Satyajit Das: Flash Boys’ HFT Mumbo Jumbo

By Satyajit Das, a former banker and author of Extreme Money and Traders Guns & Money

Michael Lewis (2014) Flash Boys: Cracking the Money Code

Flash Boys has taken flight, aided by the helium of celebrity, controversy (“the US stock market is rigged”) and prime time publicity. But the debate is not about the book, even amongst the people who may actually have read it. The debate now is about the debate about the idea of what may or may not be in the book, making an objective assessment of the book not only difficult but useless.

The Formula

Michael Lewis’ reputation as the intelligent public’s guide to the world of finance rests primarily on Liar’s Poker and The Big Short. The problem is that Mr. Lewis’ actual experience in finance was brief (as a bond salesman at Salomon Brothers) and also now dated (being over 25 years ago).

His finance books have become formulaic, rehashing themes that would be familiar to viewers of Frank Capra’s Mr. Smith Goes to Washington. His books are narratives about one or more outsiders (the ‘good’ guys) who take on the ‘establishment’, trying to correct some ‘evil’, and win. Finance provides the decorative wallpaper but is not the essential subject.

But Mr. Lewis’s writing feels less comfortable and more strained in Flash Boys than in previous efforts.

First, the subject matter is more arcane than usual. Arousing excitement about the minutiae of electronic stock trading and HFT (high frequency trading) would tax even great magic realists like the late Gabriel Garcia Marquez. It lacks the instant familiarity of housing that gave The Big Short its immediate resonance with readers. HFT is a problem than the book’s audience does not know it had and probably won’t know it has even after reading the book.

Second, the characters are less immediately interesting than in previous works. The central character – Japanese Canadian Brad Katsuyama who was described on 60 Minutes as a conformist even by Canadian standards- does not engender the interest that Steve Eisman and Mike Burry did in The Big Short.

Third, Mr. Lewis seems singularly uncomfortable in the netherworld of HFT, becoming mired in tautological and convoluted explanations of his subject.

Fourth, Flash Boys’ arguments lack logical consistency. The idea that HFT preys on retail investor, as several commentators such as Reuter’s columnist Felix Salmon have noted, is incorrect. HFT strategies, of necessity, target institutional orders which are larger and have greater informational value to traders. Individual investors may suffer damage but indirectly through their investments in mutual funds.

Mr. Lewis’ championing of the book’s hero Katsuyama and his creation IEX, a ‘dark pool’ within which investors can match buy and sell orders away from public scrutiny, are puzzling. Given that Flash Boys is highly critical of such arrangements, the conclusion that the solution to the stock market’s structural woes is another non-transparent dark pool might strike the reader as odd.

Fifth, unusually for such an accomplished wordsmith, Flash Boys lacks the smooth narrative structure that defines Mr. Lewis’s best work. The text jumps around between different storylines which are uncomfortable linked. For example, material on Goldman Sachs programmer Sergei Aleynikov, accused of theft of computer code, heavily based on the author’s Vanity Fair article is included in the book almost as an afterthought.

Sixth, Mr. Lewis has little new to say about his subject. There is also no obvious peg on which to hang the tale. Unlike the credit crisis of 2007/2008 which gave The Big Short context, the ‘flash crash’ of 2010 was not as notable an event in public consciousness and is now quite a long way in the past.

The end result is a surfeit of hyperbole and clichés.

Flash Boys quotes an anonymous investor: “There used to be this guy called Vinny who worked on the floor of the stock exchange. After the markets closed Vinny would get into his Cadillac and drive out to his big house in Long Island. Now there is the guy called Vladimir who gets into his jet and flies to his estate in Aspen for the weekend.” A fibre optic cable running from Chicago to New York becomes “a living creature, a subterranean reptile.” Mr. Lewis muses that “the numbers on the screens of the professional traders, the ticker tape running across the bottom of the CNBC screen—was an illusion.” The “average investor” or “slow-footed individual investors” are “easy kill”. A righteous John Schwall in Flash Boys tells the author that he is motivated to stop HFT “ripping off the retirement savings of the entire country through systematic fraud”.

At times, Mr. Lewis loses the plot entirely. A professional mutual fund manager, who is paid to manage a substantial sum of money for his presumed expertise, seems entirely helpless, complaining of “getting ripped off by some unseen predator”. Perhaps unfamiliar with the routine workings of commercial litigation, Mr. Lewis believes that Mr. Aleynikov’s conviction is the result of ignorant and confused jurors and muses that he should be tried by a jury of his intellectual peers.

Unfortunately, the overwrought text and attempts at titillation fails to create the necessary tension and urgency that would have made the book interesting as a narrative, leaving to one side its ability to inform readers on the subject of HFT. Wall Street Journal reporter Scott Patterson’s Dark Pools and Sal Arnuk and Joseph Saluzzi’s Broken Markets (both of which are generously acknowledged by Mr. Lewis) are alternatives to Flash Boys in the later regard.

Missing

Flash Boys is a missed opportunity. It diverts attention from important issues – the role of information and market makers, trading volumes and the basic system of markets.

All markets require liquidity providers to facilitate normal commercial purchases and sales. Historically, designated market-makers provided liquidity by assuming the risk of taking on positions as required. In some market structures, there was also a separation between these market-makers and pure brokers who acted on behalf of clients wishing to buy or sell for a commission.

Buyers and sellers want a transparent process. They want timely access to trading prices and volumes, allowing them to be informed about the correct market price of securities in making trading decisions.

Fair, transparent market structures, which meet these criteria and do not favour insiders or advantage any group, are one the holy grails of capitalism. But they conflict with the desire by all market participants to gain a competitive advantage, for example by superior access to information or faster execution of orders than competitors.

Modern market structures including HFT are merely a 21st century incarnation of these basic tensions. While they are more high tech, it is doubtful that they are any better or worse than their historical antecedents. In essence, all markets are “rigged”, with only the degree and precise mechanisms being different.

Defenders of HFT and existing market structures argue that the complex current arrangements have benefitted investors by increasing liquidity and lowering transaction costs, usually measured by the spread between buying and selling prices. This is predicated on the need for increased trading volumes.

High trading volumes are not necessarily beneficial. Investors only need liquidity to increase or decrease portfolio holdings in response to cash inflows or outflows as well as new information affecting values. There is limited support for the proposition that increased trading volumes improve market efficiency, which is difficult to measure in any case, or investment outcomes.

Evidence suggests that increased trading volumes increase volatility, which actually has a detrimental effect on capital formation and investment. In addition, much of the additional liquidity provided by HFT and hedge funds is fragile, present when markets are stable and absent in stressful conditions when it is crucial. This type of liquidity may actually be destabilising and detract from the proper functioning of markets and lead to poor investment decisions.

The case for more liquid markets and greater trading liquidity is similar to the case, sometimes made, for tolerating insider trading on the basis that it increases market efficiency, by allowing non-public information to be incorporated in security prices.

Recent revelations about collusion to rig financial markets in money market rates, foreign exchange and commodities illustrate that market manipulation is widespread. The proposition that equity markets are rigged is hardly a revelation.

Manipulation is increasingly also official policy. Government and central bank actions such as quantitative easing (“QE”) are intended to manipulate the price of sovereign bonds. QE and zero interest rate policies seek to influence equity prices and even specific sectors such as banking stocks. Intervention in currency markets in combination with QE is designed to manipulate foreign exchange rates.

Institutional complicity is evident. Stock exchanges, throughout the world, have encouraged the growth of HFT and electronic trading as they now constitute a very substantial proportion of their revenue. They offer ‘co-location’ opportunities allowing, traders to locate their computers adjacent to the exchange’s price matching engines to gain information and speed advantages over competitors, in exchange for fees.

At the core, the issue is about acceptance of corruption in the functioning of markets.

Early in the book (page 4), Mr. Lewis write that the average investor “may think he knows what happens after he presses the key on his computer keyboard, but trust me, he does not”. In using the phrase “trust me”, the author sets himself up in his now recognised role of a responsible and trusted advisor to the reader.

The real issue is also that of trust. It is about a system that delivers its citizens and their precious and hard earned savings into the maw of a deeply flawed, corrupt and exploitative financial system which is difficult to avoid.

Despite the pretence of challenging the existing order, Mr. Lewis does not repay the trust he seeks from the reader by failing to address this issue. Hedge fund AQR Capital founder Cliff Asness was correct when he argued in a Wall Street opinion piece that: “Making mountains out of molehills sells more books than a study of molehills.”

Steam

Consciously or unconsciously, Mr. Lewis’ physical appearance increasingly resembles that of author Tom Wolfe, whose glowing endorsement of Flash Boys appears on the dust jacket. Coincidentally, Mr. Lewis’ work is now reminiscent of the black activist Reverend Reginald Bacon, a character in Tom Wolfe’s novel Bonfire of the Vanities. The Reverend for a “donation” is happy to keep dissent and protest in the black population – the “steam”- under control.

Mr. Lewis’ books are designed to allow citizens to shake their heads and flail in righteous anger – vent the steam. While that might make everybody feel better, it does not address or deal with the fundamental issues.