys and clever techies. It’s not even the case that the little guy trading in underpants in his basement is immune to its costs. In January 2015 the S.E.C. fined UBS for creating order types inside its dark pool that enabled high-frequency traders to exploit ordinary investors, without bothering to inform any of the non-high-frequency traders whose orders came to the dark pool. The UBS dark pool happens to be, famously, a place to which the stock-market orders of lots of small investors get routed. The stock-market orders placed through Charles Schwab, for instance. When I place an order to buy or sell shares through Schwab, that order is sold by Schwab to UBS. Inside the UBS dark pool, my order can be traded against, legally, at the “official” best price in the market. A high-frequency trader with access to the UBS dark pool will know when the official best price differs from the actual market price, as it often does. Put another way: the S.E.C.’s action revealed that the UBS dark pool had gone to unusual lengths to enable high-frequency traders to buy or sell stock from me at something other than the current market price. This clearly does not work to my advantage. Like every other small investor, I would prefer not to be handing some other trader a right to trade against me at a price worse than the current market price. But my misfortune explains why UBS is willing to pay Charles Schwab to allow UBS to trade against my order.
The Best of Times, the Worst of Times
As time passed, the defenses erected by the high-frequency-trading lobby improved. The next was: the author of Flash Boys fails to understand that investors have never had it better, thanks to computers and the high-frequency traders who know how to use them. This line has been picked up and repeated by stock-exchange executives, paid high-frequency-trading spokespeople, and even journalists. It’s not even half true, but perhaps half of it is half true. The cost of trading stocks has fallen a great deal in the last 20 years. These savings were fully realized by 2005 and were enabled less by high-frequency market-making than by the Internet, the subsequent competition among online brokers, the decimalization of stock prices, and the removal of expensive human intermediaries from the stock market. The story Flash Boys tells really doesn’t open until 2007. And since late 2007, as a study published in early 2014 by the investment-research broker ITG has neatly shown, the cost to investors of trading in the U.S. stock market has, if anything, risen—possibly by a lot.
Finally there came a more nuanced line of defense. For obvious reasons, it was expressed more often privately than publicly. It went something like this: O.K., we admit some of this bad stuff goes on, but not every high-frequency trader does it. And the author fails to distinguish between “good” H.F.T. and “bad” H.F.T. He further misidentifies H.F.T. as the villain, when the real villains are the banks and the exchanges that enable—nay, encourage—H.F.T. to prey on investors.
There’s some actual truth in this, though the charges seem to me directed less at the book I wrote than at the public response to it. The public response surprised me: the attention became focused almost entirely on high-frequency trading, when—as I thought I had made clear—the problem wasn’t just high-frequency trading. The problem was the entire system. Some high-frequency traders were guilty of not caring a great deal about the social consequences of their trading—but perhaps it’s too much to expect Wall Street traders to worry about the social consequences of their actions. From his seat onstage beside Warren Buffett at the 2014 Berkshire Hathaway investors’ conference, vice-chairman Charlie Munger said that high-frequency trading was “the functional equivalent of letting a lot of rats into a granary” and that it did “the rest of the civilization no good at all.” I honestly don’t feel that strongly about high-frequency trading. The big banks and the exchanges have a clear responsibility to protect investors—to handle investor stock-market orders in the best possible way, and to create a fair marketplace. Instead, they’ve been paid to compromise investors’ interests while pretending to guard those interests. I was surprised more people weren’t angry with them.
If I didn’t do more to distinguish “good” H.F.T. from “bad” H.F.T., it was because I saw, early on, that there was no practical way for me or anyone else without subpoena power to do it. In order for someone to be able to evaluate the strategies of individual high-frequency traders, the firms need to reveal the contents of their algorithms. They don’t do this. They cannot be charmed or cajoled into doing this. Indeed, they sue, and seek to jail, their own former employees who dare to take lines of computer code with them on their way out the door.
In the months after the publication of Moneyball, I got used to reading quotes from baseball insiders saying that the author of the book couldn’t possibly know what he was talking about, as he was not a “baseball expert.” In the 11 months since the publication of Flash Boys, I’ve read lots of quotes from people associated with the H.F.T. lobby saying the author is not a “market-structure expert.” Guilty as charged! Back in 2012, I stumbled upon Katsuyama and his team of people, who knew more about how the stock market actually worked than anyone then being paid to serve as a public expert on market structure. Most of what I know I learned from them. Of course I checked their understanding of the market. I spoke with high-frequency traders and people inside big banks, and I toured the public exchanges. I spoke to people who had sold retail-order flow and people who had bought it. And in the end it was clear that Brad Katsuyama and his band of brothers were reliable sources—that they had learned a lot of things about the inner workings of the stock market that were unknown to the wider public. The controversy that followed the book’s publication hasn’t been pleasant for them, but it’s been fun for me to see them behave as bravely under fire as they did before the start of the war. It’s been an honor to tell their story.
The controversy has come with a price: it has swallowed up the delight an innocent reader might have taken in this little episode in financial history. If this story has a soul, it is in the decisions made by its principal characters to resist the temptation of easy money and to pay special attention to the spirit in which they live their working lives. I didn’t write about them because they were controversial. I wrote about them because they were admirable. That some minority on Wall Street is getting rich by exploiting a screwed-up financial system is no longer news. That is the story of the last financial crisis, and probably the next one, too. What comes as news is that there is now a minority on Wall Street trying to fix the system. Their new stock market is flourishing; their company is profitable; Goldman Sachs remains their biggest single source of volume; they still seem to be on their way to changing the world. All they need is a little help from the silent majority.
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