I think there were only two more chapters to go, when I started to google the facts in Michael Lewis’ „Flashboys“. The story about a transparent exchange that fights intransparent market places and high-frequency traders (HFT) just seems unbelievable. But as promised by the author, all the characters really exist. Well, of course, it is a non-fiction book. But the inconceivability of the story unfolding, as well as the sheer amount of money shifted in HFT globally, and the way Lewis portrays the fight of Brad Katsuyama make it hard to believe. But I guess, it is just pretty well written.
„The unit of trading was now milliseconds, but the records kept by the exchanges were by the seconds. There were one million microseconds in a second. It was if, back in the 1920s, the only stock market data available was a crude aggregation of all trades made during the decade.“ (81)
The main character here is the Royal Bank of Canada’s (RBC) stock trader Brad Katsuyama, who by one day makes the discovery, that stock trades happen in the time between the push of the button and the moment the order actually takes place. While Katsuyama tries to acts several different operations take place in the background. The feeling that remains with him is that the markets are rigged somehow. Or in other terms: „It’s an entire industry that overglorifies data, because data is so easy to game, and the true data is so hard to obtain.“ Someone in the market manipulated the reality to decrease the principles of “bounded rationality” (Ormerod):
„In practice, the times could vary much more than that, depending on network traffic, static, and glitches in the pieces of equipment between any two points (…) Someone out there was using the fact that stock market orders arrived at different times at different exchanges to front-run orders from one market to another.“
From here on Lewis places the reader onto Katsuyama’s shoulder who learns little by little about HFT and the way their products work. The reader basically shares every new insight with the protagonist. And this might even be the only way to explain, what is happening at HFT – by uncovering the puzzle pieces bit by bit. At this all we – Katsuyama and the reader – know „was that the stock market was no longer a market.“ So how did it all work?
First of all, the market had to be made intransparent. In all countries that had always traded on a single exchange authorities would permit the creation of a new exchange. „The new exchange was always located at some surprising distance from the original exchange. (…) Each new exchange gave rise to the need for high-speed routes between the exchanges so that the market would fragment.“ These construction were then mainpulated to gain information insights:
„The orders resting on BATS [batstrading.com] were typically just the 100-share minimum required for an order to be at the front of any price queue, as their only purpose was to tease information out of investors. The HFT firms posted these tiny orders on BATS – orders to buy or sell 100 shares of basically every stock traded in the US market – not because they actually wanted to buy and sell the stocks but because they wanted to find out what investors wanted to buy and sell before they did it. BATS, unsurprisingly, had been created by high-frequency traders.“
The HFT firms used the fact, that some exchanges paid investors if they were willing to trade their shares. „If a big Wall Street broker stood to be paid to send an order to buy 10.000 shares of Intel to BATS but was charged to send the same order to the New York Stock Exchange, it would program ist routers to send the costumer’s order to BATS. The router, designed by human beings, took on a life of its own.“ Finally, HFT traders made 99 percent of the orders: „Their orders were a tool for divining information about ordinary investors.“
But like all automated systems, this also wasn’t perfect. But since several players were linked closely together, the chain reactions were massive – a case of “vulnerability due to interconnectivity” (Barabasi). The birth of the so called flash crashes. As a result, the American’s confidence „in financial markets had collapsed“: „When some machine malfunctioned and a stock market came under scrutiny, the head of that market usually had no clue either what had happened or how to fix it: He was at the mercy of his technologists.“
But the book is also the story about Brad Katsuyama who decided to establish his own stock market or rather dark pool: the so called IEX. A market that would publish it rules and thus setting „a new standard of transparency“. And Katsuyama prooved that concept works: in December 2013 around 10 million orders were made – in May 2014 it was already 60 million orders. (http://en.wikipedia.org/wiki/IEX) The success story: It „attacked the newly automated financial system at its core: the money it made from its incomprehensibility“.
Summary: I don’t know if HFT can be as dangerous as CDOs and other financial vehicles. But HFT already caused some troubling market interferences. And financial institutions worked much too long with unregulated CODs without anyone taking could care. We should give credit to Michael Lewis for uncovering some aspects of HFT this early. The way he does it, describes best the way how these phenomenons surface and how some fast movers gamble with new tools. It also describes a new chapter in the fallacy that all systems – no matter how complex – can be controlled. And despite this fallacy we hand over more and more of the decisions to the machine – a fact Joseph Weizenbaum already recognized in 1976.
„Flashboys“ from Michael Lewis. Published in 2014 by Allen Lane. $20,00.