Speed dealing: Flash Boys and the world of high frequency trading
Posted on 29th May 2014 in Reviews
Flash Boys, by Michael Lewis
reviewed by Paul Magrath
Few authors can claim to have set in train an investigation by the FBI, but Michael Lewis’s latest book, Flash Boys, has done just that after exposing some of the more dubious practices associated with High Frequency Trading (HFT) on the US securities market. Nor is the problem confined to the USA, as demonstrated by recent action taken by both the UK’s Financial Conduct Authority and the EU’s Financial Services Commissioner.
Lewis himself is no stranger to either controversy or the revelation of criminality and fraud in the confluence of big money and technology, though he has also chronicled its more benign aspects with a sort of wide-eyed gee-whizz glee. And he does turn it all into a cracking good tale.
Lewis made a name for himself (and quite a lot of money) with Liar’s Poker, his lid-lifter on the world of merchant banking. As a twenty-something “big swinging dick” on the bond dealing floors of Saloman Brothers he was privy to some of the worst excesses of the 1980s money culture, and his financial expose made one gasp and stretch one’s eyes. It was also very funny.
Since then he’s written a series of other books dealing with, among other things, the all-consuming confluence of money and technology. In one of them, entitled (perhaps prematurely) The Future Just Happened, he detailed two separate cases in which geeky teenagers managed to run rings round the financial and legal professions in America. Exploiting the anonymity of the Internet, they gave advice which gullible web surfers were happy to accept as though it came from a respectable source.
- At just 14 years old, Jonathan Lebed was the youngest person ever to be charged with stock market fraud. He was hauled before the Securities and Exchange Commission for allegedly manipulating the market. All he did was what grownup brokers and analysists do all the time: talk up stock in the hope of making a profit. However, he used a bunch of fictitious names and email addresses to post his advice on Yahoo Finance.
- The free legal advice given by Marcus Arnold, though basic, proved just as acceptable to his readers on Askme.com as if he’d been as fully qualified as he claimed to be. In fact he’d never read a law book and learnt it all from Court TV. But apart from the fact that he was only 15, was he so very different from any barrack room lawyer or McKenzie friend?
Insiders v Outsiders
The idea that the geek shall inherit the earth was further explored by Lewis in the different (and rather more lawful) intersection of baseball and Big Data, in Moneyball. This chronicled how the Oakland Athletics baseball team replaced the collected wisdom of baseball insiders (including players, managers, coaches, scouts, and the front office) in picking new players with an approach based on rigorous statistical analysis of their on-base and slugging percentages, known as “sabermetrics.”
As in many of his books, it was the plucky outsiders who ultimately triumphed over the traditional, hidebound insiders. Sometimes this is good – Oakland Athletics transformed its fortunes and the whole story was made into a film starring Brad Pitt – and sometimes bad.
In Flash Boys it depends who you think of as the plucky outsiders: are they the geeky programmers and whizz kids who, without much consideration of the moral implications, work out how to game the market? Or is it the Canadian-with-a-conscience trader who sees what’s going on and works out how to circumvent the scam and create a more honest market? And as with many of his books, there’s a whole new world of insider jargon to learn, such as;
Front runners, algobots and flash crashing
What Lewis claims to reveal is how US stock markets are knowingly permitting a massive fraud on regular buyers and sellers, and the regulatory authorities seem unable or unwilling to do anything about it. In particular, he identifies the practice of “front running” by High Frequency Traders (HFT) as a form of market rigging in which hedge funds using computer programs exploit millisecond differences in the time lag between “normal” customers offering to buy or sell shares and their counterparts agreeing to sell or buy them on the various different electronic exchanges, in order to “get in first” and buy or sell the same shares and then sell or buy them on to the real customers.
The way he’s presented it, it does look quite scandalous. But how true a picture is it?
To understand the book’s thesis you need to understand first of all what HFT is. It is the use of computer algorithms (known as “algobots”) to buy and sell securities in fractions of a second. The programs detect when stocks are offered for sale and when someone want to buy them, and they jump in first and grab or offer them at a better price.
Lewis describes how a trader named Brad Katsuyama, a Canadian equipped (unlike many on Wall St) with a conscience, noticed how whenever he tried to buy stock for a client at the price being offered on his trading screen, the stock mysteriously disappeared and when he tried again or on another exchange (there are several different stock exchanges in America) the price had suddenly edged up. What was happening was that the HST firms with their algobots were detecting his interest in the stock and getting in first to buy it up, before then offering it to him at a slight premium.
As another reviewer, Thomas Quinn in The Big Issue, rather neatly puts it: “Imagine nipping into Tesco and finding somebody has just bought the loo roll you wanted, but will sell it to you for 10 pence more than the marked price. And you have no choice other than to buy it. In fact, it would be illegal not to.”
Brad Katsuyama was being “front run”. HFT firms pay public and private exchanges to see their incoming orders. They can trade automatically and at no risk, because they know exactly who wants what and at what price. And it all happens in less than the blink of an eye.
Because there are several exchanges, dotted about the place, it makes a huge difference how quickly the electronic information is relayed along cables between the various exchanges. A long opening section of Lewis’s book describes the efforts of a team working for one HFT outfit to lay a fresh line of fibre optic cable between New Jersey and Chicago to shave, literally, a few milliseconds off the time-lag in the routing of orders. It is within that window of milliseconds that millions can be made, because although the price differentials (the arbitrage) on each trade are tiny, the number of trades is vast.
Can anything be done?
Lewis clearly thinks the whole thing is a scam and should be investigated by the FBI, since the financial regulators seem powerless to prevent it. But he is prepared to allow his opponents to argue the supposed benefits of HFT. The main argument in its favour is that it adds liquidity to the market, reducing the bid-offer spread and thereby making the markets more efficient. In an article in The Atlantic, Matthew O’Brien suggests that “The stock market isn’t rigged, but it is taxed.” He goes on to explain that “for as long as people have been trading stocks, there have been middlemen taking a cut of the action.” He may be right, but you have to wonder what these middlemen do to justify their cut.
In TIME Magazine, Austin Gerig (a Senior Research Fellow in the CABDyN Complexity Centre, Said Business School, University of Oxford) argues that, far from being bad for the little guy, HFT helps synchronise prices. If the market is rigged, it is not the little guy (so championed by Lewis) who suffers but, rather, the big investors whose orders would otherwise make a bigger splash, or cause more turbulence, in the market.
For all these supposed benefits, it seems the FBI and the Justice Department are now investigating the practice of high-frequency trading. According to TIME, other officials looking into the legality of the practice include New York Attorney General Eric Schneiderman, the Commodity Futures Trading Commission, and the Securities and Exchange Commission.
Could it happen here?
Problems with high frequency trading are certainly not confined to the US markets, though their effect may be more pronounced given the multiplicity of exchanges within the same market there (13 public stock exchanges and more than 40 private “dark pools”, ie private exchanges in which, for a fee, HFTs can swim.) But that’s not to say it isn’t a problem in Europe, too.
In a press release from the EU Commission, Michel Barnier, the EU financial services commissioner confirmed earlier this year that the newly updated Markets in Financial Instruments directive (MiFID) will deal with the issue in European markets:
MiFID II will introduce trading controls for algorithmic trading activities which have dramatically increased the speed of trading and can cause systemic risks. These safeguards include the requirement for all algorithmic traders to be properly regulated and to provide liquidity when pursuing a market-making strategy. In addition, investment firms which provide direct electronic access to a trading venue will be required to have in place systems and risk controls to prevent trading that may contribute to a disorderly market or involve market abuse.
In the UK, the Financial Conduct Authority has been taking some enforcement action against HFT market abuse, notably in the case of Michael Coscia, a US based high frequency trader. According to an explanatory note from law firm Taylor Wessing, Coscia was fined US$903,176 (approximately £598,000) for;
deliberate abuse of the commodities markets, by means of an algorithmic program that he had designed to instigate a trading strategy known as ‘layering’. Layering involves the placement by traders of multiple, often large, orders that are not intended to be executed and which are then rapidly cancelled. This creates artificial levels of supply and demand, driving the price of stock up or down, at which point “genuine” orders are completed to benefit from the artificially inflated or reduced price.
It’s not clear from the FCA website whether they have a specific policy about HFT or indeed any plans to curb it, other than by implementing the European directive mentioned above. But if HFT is a problem on the London Stock Exchange, then after Lewis’s book it’s certainly not one that anyone could claim to be unaware of.