Early in the afternoon of 6 May 2010, the leading stock market index in the US, the Dow Jones Industrial Average, suddenly started falling. There was no evident external reason for the fall – no piece of news or economic data – but the market, which had been drifting slowly downwards that day, in a matter of minutes dropped by 6 per cent. There was pandemonium: some stocks in the Dow were trading for prices as low as 1 cent, others for prices as high as $100,000, in both cases with no apparent rationale. A 15-minute period saw a loss of roughly $1 trillion in market capitalisation.
So far, so weird, but it wasn’t as if nothing like this had ever happened before. Strange things happen in markets, often with no obvious trigger other than mass hysteria; there’s a good reason one of the best books about the history of finance is called Manias, Panics and Crashes. What was truly bizarre and unprecedented, though, was what happened next. Just as quickly as the market had collapsed, it recovered. Prices bounced back, and at the end of a twenty-minute freak-out, the Dow was back where it began. It’s the end of the world! Oh wait, no, it’s just a perfectly normal Thursday.
This incident became known as the Flash Crash. The official report from the Securities and Exchange Commission blamed a single badly timed and unhelpfully large stock sale for the crash, but that explanation failed to convince informed observers. Instead, many students of the market blamed a new set of financial techniques and technologies, collectively known as high-frequency trading or flash trading. This argument rumbles on, and attribution of responsibility is still hotly contested. The conclusion, which becomes more troubling the more you think about it, is that nobody entirely understands the Flash Crash.
The Flash Crash was the first moment in the spotlight for high-frequency trading. This new type of market activity had grown to such a degree that most share markets were now composed not of humans buying and selling from one another, but of computers trading with no human involvement other than in the design of their algorithms. By 2008, 65 per cent of trading on public stock markets in the US was of this type. Actual humans buying and selling made up only a third of the market. Computers were (and are) trading shares in thousandths of a second, exploiting tiny discrepancies in price to make a guaranteed profit. Beyond that, though, hardly anybody knew any further details – or rather, the only people who did were the people who were making money from it, who had every incentive to keep their mouths shut. The Flash Crash dramatised the fact that public equity markets, whose whole rationale is to be open and transparent, had arrived at a point where most of their activity was secret and mysterious.
Enter Michael Lewis. Flash Boys is a number of things, one of the most important being an exposition of exactly what is going on in the stock market; it’s a one-stop shop for an explanation of high-frequency trading (hereafter, HFT). The book reads like a thriller, and indeed is organised as one, featuring a hero whose mission is to solve a mystery. The hero is a Canadian banker called Brad Katsuyama, and the mystery is, on the surface of it, a simple one. Katsuyama’s job involved buying and selling stocks. The problem was that when he sat at his computer and tried to buy a stock, its price would change at the very moment he clicked to execute the trade. The apparent market price was not actually available. He raised the issue with the computer people at his bank, who first tried to blame him, and then when he demonstrated the problem – they watched while he clicked ‘Enter’ and the price changed – went quiet.
Katsuyama came to realise that his problem was endemic across the financial industry. The price was not the price. The picture of the market given by stable prices moving across screens was an illusion; the real market was not available to him. Very many people across the industry must have asked themselves what the hell was going on, but what’s unusual about Katsuyama is that he didn’t let the question go: he kept going until he found an answer. Part of that answer came in correctly formulating the question, what the hell is the market anyway?
The market was by now a pure abstraction. There was no obvious picture to replace the old one people carried around in their heads. The same old ticker tape ran across the bottom of television screens – even though it represented only a tiny fraction of the actual trading. Market experts still reported from the floor of the New York Stock Exchange, even though trading no longer happened there. For a market expert truly to get inside the New York Stock Exchange, he’d need to climb inside a tall black stack of computer servers locked inside a fortress guarded by a small army of heavily armed men and touchy German shepherds in Mahwah, New Jersey. If he wanted an overview of the stock market – or even the trading in a single company like IBM – he’d need to inspect the computer printouts from twelve other public exchanges scattered across northern New Jersey, plus records of the private deals that occurred inside the growing number of dark pools. If he tried to do this, he’d soon learn that there was no computer printout. At least no reliable one. It didn’t seem possible to form a mental picture of the new financial market.
We want a market to be people buying and selling to and from each other, in a specific physical location, ideally with visible prices. In this new market, the principal actors are not human beings, but algorithms; the real action happens inside computers at the exchanges, and the old market is now nothing more than a stage set whose main function is to be a backdrop for news stories about the stock market. As for the prices, they move when you try to act on them, and anyway, as Lewis says, there’s the problem of the ‘dark pools’, which are in effect private stock markets, owned for the most part by big investment banks, whose entire function is to execute trades out of sight of the wider public: nobody knows who’s buying, nobody knows who’s selling, and nobody knows the prices paid. The man who did most to help Katsuyama understand this new market was an Irish telecoms engineer called Ronan Ryan. Ryan’s job involves the wiring inside stock exchanges, and he explained to Katsuyama just how crucial speed has become to the process of trading. All the exchanges now allow ‘co-location’, in which private firms install their own computer equipment alongside the exchanges’ own computers, in order to benefit from the tiny advantage this proximity gives in trading time.
As Ryan spoke, he filled huge empty spaces on Brad’s mental map of the financial markets. ‘What he said told me that we needed to care about microseconds and nanoseconds,’ said Brad. The US stock market was now a class system, rooted in speed, of haves and have-nots. The haves paid for nanoseconds; the have-nots had no idea that a nanosecond had value. The haves enjoyed a perfect view of the market; the have-nots never saw the market at all. What had once been the world’s most public, most democratic, financial market had become, in spirit, something like a private viewing of a stolen work of art.
Speed matters so much because the new financial techniques involve exploiting minute discrepancies in price that exist only for fractions of a second. Exploiting them and, at times, creating them too. Aided by co-location, high-frequency traders ‘sniff’ incoming orders made by people like Katsuyama. In microseconds (that’s millionths of a second) their computer algorithms buy the share before the order has been executed, and then sell it on to the initial buyer for a tiny but guaranteed profit. That is the reason Katsuyama couldn’t buy shares for the price shown on the screen: he was being ‘front-run’. This is one of the main ways high-frequency traders make their money. The other two techniques singled out by Lewis are ‘rebate arbitrage’ and ‘slow market arbitrage’. Rebate arbitrage occurs when HFT firms profit from the fact that some exchanges now pay for traffic, by directing trades accordingly in order to make money from kickbacks. Slow market arbitrage involves HFT firms exploiting tiny lags in the movement of prices:
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 than the other strategies combined.
And all of this, Lewis makes clear, is the new normal – it’s just the way the modern market works.
The reaction to Flash Boys has been explosive. Lewis is the kind of writer who creates his own weather system, and the book went straight to the top of the bestseller list on both sides of the Atlantic. (In the US, it has only just been displaced, by Thomas Piketty’s Capital in the 21st Century. Truly, we live in interesting times.) In the week of publication, inquiries into high-frequency trading were announced by the US Justice Department, the FBI, the Securities and Exchange Commission, the New York attorney general, the Commodities Futures Trading Commission and the European Union (some of these august bodies claimed their inquiries were already in train when the book came out). Only Lewis could have had this impact, just as only Lewis could have written the book in the first place. It’s become harder and harder for outsiders to gain access to the world of finance, and the people involved do a good job of behaving as if they have a lot to fear from scrutiny. People talk to Lewis because he was once an insider himself; because he ‘gets it’, that most elusive and precious thing for anyone writing about any closed world; and also because as the institutions have got more controlling and secretive, many of the people who work for them ‘have grown more cynical about them, and more willing to reveal their inner workings, so long as their names are not attached to the revelations’. No one else would have elicited this degree of candour from the people who really know what’s been going on.
It’s been interesting to observe the reaction from the flash boys themselves. There are three main lines of counter-attack (I leave out the ones that try to smear Katsuyama and his motives). The first is to claim that HFT provides a valuable service to the markets by supplying ‘liquidity’. This is a magic word in the context of finance. ‘“Liquidity” was one of the words Wall Street people threw around,’ Lewis writes, ‘when they wanted the conversation to end, and for brains to go dead, and for all questioning to cease.’ In markets, liquidity, meaning the presence of willing buyers and sellers on both sides of all prospective transactions at all times, is close to an absolute good. But Lewis deals briskly with the notion that HFT is a genuine source of liquidity. He proposes a hypothetical entity, Scalpers Inc., a legally required presence in all market transactions. Every time you go to buy a share in anything, you are front-run by Scalpers Inc., which buys the shares first and then sells them on to you. Scalpers Inc. is banned from taking any risk, and never buys or sells a stock without having the other end of the transaction already in hand: it trades ‘for the sole purpose of interfering with trading that would have happened without it’. It is evident from this thought experiment that Scalpers Inc. brings no real liquidity to the market, because it takes no risk. It is not a ‘market-maker’, an old-school financial entity which would guarantee buying and selling in a market, to ensure that the market always existed. Scalpers Inc. is ‘less a market enabler than a weird sort of market burden’. Also, Scalpers Inc. has an incentive to increase the amount of volatility in the market, since movements in prices are always beneficial to it: the more prices jiggle about, the more opportunities there are to make money from the movement.
This takes care of the liquidity line of argument. The flash boys make additional claims in their own defence. The most superficially plausible concerns ‘spreads’, the gap between the prices at which something is bought and sold. In the P&G example above, the spread is 80-80.01. This spread is guaranteed profit for the exchange where the share is sold, and as such is a kind of transaction fee or tax on all market activity. The lower the spreads, the better the market for participants. High-frequency traders point to the fact that spreads have reduced a lot over the last decade or so, and claim the credit for it; they say that the extraordinary proliferation of their super-fast computer trading activity is the main reason spreads have come down. In its strong form, the claim is that this reduction in spreads represents a saving to the ordinary investor which more than makes up for the profits the HFT crowd are making by riding piggyback on other people’s transactions. The problem with this claim is that because HFT traders are so secretive, they offer no data to support it. Yes, spreads have fallen. The majority of the fall happened in the first years of this century, as computers took more and more of a role in the markets. We would reasonably expect that to lead to a fall in costs, and therefore a fall in spreads – that’s the whole point of using computers, from the customer’s point of view. The HFT players want to take the credit, without giving any evidence for their role in what’s happened.
Another claim made by the HFT lobby is that most of their activity is not front-running. They need to say this, because the fact that front-running is indefensible is, as nerds say, IOTTMCO (Intuitively Obvious to the Most Casual Observer). Here again, though, there is the no-data problem. The HFT posse talk about ‘algo-sniffing’, i.e. detecting of other people’s algorithms operating in the market, and making profits from them.CC rule: ‘Big boys don’t cry.’ But again, the industry is so secretive it can’t defend itself. Lewis quotes a trader who moved from a job with top-secret access at the Pentagon to a well-known HFT firm, Citadel. ‘To get into the Pentagon and into my area, it took two badge swipes. One to get into the building and one to get into my area. Guess how many badge swipes it took to get to my seat at Citadel? Five.’ All one can do, in the face of such an information deficit, is offer a vague, benign wave, like the pope from the balcony at St Peter’s, and announce ‘it is possible that some of what some of you do is not entirely evil.’ In the absence of evidence, data, stories and specifics, it’s difficult to go any further in the industry’s defence than that. The upshot is that the flash boys offer a case study in two different types of indefensibility: the sort which arises when what you’re doing is obviously wrong, and the sort which arises because of a self-imposed code of secrecy.The techniques are proprietary and super-secret, and the defence can only be mounted in general terms. It is apparent that quite a lot of what the HFT industry does isn’t front-running, and can be seen as the legitimate activity of well-informed insiders making money off one another. It’s permissible under what I like to call the 10
Flash Boys has lobbed a very big, very splashy rock into the HFT pond. It’s clear that things aren’t going to go on exactly as they have been; the question is what’s going to change, and whether changing anything will actually change anything. Lewis’s preferred solution features his hero, Brad Katsuyama. The Canadian banker has developed a share exchange, IEX, which builds in a 350-microsecond delay – that’s 0.00035 seconds – on all trading, which means that all buying and selling happens at the same speed and high-frequency activities of the front-running type aren’t possible. If you buy from the IEX, you buy clean; when you click Enter, the price you see is the price you pay. If this exchange catches on, which it is showing early signs of doing, the other exchanges will either be competed out of business or will have to change their practices to prevent customers from being exploited – that’s the idea, anyway. This is a market purists’ solution to the problem arising from HFT, and it would be an interesting counter-case to the credit crunch and its aftermath. In that case, the market created a problem it could not itself solve; instead taxpayers bailed out all the participants, and were then excused from the room when the party got started again. If Katsuyama’s new exchange cleans up HFT, that would be an elegant (and slightly overdue) example of a pure market fix for a market problem.
The other possible solution would involve regulation. For a start, it’s possible that the activities described in Lewis’s book aren’t legal. The people running HFT strategies have bought roomfuls of expensive lawyers to tell them that what they’re doing is OK. But the principle on which much market legislation rests is that it’s illegal to trade on the basis of information that is not publicly available. The fact that the apparent price is not the actual price: does that fit the legal definition of non-public information? I’d have thought it does. If the Justice Department agrees, there will be blood.
In addition, there is the prospect of new laws to rein in the flash boys. Lewis is not a fan of this line of action, on the robust grounds that it was legislation which created many of the opportunities for HFT in the first place. The principal culprit was a 2005 law, enacted in 2007, called Reg NMS (Regulation National Market System). This well-intentioned and reasonable sounding piece of lawmaking set out to protect customers from front-running. (Ha!) The idea was to agree a nationally accepted standard for share prices, the NBBO or National Best Bid and Offer, which would be set by collating the price for a share across all public exchanges. That collated price is the official price. Hard to disagree with that in principle. The problem is that the technology behind the NBBO is laughably slow. The Securities Information Processor, or Sip, the computer which calculates the NBBO, could lag behind the HFT industry’s computers by as much as 25 milliseconds, or 0.025 seconds. By the standards of high-frequency trading, that is geological time. It was this laggardliness which created much of the modern HFT industry, by in effect mandating that the official price would always be late, slow, and begging for exploitation by the faster participants in the market.
This is part of a consistent pattern in the modern world of finance, whereby legislation introduces complexity, and complexity offers the chance of profit-making. If you have super-smart people who have powerful incentives to spend all day every day working out ways to game the system, the system is going to be gamed. Lewis has a theory about why so many of the backroom wizards behind HFT are Russian: ‘The Soviet-controlled economy was horrible and complicated and also riddled with loopholes,’ he writes. ‘Everything was scarce; everything was also gettable, if you knew how to get it.’
The prospect for regulation is further clouded by the fact that the industry is lobbying hard against it. An EU proposal to clean up flash trading had a simple fix: a legally mandated delay of 0.5 seconds on all trading. That, like Katsuyama’s IEX, is a brutal but effective device which would break most of the tricks the industry uses. Unfortunately the idea has been pronounced dead by the European Securities and Markets Authority. Instead ESMA has announced that it is coming up any minute with its own proposals, to be enacted in 2016. Let’s hope everyone involved has read Lewis’s book.
One of the most adroit things about Flash Boys is the size of its frame: Lewis tells his story and then lets the reader draw her own conclusions about its meaning and consequences. He keeps the focus tight. That’s one reason the book has done so well: avid lefties and ardent free-marketers can fully agree with pretty much everything in it. If you want to, though, you can see large questions lumbering into the background of the shot. One of them is: to what extent is the story of the flash boys just the story of the flash boys, and to what extent is it a story about the nature of modern capitalism? In a New York Times op-ed, Paul Krugman argued that the important point isn’t so much the specifics of Lewis’s story, as the big picture of a dysfunctional and predatory financial sector: ‘Never mind the debate about exactly how much damage high-frequency trading does. It’s the whole financial industry, not just that piece, that’s undermining our economy and our society.’
Lewis would disagree with the ‘never mind’ part, but I suspect he’d agree with the rest. The story about finance that he began to tell in his first book, Liar’s Poker, the exuberant and uproarious account of his time as a bond salesman at Salomon Brothers, and continued with his credit crunch book, The Big Short, is getting steadily darker. In the prologue to The Big Short, Lewis wrote that when he sat down to write his first book, ‘I hoped that some bright kid at Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Goldman Sachs, and set out to sea.’ Instead, and of course, ‘six months after Liar’s Poker was published, I was knee-deep in letters from students at Ohio State University who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual.’ After finishing Flash Boys, I found it hard not to think about those missing oceanographers, the computer geniuses and engineers and physicists and entrepreneurs, all those brilliant minds, all that passion and energy disappearing into the black hole of money, lost to all the more productive and interesting things that we humans can do. It’s hard not to feel a sense of loss when you think of what these people would have done, if they hadn’t been sucked into the enterprise of making money out of money. If we ever get enough distance to look back with some sense of perspective on the delirium of modern finance, I think this is what will stand out clearly: that sense of human and intellectual waste.
That ought to be enough gloom to be getting on with, but Flash Boys left me with an additional thought. The story of high-frequency trading is, more or less, the same story that is being told by Thomas Piketty. Lewis is about narrative and Piketty is all about analysis and data, but these two big books about modern capitalism are both accounts of how capital became more and more ruthless; how the very richest got even richer. You could well see Flash Boys as a case study in the story of Capital in the 21st Century. ‘It is tempting to believe that people who think this way eventually suffer their comeuppance,’ Lewis wrote about Wall Street, in his epilogue to the 2010 reissue of Liar’s Poker. ‘They don’t. They just get richer. I’m sure most of them die fat and happy.’