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A Brief Summary and Review
am 7. April 2014
The thrust: Over the past 20 years, and particularly in the past decade, the stock market has undergone some significant changes. The most visible change is that much of the action has now become computerized. For example, whereas stock markets used to consist of trading floors (pits), where floor traders swapped stocks back and forth, we now have computer servers where sellers and buyers are connected automatically. Now, on the one hand, this automation has led to some substantial efficiencies, as once necessary financial intermediaries have now largely become obsolete (this has led to savings not only because the old intermediaries earned an honest commission for their dealings, but because their privileged position sometimes led to corruption).
It is not that the new stock market has done away with intermediaries entirely. Take brokers, for example. Brokers are still used by large investors to help them move large chunks of stock where the market may not be able to fill the order immediately. The brokers take some risk in this action, and provide liquidity in doing so, since they help move capital to its most useful location, and thus brokers still provide a very useful service.
While brokers have always existed, the new stock market has also added a new breed of intermediary. This new breed of intermediary is known as the high frequency trader (HFT). The high frequency trader operates on speed, relying on location and advanced communications technology to learn about the movement of the market before others, and uses this knowledge to make winning trades.
To give you an indication of how important high frequency trading has become, consider that at least half of the trades now being made in the United States are coming from high frequency traders.
Those who defend high frequency trading argue that these quick trades actually help move money through the stock market, and thus add liquidity to the system (the way brokers do); and that, therefore, high frequency traders provide a valuable service.
However, just how high frequency trading works has largely remained a mystery to anyone outside of the industry itself; and many have become concerned that high frequency trading is not so much a liquidity-contributor as a way of scalping money off of trades that would have happened anyway.
In 'Flash Boys: A Wall Street Revolt', Michael Lewis follows one man who made it his mission to find out what was going on at the heart of HFT. That man is one Brad Katsuyama, a broker from the sleepy Canadian bank RBC.
Katsuyama’s interest in the mystery began back in 2007, when he found that the trades he was trying to make from his desk at RBC were not being executed in the way they once had. In short, Katsuyama was being ripped off. And that’s not all. Katsuyama soon found that other brokers were also being ripped off—and even the investment firms were being ripped off. And since the investment firms manage your money and mine, we were being ripped off too!! This was big.
Katsuyama’s dogged persistence eventually led him (and a growing band of fellow mystery-solvers) to find that it was indeed the high frequency traders who were ripping him (and everyone else) off (though the HFTs were not the only culprits involved). What’s more, Katsuyama’s team also discovered just how the HFTs were doing it. The long and the short of it is that the HFTs are just gaming the technology. And in a way that is not only ripping others off, but making the system more volatile, and prone to errors and disasters as well (witness the flash crash of May 6, 2010).
Rather than deciding to join the HFTs at the trough (which would have been easy enough to do), Katsuyama and his team decided to fix things. Specifically, the team decided to start their own stock exchange: a stock exchange (called the IEX) that was designed to be immune to advantages in technology, and hence fundamentally fair to all (it was either that or wait around for the SEC to do something—which may take forever).
Now, you would think that a stock exchange that is fundamentally fair to all would be a big hit. But then again, a whole heck of a lot of people have no interest in making things fair to all. Which side will win? The fate of the IEX (which opened in October of 2013) has yet to be determined...
This book is fantastic. The story will confirm your suspicious that truth is stranger than fiction. Lewis writes beautifully, unpretentiously, and makes the characters jump right off the page (that wouldn’t have been that difficult here—these are some brilliant characters). My only objection is that Lewis’ explanations of the technical side of things, while very good, could have occasionally been slightly more clear. Still, an enlightening and wonderful read.