With his new book, Flash Boys, Michael Lewis has made a story that very few people in America had known, or cared, anything about—the rise of high-frequency trading on Wall Street—into the object of national outrage. More than one reviewer wrote that Lewis’s book would make readers’ “blood boil.” Democrats in Congress cited it in renewing their call for a tax on financial transactions. The FBI publicly disclosed, the day Flash Boys was published, that it was investigating high-speed traders. Virtu Financial, a high-frequency trading firm that had been scheduled to go public in late April, delayed its IPO because of the negative publicity generated by the book. And so influential was Lewis’s claim that the US stock market was now being manipulated by high-frequency traders that SEC Chair Mary Jo White felt obliged to declare, in testimony before Congress: “The markets are not rigged.”
Flash Boys has also been the subject of a strong backlash from Wall Street in general, and high-frequency traders in particular, with Lewis’s critics dismissing the book as a simple-minded and ill-informed (if well-told) fairy tale that completely ignores the actual benefits that high-frequency trading brings to investors. As one critic put it simply, the “analysis is wrong. What he is missing could fill another book.”
That Wall Street responded in force to Lewis’s attacks was unsurprising. Though high-frequency trading is dominated by firms that most Americans have never heard of, like Getco and Citadel, it plays an integral part in the way today’s stock market works. As their name suggests, high-frequency traders buy and sell in large volumes and at an extraordinarily fast pace, trading thousands of times a second. Their trading is entirely automated—humans may come up with the algorithms that the computers use, but machines do all the trading. In 2009, a report from the Tabb Group estimated that high-frequency trading accounted for an estimated 70 percent of all the trading in US stocks. And while these firms are less active currently (in part because markets are calmer), they still account for roughly half the trading volume in the US. Indeed, much of what happens in the stock market these days consists simply of computers trying to outsmart each other.
The idea that every day, investing decisions worth many billions of dollars are being made entirely by machines is, even to some on Wall Street, disconcerting. But Lewis is arguing in Flash Boys that high-frequency trading is more than just risky. Instead, it’s a form of legalized theft. The market, Lewis contends, is now effectively designed to allow high-frequency traders to skim profits from other investors. And we’re all paying a price as a result.
To make this case, Lewis uses a formula that’s served him well in the past, focusing his narrative on an intrepid band of outsiders challenging an entrenched establishment. In Moneyball, Lewis’s hero was Billy Beane, the general manager of the small-market Oakland A’s, who was able to use keen statistical analysis to make his low-payroll team a winner. In The Big Short, Lewis’s heroes were short sellers who realized before anyone else that the housing “boom” was nothing more than a giant bubble waiting to pop. In Flash Boys, Lewis focuses on a group at the Royal Bank of Canada, led by a trader named Brad Katsuyama, who come to believe that the stock market has been rigged against them, and who then set about finding a way to fix it.
Structurally, Flash Boys is set up as a mystery. Katsuyama’s job was to buy and sell large chunks of stock, often on behalf of big investors like mutual fund and hedge fund managers. But beginning in 2007, that job became much more difficult. Katsuyama found that if, say, there were a hundred thousand shares offered for sale at a given price, it was next to impossible for him to actually buy the shares. As soon as he tried to, “the offers vanished,” meaning that suddenly the price would jump higher. So instead of being able to buy a hundred thousand shares, he might be able to buy ten thousand, while having to pay a higher price for the rest. Mysteriously, the mere fact of trying to take people up on their putative offers to sell stock was causing the price to rise.
So what was happening? To understand that, you have to know that in the US there isn’t one stock exchange. Instead, there are thirteen public stock exchanges—including the ones everyone’s heard of, like the NYSE and the Nasdaq, but also exchanges with names like BATS and EDGX. (There are also more than forty private exchanges, called “dark pools,” where shares are traded as well.) When Katsuyama went into the market, the shares he was trying to buy weren’t all for sale at one exchange—instead, some were being offered at BATS, some at Nasdaq, and so on. So when he hit the enter button on his computer, he was in effect transmitting a buy order to all of these different exchanges.
To the human eye, it would look like Katsuyama’s order was being sent to every exchange instantaneously. But the reality is that depending on where the exchanges were located, his order might reach one exchange a few milliseconds before it reached others. And in today’s stock market, those milliseconds are an eternity, because they give high-frequency traders the chance to beat you to the punch. What Katsuyama realized was that between the time he hit the buy button and the time that order arrived at an exchange where the shares were theoretically for sale, someone else was zipping in, buying up the shares he wanted, and then offering them back to him at a higher price. As Lewis puts it, “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.” It’s as if you went into a pizza place that had one slice left for sale, and between the time you said “Give me the slice” and the counter guy heard you, someone else jumped in, bought the slice, and then resold it to you for an extra nickel.
High-frequency traders were able to pull off this trick because they were faster than Katsuyama. Their trading machines were “co-located,” which means they were in the same room as the exchanges’ servers. And they had also developed sophisticated computer models that allowed them to predict not only who was placing big orders, but where and how much they’d be buying. These models weren’t perfect, but they gave high-frequency traders a reasonable picture of what was going to happen a few milliseconds down the road. And that was all they needed, as Lewis puts it, “to skew the odds systematically in their favor,” allowing them to capitalize on Katsuyama’s intention to buy.
Lewis calls this “front-running.” Defenders of high-frequency trading call it “anticipatory trading.” But whatever you call it, the consequence was the same: Katsuyama ended up paying more for the stock he bought (and getting less for the stock he sold) than he otherwise would have. So he and his crew decided to do something about it. First, they came up with a computer program called Thor that was designed to make their orders arrive at every exchange at exactly the same time. Thor worked reasonably well, but by that point Katsuyama and co. had become evangelists for a better market. So they left the Royal Bank of Canada and set up their own trading exchange, which they call IEX, and which went live last fall.
IEX doesn’t ban high-frequency traders, but it’s designed to make their lives difficult. There’s no co-location. An “electronic speed bump” slows down every order, so that front-running is impossible. And while other exchanges often have a plethora of order types (featuring names like “Hide Not Slide”), which high-frequency traders use cleverly to their advantage—allowing them, for instance, “to withdraw 50 percent of its order the instant someone tried to act on it”—IEX has only four order types. IEX is still just a small player in the stock market—it accounts for less than one percent of US stock volume. But the hope is that over time, investors will prefer to trade on an exchange where they don’t have to worry about being front-run.
Katsuyama’s descent into the high-frequency realm has a certain drama to it, but it’s not, on the surface, the stuff of popular nonfiction, let alone a number-one best seller. What Lewis does so well with high-frequency trading in Flash Boys, much as he did with the world of baseball statistics in Moneyball and the world of collateralized debt obligations and credit default swaps in The Big Short, is to take an esoteric and opaque subject and make it vivid, accessible, and even entertaining. Flash Boys is not, in the end, as exciting as those earlier books, largely because Lewis’s characters here are not as memorable. (Though he does his best to amp up the personal drama—there are a few too many mentions of September 11—ultimately Brad Katsuyama seems like a really nice, successful Canadian fellow, while his team of tech and finance guys seem a lot like other tech and finance guys.)
But Lewis makes the intellectual mystery they’re trying to solve entirely engaging, and in the process illuminates a part of Wall Street that has generally done business in the shadows. He does so without, for the most part, oversimplifying. In Lewis’s short-form journalism, he sometimes takes shortcuts. But in his books, he takes the time to walk through topics in depth and with considerable sophistication. Flash Boys does not provide as rigorous a look at high-frequency trading’s origins and its mechanics as Scott Patterson’s excellent 2012 book Dark Pools does. But readers will come away from Flash Boys with a good picture of how high-frequency trading works.
They’ll also, in all likelihood, come away from it convinced that high-frequency trading is a curse on the markets. Flash Boys may be sophisticated, but it’s not subtle. While Lewis does make one or two nods to the idea that not all high-speed traders are con artists, his book is ultimately a polemic, intended to convince you that high-frequency trading is nothing more than a scam. As he writes:
By the summer of 2013, the world’s financial markets were designed to maximize the number of collisions between ordinary investors and high-frequency traders—at the expense of ordinary investors, and for the benefit of high-frequency traders, exchanges, Wall Street banks, and online brokerage firms.
Which raises the obvious question: Is he right?
When you talk to people on Wall Street about why high-frequency traders are good for the market, the answer is always the same: they provide liquidity. When a market is liquid, it means that it has lots of buyers and sellers, which means that if you want to buy or sell shares, you can find someone to take the other side of the trade, and you can make trades without moving the price too much. When markets are illiquid, by contrast, it’s more difficult to find someone to trade with, and because it’s harder, the price you have to pay to trade rises. Liquid markets are good, in a social sense, because if markets are more liquid, people will be more likely to invest. (If you’re not sure that you’ll be able to sell your stocks at a fair price when you want to sell them, you’re going to be more cautious about investing in the first place.)