"The Wall Street titans of old are gone, having been usurped by a new breed" © Thomas J. O'Halloran
A new, highly complex and insidious breed of animal stalks global finance—high frequency trading firms (HFTs)—an esoteric group of companies that are the focus of Michael Lewis's latest book,
Flash Boys. A strict definition of high frequency trading is difficult to give. What can be said is that they buy and sell vast numbers of stocks very quickly and that they make money by knowing things about stock markets before everyone else.
HFTs do not come off well from this book. As far as Lewis is concerned, high frequency trading amounts to little more than a clever way of rigging the market—and of earning tens of billions in the process. The suggestion of the book is that a new class of operative has insinuated itself into the financial mechanism and has imposed something like a tax on everyone else who tries to use it.
Lewis delves into this world through the true story of Brad Katsuyama, a Wall Street trader at the Royal Bank of Canada, who recognised that something odd was going on. He couldn't work out why, when he tried to buy shares, they kept vanishing from his computer screen. This constant stymieing of his trades prompted him to start asking questions, and his investigation forms the backbone of the book.
What is most startling about Katsuyama’s investigation is that it shows how many of the big investors, hedge fund managers and Wall Street investment houses had no idea what the high frequency traders were up to. The Gordon Gekko-style, Wall St titans of old are gone, having been usurped by a new breed. In their place are IT experts, coding geeks and mathematicians. It is only when he starts talking to these new types of financier that Katsuyama learns the explanation for his strange vanishing shares.
The root of that explanation is that stock markets are very unusual things. Most people have a received idea of what stock markets might be (perhaps something like the closing sequences of the film
Trading Places, see below), where jobbers crowd onto a trading floor, taking telephone orders from brokers and shouting to one another across the pits.
But exchanges are nothing like that any more. The packed trading pits have gone. In their place are warehouses full of glimmering computers, inside which the trading takes place. Stock markets are now data. Trades are no longer spoken over analogue telephone lines, but are executed by computerised trading algorithms, which automatically buy and sell shares based on minuscule movements in price, in fractions of a second. These speeds are beyond the time-frame accessible to human perception. A millisecond is a thousandth of a second. A human blink takes between 100-400 milliseconds. HFTs can now send their trading instructions from Chicago to New York in 8 milliseconds.
It is the business of HFTs to run the fastest operations in the market in order to get stock market information before anyone else. They have achieved this advantage by “co-location”, which means putting their own computers as close as possible to the stock exchanges’ computers. In some cases they have located them in the same room as the exchanges’ own servers. This gives HFTs a colossal advantage: they can scan the bids coming into a stock exchange and exploit that infinitesimal fraction of a second during which time they know what the rest of the market does not.
HFTs have also cleverly gamed the relationships between the various stock exchanges that operate in the US. When a trade instruction is issued, it can sometimes reach one stock exchange before all of the others. HFTs can then use the information that a buyer is looking for a certain share to their advantage. This is what was happening to Katsuyama, whose trades were registering at an exchange called BATS before they were registering at other exchanges. The HFTs were detecting these attempts to buy shares and using their speed advantage to step in and buy them first, only to sell them back to Katsuyama a moment later at a higher price—all within milliseconds. The margin between the two is the HFT’s profit.
As Lewis notes, the corrupting effects of this can be substantial. The savings and pensions of millions of people are invested in stock markets, but these investments are being preyed upon to the detriment of savers—and of the markets themselves, which become prone to extreme swings. The most arresting example of this was the so-called “flash crash” of May 2010, during which the Dow Jones lost over 1,000 points for a fraction of a second, before recovering. Lewis attributes this to the activities of the high frequency firms.
Flash Boys has, understandably, provoked outrage. Eric H Holder, the US Attorney General, has said that the Justice Department would push ahead with its investigation into high frequency trading, to establish whether it violates insider trading laws. The FBI has also been looking closely at HFTs, as has the Securities and Exchange Commission. These investigations have been running for some time: since well before the book’s publication. It was back in 2009 that James A Brigagliano, the Co-Acting Director, of the SEC testified in Congress that: “Many are concerned that high frequency trading can be harmful, depending on the trading strategies used, both to the quality of the markets and the interests of long-term investors.”
In 2013, Eric T Schneiderman, the Attorney General of New York described the activities of HFTs as “Insider Trading 2.0.” In a speech, he commented; “a new generation of market manipulators has emerged,” adding that “when blinding speed is coupled with early access to data, it gives people the power to suck value out of markets before it even hits the rest of the Street.” Schneiderman made further similar comments this week.
European authorities have also been keeping a close eye on the “flash boys”, and last year the UK’s own Financial Conduct Authority (FCA) announced that it had “fined US-based High Frequency Trader, Michael Coscia, US $903,176 (£597,993) for deliberate manipulation of commodities markets.” The FCA has no on-going inquiry into high frequency trading.
The European Union has plans to beef up the regulation of high frequency trading in its clutch of regulatory changes known as the “Markets in Financial Instruments Directive” or Mifid. Michel Barnier, the EU’s financial services chief, said in a recent e-mail that, “the EU is putting in place one of the strictest set of regulations for high-frequency trading in the world.”
But these investigations and regulatory changes, though welcome, are not new. As such,
Flash Boys has not only revealed the ultra-high speed of the high frequency traders, but it has also shown the sluggishness with which authorities have responded to the changing nature of financial markets. Next month will be the fourth anniversary of the Flash Crash. So far, there has been almost no response.
This is exactly the kind of book that MPs will read over the Easter break, and there will likely be a renewed political call for a regulatory response, possibly also for a financial transactions tax. In the United States, there is now the expectation among Wall Street watchers that legal action will be taken.
This is a brilliant book and it will sell by the truck-load. Not only does it make one of the most complicated subjects in finance engrossing, but it also suggests that there now exist firms with the potential to be more damaging to financial stability than the banks.
Flash Boys: cracking the money code by Michael Lewis (Allen Lane, £20)
