If you’ve read any financial news at all over the past month, you know that Michael Lewis has a new book out called Flash Boys: A Wall Street Revolt. I finished it over a week ago, but it’s rather intimidating to write a review when everyone else already has an opinion.
Perhaps I just seek out the critical reviews, but I see many financial pundits basically saying “Pfft. Everyone thinks this Michael Lewis guy is just sooo smart and sooo clever. Well, I’m smarter than him so here are all the things he didn’t get exactly right.” I’ll keep with my usual format of notes and highlights:
- The book was an entertaining and educational read. If you like other books by Michael Lewis (The Big Short, Liar’s Poker, Moneyball, The Blind Side), you’ll probably like this one. As a gifted storyteller, he made learning about high-frequency trading (HFT) into an intriguing adventure complete with heroes and villains.
- The most impactful form of frequency trading is slow market arbitrage. Here, HF traders use their speed advantage of microseconds (gained by paying off exchanges or drilling through mountains):
…a high-frequency trader was able to see the price of a stock change on one exchange, and pick off orders sitting on other exchanges, before the exchanges were able to react. Say, for instance, the market for P&G shares is 80–80.01, and buyers and sellers sit on both sides on all of the exchanges. A big seller comes in on the NYSE and knocks the price down to 79.98–79.99. High-frequency traders buy on NYSE at $79.99 and sell on all the other exchanges at $80, before the market officially changes. This happened all day, every day, and generated more billions of dollars a year than the other strategies combined.
Each trade may make a penny or even a fraction of a penny, but it all adds up. You could view it like a small tax of less than 1/10th of 1% of every trade.
- Many people in the industry have come to the defense of HFT in the wake of the book. Some say that HFT improves liquidity, but others say that HFT actually makes the market more volatile and fragile. Others rationalize that someone is always screwing you, it’s just different people this time. (How comforting.) Traditional market-makers make money from trading but expose themselves to risk by providing valuable liquidity. In contrast, the successful HFT traders took nearly no risk:
In early 2013, one of the largest high-frequency traders, Virtu Financial, publicly boasted that in five and a half years of trading it had experienced just one day when it hadn’t made money, and that the loss was caused by “human error.” In 2008, Dave Cummings, the CEO of a high-frequency trading firm called Tradebot, told university students that his firm had gone four years without a single day of trading losses. This sort of performance is possible only if you have a huge informational advantage.
- HF traders should just admit that they’re doing it for the money. I think the best defense would simply be that these traders are operating within the current laws and regulations (although Providence, Rhode Island is now suing several HFT traders, stock exchanges, and large brokers). Is it ethical or helpful to society? Questionable. Consider this analogy from the book:
It was like a broken slot machine in the casino that pays off every time. It would keep paying off until someone said something about it; but no one who played the slot machine had any interest in pointing out that it was broken.
Do we hate the player or the game? Brad Katsuyama, one of the primary heroes who eventually creates a new stock exchange to neutralize HFT:
“I hate them a lot less than before we started,” said Brad. “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. The system has let down the investor.
- Another common argument is whether it really affects the little guy investor, or just the big institutional investors. Yes, it’s easy to think of hedge funds trading on behalf of the super-wealthy and not really feel sorry for them. But institutional investors include pensions, mutual funds, and life insurance (annuity) companies. Of course, on a relative basis the big money managers often charge their own layer of fees which are much higher than any HFT “tax”. But since HFT is essentially a transaction tax, the less that your mutual fund or pension plan trades, the less they’ll be affected.
The CEO of Vanguard actually stated in an interview with Financial Times that HFT firms had actually helped investors cut their transaction costs through tighter trading spreads. Perhaps things aren’t so black and white. Excess trading has long been linked with worse performance, so my index funds are probably barely affected at all. (Vanguard does support some HFT-related reforms.)
- Can you stop HFT without opening the door to another form of skimming? Maybe Vanguard’s CEO is hinting that HFT is the lesser of many possible evils. Whenever there is big money sloshing around, there will always be splashing. I don’t know. But now that Michael Lewis had thrown a big spotlight on this issue, that in itself may get rid of this market inefficiency. People have written about HFT before but this finally got people’s attention.
If you want to learn about high-frequency trading or like a good investigative story, I would recommend reading the book for yourself. If you’re still on the fence, here are two links which are essentially direct excerpts from the book:
- Wolf Hunters of Wall Street: Adaptation from Flash Boys for New York Times Magazine
- Vanity Fair article about HFT programmer Sergey Aleynikov, also see Wikipedia for his eventual acquittal and then re-arrest.