- Lewis, Michael.
Flash Boys.
New York: W. W. Norton, 2014.
ISBN 978-0-393-24466-3.
-
Back in the bad old days before regulation of financial markets,
one of the most common scams perpetrated by stockbrokers
against their customers was
“front running”.
When a customer placed an order to buy a large block of stock, which
order would be sufficient to move the market price of the stock
higher, the broker would first place a smaller order to buy the same
stock for its own account which would be filled without moving the
market very much. Then the customer order would be placed, resulting
in the market moving higher. The broker would then immediately sell
the stock it had bought at the higher market price and pocket the
difference. The profit on each individual transaction would be
small, but if you add this up over all the volume of a broker's trades
it is substantial. (For a sell order, the broker simply inverts the sense
of the transactions.) Front running amounts to picking the customer's
pocket to line that of the broker: if the customer's order were placed
directly, it would execute at a better price had it not been front run.
Consequently, front running has long been illegal and market regulators
look closely at transaction histories to detect evidence of such
criminality.
In the first decade of the 21st century, traders in the U.S. stock market
discovered the market was behaving in a distinctly odd fashion. They had
been used to seeing the bids (offers to buy) and asks (offers to sell) on
their terminals and were accustomed to placing an order and seeing it hit
by the offers in the market. But now, when they placed an order, the
offers on the other side of the trade would instantly evaporate, only
to come back at a price adverse to them. Many people running hundreds of
billions of dollars in hedge, mutual, and pension funds had no idea what
was going on, but they were certain the markets were rigged against them.
Brad Katsuyama, working at the Royal Bank of Canada's Wall Street office,
decided to get to the bottom of the mystery, and eventually discovered
the financial equivalent of what you see when you lift up a sheet of
wet cardboard in your yard. Due to regulations intended to make
financial markets more efficient and fair, the monolithic stock exchanges
in the U.S. had fractured into dozens of computer-mediated exchanges
which traded the same securities. A broker seeking to buy stock on behalf
of a customer could route the order to any of these exchanges based upon
its own proprietary algorithm, or might match the order with that of another
customer within its own “dark pool”, whence the transaction
was completely opaque to the outside market.
But there were other players involved. Often co-located in or near the
buildings housing the exchanges (most of which are in New Jersey, which has
such a sterling reputation for probity) were the servers of
“high
frequency traders”
(HFTs), who placed and cancelled orders in times
measured in microseconds. What the HFTs were doing was, in a nutshell,
front running. Here's how it works: the HFT places orders of a minimum size
(typically 100 shares) for a large number of frequently traded stocks on
numerous exchanges. When one of these orders is hit, the HFT immediately
blasts in orders to other exchanges, which have not yet reacted to the
buy order, and acquires sufficient shares to fill the original order before
the price moves higher. This will, in turn, move the market higher and
once it does, the original buy order is filled at the higher price. The
HFT pockets the difference. A millisecond in advance can, and does, turn into
billions of dollars of profit looted from investors. And all of this is
not only completely legal, many of the exchanges bend over backward to
attract and support HFTs in return for the fees they pay, creating
bizarre kinds of orders whose only purpose for existing is to
facilitate HFT strategies.
As Brad investigated the secretive world of HFTs, he discovered the
curious subculture of Russian programmers who, having spent part of
their lives learning how to game the Soviet system, took naturally
to discovering how to game the much more lucrative world of Wall
Street. Finally, he decides there is a business opportunity in creating
an exchange which distinguishes itself from the others by not being
crooked. This exchange, IEX, (it was originally to be called
“Investors Exchange”, but the founders realised that the
obvious Internet domain name, investorsexchange.com, could be
infelicitously parsed into three words as well as two), would
include technological constraints (including 38 miles of fibre optic
cable in a box to create latency between the point of presence where
traders could attach and the servers which matched bids and asks)
which rendered the strategies of the HFTs impotent and obsolete.
Was it conceivable one could be successful on Wall Street by
being honest? Perhaps one had to be a Canadian to entertain
such a notion, but in the event, it was. But it wasn't easy. IEX
rapidly discovered that Wall Street firms, given orders by customers
to be executed on IEX, sent them elsewhere to venues more profitable
to the broker. Confidentiality rules prohibited IEX from identifying
the miscreants, but nothing prevented them, with the brokers'
permission, from identifying those who weren't crooked.
This worked quite well.
I'm usually pretty difficult to shock when it comes to the underside
of the financial system. For decades, my working assumption is
that anything, until proven otherwise, is a scam aimed at picking
the pockets of customers, and sadly I have found this presumption
correct in a large majority of cases. Still, this book was
startling. It's amazing the creepy crawlers you see when
you lift up that piece of cardboard, and to anybody with an
engineering background the rickety structure and fantastic
instability of what are supposed to be the capital markets of
the world's leading economy is nothing less than shocking.
It is no wonder such a system is prone to
“flash crashes”
and other excursions. An operating system designer who built such
a system would be considered guilty of malfeasance (unless, I suppose, he
worked for Microsoft, in which case he'd be a candidate for employee of
the year), and yet it is tolerated at the heart of a financial
system which, if it collapses, can bring down the world's economy.
Now, one can argue that it isn't such a big thing if somebody shaves a
penny or two off the price of a stock you buy or sell. If you're a
medium- or long-term investor, that'll make little difference
in the results. But what will make your blood boil is that the stock
broker with whom you're doing business may be complicit in
this, and pocketing part of the take. Many people in the real world
look at Wall Street and conclude “The markets are rigged; the
banks and brokers are crooked; and the system is stacked against the
investor.” As this book demonstrates, they are, for the most
part, absolutely right.
May 2014 