Michael Lewis couldn't have timed it better if he'd tried. His blockbuster new book about high-frequency trading, Flash Boys, came out in a blaze of publicity during exactly the same week as a little-known Wall Street company named Virtu was scheduled to start marketing its initial public offering of shares.
Virtu, pronounced virtue, describes itself as a force for good in the world of electronic trading. “As market makers,” they say, “we lower costs for both retail and institutional investors by supplying competitive bids and offers. … Virtu's liquidity provision plays a vital role in the overall health and efficiency of the global financial markets, especially in times of market turbulence.”
As everybody who remembers the May 2010 “flash crash” knows, high-frequency trading, or HFT, is certainly responsible for its fair share of market turbulence—the phenomenon Virtu claims to have mastered. And Flash Boys presents an ingenious, private-sector solution to the problems caused by HFT. Indeed, the main narrative of his book is a simple story of good guys versus bad guys. On one side is Virtu; on the other side is a shadowy "dark pool"—a stock exchange where no one can see the orders being placed—going by the mysterious name of IEX, which almost nobody had heard of before Lewis’ book came out.*
But here's the twist: In Lewis' book, IEX are the good guys. And it's Virtu—the company that was about to start its IPO roadshow last week—which plays the part of the shadowy, evil corporation. Virtu gets named only in a footnote midway through the book, never to be referred to directly again; Flash Boys ends with a mysterious FCC license number, obtained after Lewis “leapt over the signs warning of various dangers” to discover something “as difficult to comprehend as the forces of nature once had been.” Lewis tells us that behind the license number is an “incredible but true Wall Street story, of hypocrisy and secrecy”—and then, on that cliffhanger, ends the book. So I guess it’s not really a spoiler to tell you that one of the companies behind that untold story is in fact Virtu, which ended up indefinitely postponing its IPO in the wake of Flash Boys’ release.
You never know which side Lewis is going to pick in his books. In The Big Short, for instance, he sided with, of all people, the hedge funds who helped destroy the world by making multibillion-dollar bets against the U.S. economy in the highly complex world of mortgage-bond derivatives. And now, in Flash Boys, he sides with a small group of stock traders, funded by some of New York’s most notorious hedge fund billionaires, who have created their own private stock exchange, IEX. Truth be told, the IEX guys are a lot more sympathetic than the guys shorting mortgages. But by creating an oppositional narrative of what he explicitly describes as “good guys and bad guys,” Lewis runs the risk of turning a highly complex issue into an unhelpfully simplistic morality tale.
Flash Boys is unapologetically polemical: The New York Times reviewed it twice on the day it came out, with Andrew Ross Sorkin calling it a “a make-your-blood-boil read” and Janet Maslin saying that it “is guaranteed to make blood boil.” (The Times clearly was running short on clichés that day.) Lewis’ pugnaciousness is fine and good—journalism should make you angry. But the problem with Flash Boys is that the demands that master storyteller Michael Lewis makes of his narrative don’t align well with the structural problems of HFT that Lewis the journalist should want to expose. The result is that the general public, after reading this book or watching Lewis on 60 Minutes, thinks that the scandal of HFT is that they’re being ripped off, and that the stock market is a scam. Neither of which is true.
The first thing that Michael Lewis looks for in a story is always a narrative; his nonfiction, at its best, rollicks along with the pace and structure of a thriller. And one of his strengths is the way in which he ruthlessly cuts out of his tales anything that doesn’t serve the needs of his narrative. By far the biggest risk posed by the HFT industry, for instance, is the risk of the kind of event we saw during the flash crash, only much, much worse. The stock market is an insanely complex system, which can fail in unpredictable and catastrophic ways; the HFT industry only serves to make it much more brittle and perilous than it already was. But in Lewis’ book-length treatment of HFT, he barely mentions this risk: I found just one en passant mention of “the instability introduced into the system when its primary goal is no longer stability but speed,” on Page 265, but no elaboration of that idea.
The book’s narrative demands that a small band of pure and plucky outsiders must abjure a life of guaranteed riches in order to embark upon a quixotic attempt to fight the entire structure of the stock market. At one point, our Canadian hero, the future founder and CEO of IEX, declares to his wife that “there’s only a few people in the world who can do anything about this. If I don’t do something right now—me, Brad Katsuyama—there’s no one to call.” Not much later, his trusty Irish sidekick, Ronan Ryan, decides “to quit his $910,000-a-year job for one that paid $2,000 a month—money that would quite possibly be paid to him out of funds he himself invested in the new company.” Lewis doesn’t mention that the history of Wall Street is full of people using their overstuffed paychecks to kick-start their entrepreneurial dreams: Katsuyama and Ryan are simply following in the footsteps of, say, Michael Bloomberg—or even of Michael Lewis himself, who used his earnings from Salomon Brothers to support the writing of his first book.
Lewis needs more than just a classic underdog tale, however. He also needs victims: He needs people whom the underdogs are fighting for. As Lewis explains very well, the history of HFT is in large part a story of small, nimble outsiders upending the old Wall Street ways: The banks are just too big and lumbering to be able to compete in this space against the likes of Virtu. But for Lewis’ purposes, the banks and the HFT upstarts all have to wear black hats, while IEX and a few noble others fight for … well, for whom?
The answer, if Lewis is honest, is very rich investors. Flash Boys begins with Katsuyama working as a highly paid stock trader for a huge Canadian bank, putting through orders worth millions of dollars for the bank’s biggest clients. It ends with Katsuyama setting up his own stock exchange, bankrolled by the likes of David Einhorn, Bill Ackman, and Dan Loeb—all of them billionaire hedge fund managers extracting mind-boggling fees from their hugely wealthy clients—and all of them much richer than anybody who made his fortune in HFT. Hedge funds, still, are the place to make more money than God.
When 80 percent of the money in the U.S. stock market is owned by just 10 percent of the U.S. population, how is Lewis going to find a sympathetic victim? The answer is by pulling out every rhetorical device he can muster. He describes a fiber-optic cable running from Chicago to New York as “a living creature, a subterranean reptile.” He says that “what people saw when they looked at the U.S. stock market—the numbers on the screens of the professional traders, the ticker tape running across the bottom of the CNBC screen—was an illusion.” He pities “the average investor” with “his TD Ameritrade or E*Trade or Schwab account,” who should “think twice” before placing an order. He says that “slow-footed individual investors” are “easy kill” for high-frequency traders. And he interviews a righteous avenger by the name of John Schwall, an IEX employee with justice on his mind:
“As soon as you realize that you are not able to execute your orders because someone else is able to identify what you are trying to do and race ahead of you to the other exchanges, it’s over,” he said. “It changes your mind.” He stewed on the situation; the longer he stewed, the angrier he became. “It really just pissed me off,” he said. “That people set out in this way to make money from everyone else’s retirement account. I knew who was being screwed, people like my mom and pop, and I became hell-bent on figuring out who was doing the screwing.”
Schwall tells Lewis that HFT is “ripping off the retirement savings of the entire country through systematic fraud,” and Lewis just allows the quote to sit there, damningly, even if he would never come out and put it that way himself. After all, the fact of the matter is that of all the various actors screwing your mom and pop out of the money in their retirement account, high-frequency traders are at the very bottom of the list. If, that is, they’re on the list at all.
If your mom has a brokerage account, or a mutual fund manager, or generally entrusts her retirement savings to any kind of intermediary, then the fees charged by her broker or fund manager will dwarf any profits being skimmed from her by HFT. And if your pop invests in the market himself—if he’s among those people with a TD Ameritrade or E-Trade or Schwab account, the “easy kill” for the high-frequency algorithms, then, in reality, he is the one big winner of the high-frequency game.
Of course, the stock market is a game with winners and losers: Every time one person is buying, another person is selling. If you sell before a stock goes up, you’re a loser, but if you sell before it goes down, you’re a winner. And if you’re making your own decisions of what to buy and sell, and at exactly what price, then there is no room to blame anybody but yourself if you make bad decisions. The trading fees and the stock prices, for individual investors, are all completely transparent.
If you’re a big investor, that’s not the case. Brad Katsuyama, when he was at Royal Bank of Canada, would see thousands of shares available for sale at a certain price—but when he tried to buy them, they would suddenly disappear, and he would be forced to pay more. That was the high-frequency traders, front-running his order.
Retail investors don’t run into this problem. If they see a stock available for $50.00, they can buy it at $50.00—not $50.01 or anything higher. They get exactly what they want, at exactly the price they want, which is also the best price in the market, and they get it immediately, in a way that makes big investors rather jealous. (Which raises one of my factual quibbles with the book: On Page 78, Lewis says that a retail order was filled “at a higher price than originally listed”; I don’t believe it. I believe that the stock-market price rose as soon as the retail order was placed; I don’t believe that the retail order itself got front-run.)
If your mom or your pop buys or sells a stock, that order will almost certainly never make its way to any stock exchange: It will be filled by a high-frequency trading shop that is happy to pay good money for the privilege of doing so. The high-frequency traders do make money from the retail investors—but mainly they do so the old-fashioned way, just by being on the right side of the trade.
If an HFT shop simply fills every single retail order at the best price in the market, then over the course of a day, and certainly over the course of a year, it will make a decent profit. Retail investors, in aggregate, are dumb money: If you take the opposite side of their trades, you’re going to do just fine. Especially when you also buy stock off them for a penny or two less than you will sell the same stock to them. That’s called NBBO—the national best bid/offer—and it simply reflects the fact that there’s always a small gap between the highest price that someone is willing to buy, and the lowest price that someone is willing to sell.
That’s why HFTs love to give retail investors what they want: It turns out that retail investors are very good at making very bad decisions all on their own. What’s more, if you’re an HFT seeing what retail is doing at any given moment, you can use that information to inform your stock-market trades elsewhere. So mom and pop end up making you a lot of money, without your ripping them off in the slightest.
If you read Lewis’ book with the eyes of a retail investor, it can get quite confusing. At one point, for instance, Lewis tells the story of Rich Gates, a mutual fund manager being front-run by HFTs. Gates “devised a test,” writes Lewis, to see whether he was “getting ripped off by some unseen predator.” The test involved placing two orders, a few seconds apart: The first would be an order to buy 1,000 shares of a certain thinly traded stock at $100.05, and then the second would be an order to sell 1,000 shares of exactly the same stock at $100.01. Gates “was dutifully shocked” when he discovered the results of his test: He ended up buying the stock at $100.05, selling it at $100.01, and losing 4 cents per share. “This,” he thought, “obviously is not right.”
Lewis does have a point here: It’s not right. (Whether it’s obviously not right rather depends on how familiar you are with stock-market protocols.) If the stock market works the way it’s meant to work, then the stock exchange’s order-matching algorithms should have seen that the best bid, at $100.05, was higher than the best offer, at $100.01. They then should have matched the two, so that Gates would have traded with himself, and lost no money. Instead, a fast algorithm managed to insert itself between the two orders, buying at $100.01, selling at $100.05, and making a 4-cent profit for itself, in a fraction of a second. In terms of the official ticker tape, rather than one trade taking place at $100.03, there were two trades: one at $100.01, and another at $100.05.
In Gates’ mind, what he saw was the 35,000 customers of his mutual fund being “exposed to predation” in the stock market. Between them, those customers had lost $40: 4 cents per share, times 1,000 shares. Which means they had lost roughly a tenth of a cent apiece, buying and selling $100,000 of Chipotle Mexican Grill within the space of a few seconds.
But there’s always going to be a nonzero “round-trip cost” to buying $100,000 of a stock and then selling it a few seconds later. And it was not so long ago that $40 would be a veritable bargain for such a trade. Gates has good reason to feel preyed upon, given the way the market is supposed to work. But still, $40 for two $100,000 trades is hardly a rip-off. Especially when you consider the money that Gates himself is charging his 35,000 mom-and-pop customers.
When Gates was running his experiments, his flagship fund, the TFS Market Neutral Fund, had an expense ratio of 2.41 percent: For every, say, $100,000 you had invested in the fund, you would pay Gates and his colleagues a fee of $2,410 per year. That helps puts the tenth of a cent you might lose on Gates’ Chipotle test into a certain amount of perspective. TFS trades frequently, but even so, any profits that HFT algos might be making off its trades are surely a tiny fraction of the fees that TFS charges its own investors.
When Gates was running his experiment, the official national best bid/offer on those hypothetical Chipotle shares was $100.00 to $100.10. A retail investor could have bought 100 shares of Chipotle for $10,010, and then sold them immediately for $10,000. The total round-trip cost would be just $10, plus whatever the trading fee might be—maybe another $5. That’s amazingly cheap execution, which would involve no HFT front-running at all. If the retail investor could buy at $10,005 and sell at $10,001—as Gates did—that would have been even cheaper. Which means that from a retail investor’s point of view, everybody is getting a bargain. For all that Gates feels aggrieved, the stock market remains a very efficient place to move around enormous sums of money.
At some points in his book, Lewis realizes this. He says that stock-market intermediaries have always made money by ripping off investors: “the entire history of Wall Street was the story of scandals,” he writes, “linked together tail to trunk like circus elephants.” Front-running has always been around. At other points in the book, however, Lewis starts getting weirdly nostalgic for the stock market of the past. The U.S. stock market, he says, was once “the world’s most public, most democratic, financial market.”
When were these halcyon days? Lewis never says. Back in 2000, Goldman Sachs spent $6.5 billion buying a stock exchange market-maker named Spear, Leeds & Kellogg; today, thanks to HFT, that investment is largely worthless. The $6.5 billion gives you an idea of how profitable market-making was just a decade and a half ago—and yet Lewis is comfortable claiming that by 2008, the HFT shops were “making perhaps more money than people have ever made on Wall Street.”
“Financial intermediation is a tax on capital,” writes Lewis, accurately. “This new beast rose up in the middle of the market and the tax increased—by billions of dollars.” But even if you accept that HFT generates billions of dollars, that doesn’t mean it generates billions of dollars more than intermediation generated in the past. For the sake of larding his rhetoric with maximal outrage, Lewis is drifting into the arena of highly dubious claims. After all, in the past, stocks traded in units of eighth of a dollar; today, they trade down to the penny. That alone has cost intermediaries—and saved investors—billions of dollars.
The problem with Flash Boys, at heart, is that Lewis is too wedded to his narrative of a rigged stock market. The word “fraud” appears in three different places in the book; at one point it’s explicitly attached to the possibility that “enterprising politicians and plaintiffs’ lawyers and state attorneys general” might “respond to that news” with entrepreneurial activity of their own. And indeed that’s exactly what seems to be happening: A series of leaks and announcements have responded to the release of Lewis’ book with dark hints that insider-trading prosecutions might be coming down the pike.
But what we’re seeing, in the world of HFT, is not fraud, nor is it insider trading. Rather, HFT is a ridiculously and unnecessarily complicated mechanism for divvying up intermediation revenues between banks, exchanges, high-tech telecommunications outfits, and various algo-driven shops. Everybody is in on the game: not just the HFT guys, but also the exchanges, which optimize themselves for HFT game-playing, and the banks, which let HFTs into their dark pools, and especially the SEC, which has been cheering on the whole motley crew from the beginning. Even the big money managers are in on the act. Because they pass on their trading costs to their investors, managers have precious little incentive to chase aggressively after the very best execution on their trades. Rather than routing trades to the brokers (like Katsuyama’s former employer, Royal Bank of Canada) who will get them the best price, they embrace the mildly corrupt “soft dollar” system, and pay brokers with trade flow in return for access to analysts and research.
Prosecutors are powerful creatures, of course, and if they want to bring charges against some HFT shop, they probably will. It wouldn’t be the first time that behavior which was broadly accepted on Wall Street suddenly became retroactively criminalized. Lewis claims that he would rather see a market solution to the HFT problem: He would prefer to see IEX become a success than see a group of high-frequency traders go to jail. But by writing his book in such an incendiary manner, he has certainly done his best to maximize the probability of the latter. Policymakers and prosecutors find themselves in something of a pickle—precisely because Flash Boys is so good at boiling its readers’ blood.
Michael Lewis, unlike HFT’s defenders, has his finger on the popular pulse. That’s why he spends so much time detailing the work that went into building a fast fiber-optic cable between Chicago and New York, and explaining the gory details of co-location, where HFT companies place their computer servers as physically close to the stock exchanges as possible, just so that their orders can arrive precious microseconds ahead of the competition’s. He’s not talking to Wall Street, here; he’s not even talking to prosecutors. He’s talking to the general public.
On Wall Street, it has been long understood that speed is money. That truism dates back much further than HFT; my own employer, Reuters, is named after a farsighted man who made his millions selling ultra-fast information in the 19th century. The general public, by contrast, believes that the stock market is a democratic level playing field. It never has been, but the SEC does its best to preserve the fiction that it is. Hence rules like Regulation FD, which mandates that companies release information simultaneously to everybody, so that, at least in theory, every investor has an equal shot at trading on that information and making money from it.
In practice, by the time any such information has begun to load in your Web browser, it’s too late: The price has already moved. Reg FD might ostensibly exist to level the playing field for small investors, but in reality it does more harm than good, because it gives some small investors the ruinous illusion that they might have a sporting chance to compete against the big guys.
Similarly, if any high-frequency traders get prosecuted for insider trading, the message will be clear: The stock market is supposed to be fair, and if anybody is found to be taking advantage of information unavailable to the rest of us, even if it’s only for a millisecond, they’re going to risk a serious fine, or jail, or both. That’s not a good message to send, because the stock market is not fair, it never has been, and it never will be. And you’re doing nobody any favors by encouraging them to believe otherwise.
Michael Lewis begins Flash Boys with a quotation from The Wire’s Omar Little: “A man got to have a code.” Lewis has succeeded in shocking millions of people with the news that the stock market has violated their code—that it isn’t fair. Wall Street insiders, and those of us who knew about HFT already, have been generally underwhelmed by this revelation, because we’ve known that the Wall Street code has always favored a small group of rich and well-connected institutions who can afford to pay enormous sums of money to maintain their edge in the market. The advent of HFT just created new entrants into that charmed circle, while causing many incumbents to lose their gilded meal tickets.
Thanks in no small part to Lewis’s storytelling prowess, Flash Boys has hit a chord. It might even have a positive effect, in terms of prodding Wall Street in the direction of a simpler, more robust market. The emotional climax of the book takes place during 51 minutes in the afternoon of Dec. 19, 2013, when Goldman Sachs routed orders for some 40 million shares to Katsuyama’s IEX. Lewis was in the IEX offices at the time, talking to Katsuyama, and tells the story masterfully:
“Now the others can’t ignore this. They can’t marginalize it.” Then he blinked. “I could fucking cry now,” he said.
He’d just been given a glimpse of the future—he felt certain of it. Goldman Sachs was insisting that the U.S. stock market needed to change, and that IEX was the place to change it. If Goldman Sachs was willing to acknowledge to investors that this new market was the best chance for fairness and stability, the other banks would be pressured to follow. The more orders that flowed onto IEX, the better the experience for investors, and the harder it would be for the banks to evade this new, fair market.
That was the dream, on Dec. 19; it remains the dream today. Disappointingly, Goldman didn’t come back on Dec. 20, or on any other day. There were 51 minutes when Goldman looked like the white knight, galloping in to save the day. But as Lewis notes, Goldman Sachs is not a monolithic entity; it’s “a complex environment,” with lots of internal politics.
The best possible outcome from the publication of Flash Boys would not be a series of insider-trading prosecutions. Rather, it would be a decision made at the highest levels of banks like Goldman Sachs and Credit Suisse: If our clients want us to route their orders through IEX, then we’ll route their orders through IEX. That would involve the banks giving up precious revenue of their own, from their dark pools and the other methods by which they extract rents from high-frequency traders. But it would give Katsuyama the opportunity to prove his case, once and for all, that his technology really does give big investors much better execution.
If all went according to plan, the result would be less money for high-frequency traders, and more money for mutual funds, pension funds, insurance companies, hedge fund billionaires, and other big investors. Small investors would, realistically, see no difference at all. But most importantly, the market as a whole would be less skittish, less brittle, more robust. IEX, if it works, might just be the technology which could prevent a catastrophic global Flash Crash II.
Update, April 7, 2014: This sentence has been updated for clarity. (Return.)
Flash Boys: A Wall Street Revolt by Michael Lewis. Norton.