In Flash Boys: A Wall Street Revolt,’ Michael Lewis’s controversial new book about how investors are shortchanged billions of dollars by high speed technology, Lewis’s acknowledgements’ page reflects the seditious nature of his conclusion.
“People who work in these (Wall Street) firms have grown more cynical about them, and more willing to reveal their inner workings, so long as their name is not attached to these revelations.’’
Lewis says that technology has enabled high frequency traders and dark pools (private exchanges) to “scalp’’ billions yearly from investors. The heroes of his book discovered massive inequity in trading and then spent six years figuring out how to combat and correct it.
It was not a popular campaign. Resistance was widespread. For example, on a recent cable news program, Stifel Financial Corp. Chairman Ron Kruszewski said there are issues in the stock market that could be improved but that to call the stock market rigged, as Lewis and his book’s heroes, have, “is reckless.’’
Lewis gives the story a David and Goliath structure: It’s the big banks, hedge funds and HFTs versus half a dozen young men who share a passion for transparency and fairness.
These self-appointed guardians are gathered together by Brad Katsuyama, a trader with the Royal Bank of Canada who suffers culture shock when he’s transferred, in 2002 at age 24, from Toronto to RBC’s Wall Street offices.
As Lewis says, Katsuyama has a problem. It’s not only that Katsuyama, best described as “nice,’’ finds the Wall Street milieu brash and offensive, and not just that he is aghast that excess rules and many of his new acquaintances are in debt. It’s that his trading is suddenly, inexplicably, losing RBC money.
“By the spring of 2007, when his screen showed 10,000 shares of Intel offered at $22 and he pushed the button, the offers vanished. In his seven years as a trader he had always been able to look at the screens on his desk and see the stock market. Now the market as it appeared on his screen was an illusion,’’ Lewis writes.
To his horror, Katsuyama sees that the difference between what used to happen when the stock market was as stated on his screen, and what was happening by the spring of 2007 “was tens of millions of dollars’’ in losses plus fees to RBC. We were hemorrhaging money.’’
Over the next six years, the dogged Katsuyama hires people who help him uncover the mystery of “the illusion’’ that has changed the U.S. stock market radically.
And then, angry at apathy and resistance to correcting what they uncover -- unfair “scalping’’ of investors -- the team creates its own exchange, and calls it Investors Exchange (IEX).
Katsuyama’s core group is made up of traders, computer programmers and high-level tech trouble shooters. They are profane, apt to be loners, obsessed with minutiae, and brilliant. Perhaps to balance the nefariousness of the greedy in his book, Lewis shows that the IEX team has flaws; they are no angels. But they are not corrupt.
They see that trades are now made by hyper-fast computing, and that the cost of being the fastest is enormous -- millions of dollars a year in fees are paid to gain an edge by having a line closest to an exchange computer network.
The shorter the trip, the faster the trading information travels. Katsuyama and company ask, “How was it legal for a handful of insiders (big banks, HTFs, et al.) to operate at faster speeds than the rest of the market and, in effect, steal from investors?’’
Enter Regulation National Market System, passed by the SEC in 2005 and implemented in 2007, which “required brokers to find the best market prices for the investors they represented.’’ Reg NMS was implemented in response to charges of front running.
Then, the National Best Bid and Offer was implemented to measure all the bids and offers for all U.S. stocks, and that data was compiled in one place, a computer, and was called Securities Information Processor (SIP). But the savvy discovered a loophole: “It (the new regulation) failed to specify the speed of the SIP,’’ Lewis writes.
Because technology was old and outdated, high frequency traders set up their own, much faster computers in their exchanges, and a gap was created between an HFT’s view of the market and an average investor’s. That was why Katsuyama’s trades in 2007 became an illusion; his computer wasn’t fast enough to compete with the new technology paid for by HTFs.
Intended to create equality of opportunity in the market, Reg NMs created “a more pernicious inequality’’: “A small class of insiders with the resources to create speed were now allowed to preview the market and trade on what they had seen.’’
Lewis provides numerous examples of how faster technology can be exploited to hurt investors, including big institutional investment funds.
Katsuyama’s team decides that their new exchange, Investors Exchange, must be extremely fast -- much faster than any other exchange, “thus preventing investors’ orders from being abused by changes in that market. In the bargain, it (IEX) prevented high frequency traders from submitting their orders onto IEX more quickly than everyone else.’’
IEX opened on Oct. 25, 2013, with 32 employees. On Dec. 19, 2013, they traded 40 million shares, with Goldman Sachs placing the biggest order. The ramifications were momentous. Brian Levine and Ron Morgan of Goldman Sachs are credited with instilling a new sense of order and fair play.
“Goldman Sachs was insisting that the U.S. stock market needed to change, and that IEX was the place to change it. The market felt fair: 92 percent of those orders traded at the midpoint -- the fair price -- compared to 17 percent that traded at the midpoint in Wall Street’s dark pools.’’
But while reading Lewis’s account, keep in mind this cautionary note from Floyd Norris in his April 11, 2014, High & Low Finance column in The New York Times: “The solution his (Lewis’s) heroes advocate -- more computerization to drive out middlemen -- risks making the market even more vulnerable to disruption as it becomes less attractive for anyone to provide liquidity.’’
'Flash Boys: A Wall Street Revolt' by Michael Lewis. W.W. Norton & Company. 274 pages. $27.95.
Eleanor O'Sullivan is an award-winning freelance journalist who has written for USA Today and Gannett newspapers. She has covered alternative and green investing, estate planning and family offices for Financial Advisor and Private Wealth magazines, and reviews new business books of interest to financial advisors. She can be reached at [email protected]