In Flash Boys, Michael Lewis has again launched a book that hews to his established formula: colorful outsiders take on a big bad entrenched establishment and win. Even though Lewis seems assured of having yet another best-seller, this book is getting more criticism than his works usually do. Put it this way: when commentators as diverse as Felix Salmon, Matt Levine, and Pam Martens feel compelled to object, it looks like Lewis has overfitted this tale to his blockbuster formula.
I must confess I have yet to read his book, but the accounts of it are so similar that I don’t think I’m doing readers a disservice by relying on them. Virtually all of the objections key off of a remarkable defect: that Lewis fundamentally misrepresents the relationships and operations of the high-frequency trading ecosystem.
Lewis focuses on a team of merry outsiders (a Lewis trope) from the Royal Bank of Canada who take on what Lewis presents as big Wall Street insiders of the HFT world, and beat them by forming their own exchange that offers fairer prices and thus helps combat “rigging” that hurts ordinary investors. But this story, though appealing, is wrong in a stunning number of ways. As Felix points out, HFT firms target institutional orders; retail orders are too small to move the market (as in they have no informational value) and many firms “cross” orders in house. Now small investors who trade through mutual funds can suffer, since the funds are institutional players but that wasn’t the point Lewis was making (and as much as no ripoff should go unpunished, abuses by many 401 (k) providers make the clipping by HFT look like chump change).
Lewis also presents the HFT traders as The Establishment and the his disruptors as the brave newbies. But the reality is this is more like the freshest immigrants off the boat fighting to displace the ones that arrived a few years back. As Bloomberg points out:
….Lewis misses the much bigger tale of disruption that speed-trading firms themselves brought about over the past 15 years. Hardly a group of typical Wall Street old-boy, big-bank types, many HFT ventures are the consummate outsiders. Such firms as Tower, Hudson River Trading, and ATD were started by tech geeks who figured out a better, more efficient way to trade. Their first victims weren’t mom-and-pop traders but big, established, market-making firms that made up the clubby insiders’ group of floor specialists.
Moreover, Lewis presents the HFT cohort as highly profitable, when by all accounts, the fierce competition among them has severely eroded their returns. I doubt that they are hurting, but this isn’t the “shoot fish in a barrel” business that it once was.
But their are even more serious lapses. Pam Martens lambastes Lewis for barely mentioning the role of the exchanges in enabling HFT, which was highly profitable to them. If there are any Wall Street insiders to attack, it’s the like of the New York Stock Exchange, not the behemoth brokerages. Key sections of Pam Marten’s must-read account, which is based on the 60 Minutes feature on Lewis’ book:
Two of the chief culprits of aiding and abetting high frequency traders, the New York Stock Exchange and the Nasdaq stock exchange, failed to come under scrutiny in the much heralded 60 Minutes broadcast on how the stock market is rigged…
Lewis responds that it’s a “combination of these stock exchanges, the big Wall Street banks and high-frequency traders.” We never hear a word more about “the big Wall Street banks” and no hint anywhere in the program that the New York Stock Exchange and Nasdaq are involved.
60 Minutes pulls a very subtle bait and switch that most likely went unnoticed by the majority of viewers. In something akin to its own “Flash Boys” maneuver, it flashes a photo of the floor of the New York Stock Exchange as [60 Minutes producer] Kroft says to the public that: “Michael Lewis is not talking about the stock market that you see on television every day. That ceased to be the center of U.S. financial activity years ago, and exists today mostly as a photo op.”
That statement stands in stark contrast to the harsh reality that the New York Stock Exchange is one of the key facilitators of high frequency trading and making big bucks at it.
Martens goes through New York Stock Exchange promotional materials for co-location services (which raises another issue: co-location of servers at the exchanges to gain a speed advantage is so well known that Martens doesn’t have to unpack it. Lewis’ account, which promised fresh revelations, is largely stale news, since the business press ramped up coverage of HFT after the May 2010 “flash crash”). She also points out how both the SEC and Congress are well aware of these practices and have chosen to be complacent (it’s hard to take the SEC piping up and saying it’s investigating HFT seriously given the long period since the May 2010 meltdown).
And the 2010 meltdown, and the declining volumes of trading despite frenetic activity raises a less obvious, but no less important issue: that of market structure. That old club of insiders did stand ready to provide liquidity. Mind you, they might not always be there, but they understood that making a market was the price they paid for their advantaged position.
By contrast, HFT traders are about as healthy to trading as sugar is to the ordinary American’s diet. Most studies of their activities have found that they provide junk liquidity. It’s there when markets are working fine, when more liquidity isn’t beneficial and could even be detrimental (by given traders a false impression of market depth, by lower spread, which are already super-cheap, with the net effect of encouraging even more short-term trading, as opposed to investment). But worse, it vanishes when markets are roiled, which quite a few academics have found makes the market disruption even more severe.
I have an additional beef about Lewis, and it extends across all of his major books on finance: Liar’s Poker, The Big Short, and from what I can infer from Lewis’ interviews, Flash Boys. It is part of the Lewis shtick not to challenge the social order. And it says a lot that someone about the times we live in that America’s most powerful and popular business journalist is dedicated to telling, again and again, the story of outsiders who butt heads with the status quo, yet he manages never to find anything seriously wrong with the settled order. Again and again, the people who are part of his bad status quo are never guilty of anything more than being lazy, or greedy, or (in the case of Liar’s Poker) being schlubs.
Yet the very same bond trading operation that Lewis mocked but simultaneously lauded as a huge profit engine led to the firm’s demise. Its head Treasury trader Paul Mozer was so poorly controlled that he got in pig fights with the Fed twice over his efforts to corner Treasury auctions. After Mozer was reprimanded by the firm but again resumed a more covert, and far less kosher version of his strategy (it involved records falsification), when he was caught out by Salomon management, they not only failed to inform the Fed promptly, but CEO John Gutfreund brazenly argued that Salomon should keep Mozer’s ill-gotten profits. Mozer was indicted and eventually entered into a plea bargain. Gutfreund, the vice chairman, the general counsel, and Mozer’s boss John Merriwether all were forced to resign four days after Gutfreund tried defying the Fed.
As we discussed long form in earlier posts, Lewis in The Big Short failed to tell readers that the subprime shorts that he lauded were the reason that what otherwise would have been a mere housing bubble and S&L level crisis instead became a global financial crisis. The shorts provided the raw material for synthetic and heavily synthetic CDOs that allowed BBB subprime risk to be sold mainly at AAA prices. That in turn distorted market signals, created demand for the very worst mortgages, and allowed for risky synthetic mortgage exposures to be created that greatly exceed real economy activity. But you never heard from Lewis that his intrepid band of misfits was a huge crisis amplifier. And the idea that any of the activity in this area might be an abuse, or even criminal, passed Lewis by. It is true that all the SEC did was file one civil “cost of doing business” CDO suit against each large player. We’ve long believed that the lack of vigor here wasn’t just part of the general pattern of Administration “little to see here” on crisis-related fraud. The SEC’s head of enforcement, Robert Khuzami, was general counsel for the Americas for Deutsche Bank from 2004 to 2009. And who did Lewis reveal to be one of the biggest instigators of the subprime short and related CDO sales? Gregg Lippmann of Deutsche Bank, patient zero of this strategy. Any serious investigation of CDO malfeasance would implicate Khuzami.
And for Lewis’ current book? As soon as the 60 Minutes story ran, the FBI cleared its throat and said they were investigating HFT, including front running. That means they are on the trail of what they believe is criminal behavior. Yet Lewis’ posture, as always, is that the bad boys are simply exploiting the system, as opposed to engaging in possible criminal conduct. It’s one thing to acknowledge that enforcement has become a joke, another to refuse to consider that the misconduct might indeed be serious.
But Lewis, like it or not, is simply a mirror of our times. Just as we get the politicians we deserve, it also appears we get the journalists we deserve.