It’s a Gas Gas Gas

Flash Boys: A Wall Street Revolt
Michael Lewis

flash_boys

In a perfect storm of coincidence the subject of this book was legitimized the week I finished reading it. Legitimacy is welcome since this is a tale, in part, about selling the immeasurable as the irreplaceable even though what it may really be about is behavior that is irredeemable.

That’s a lot of  words starting with im- and ir-. If I were you I’d be wondering just what had gotten  ahold of me.

The subject, once again, is Wall Street. Most of the time I have a wary respect for the Street. On the one hand, they espouse a value system I don’t think much of. On the other hand, they can be nakedly honest about it in a way others aren’t.

At a very fundamental level, though, something strikes me as quite wrong. Wall Street isn’t really about funding the economy through the efficient allocation of capital; that may be the smallest part of what they do. It’s all the other things they do that get worrisome.

But I’m getting ahead of myself. As a brand name writer Lewis has a franchise. He owns the small-group-of-outside/insiders-that-really-knows-what’s-going-on tale. That’s the common thread in his book on the financial crisis and his political writing (and presumably the sports books to judge from the films). He gets in trouble when he ventures very far from that approach.

The New York Stock Exchange (at right sporting the flag).At one itme the epicenter of American finance, the building is really a made for tourists an television set.

The New York Stock Exchange
(at right sporting the flag).
At one itme the epicenter of American finance,
the building is really a made-for-tourists-and-television set.

This time his motley crew is assembled by a humble (by American standards) Canadian who runs the US trading desk for a big Toronto bank. (Okay, it’s Canada’s biggest bank and the 9th largest in the world. I told you, it’s always someone on the inside with Lewis.)

His confreres include an Irish emigre who’s been selling  telecom to the Street’s big players, an obsessive who’s driven to do the right thing, a group of master puzzle solvers and a genius straight out of central casting. (I honestly kept seeing Masi Oka, who plays the coroner, Max, on the reboot of Hawaii Five-Oevery time Allen appeared in the book.)

All tales like this need a starting point and ours gets under way when Brad Kutsumaya, the aforementioned Canadian, notices something. He can’t price stocks properly in the market anymore.  The minute he sees a stock at a price he wants to pay, it vanishes. Is it a software glitch? Is something amiss in  his employer’s electronic systems? Is he the only one experiencing this?

This is what the NYSE really is and has been for lamost a decade. Just a bunch of computers talking to each o ther at the speed of light. Humans need not apply.

This is what the NYSE really is and has been for almost a decade. Just a bunch of computers talking to each other at the speed of light. Humans need not apply.

The answer to all three questions being no,  our quixotic search for the truth begins. It’s a quest, though, that leads rather quickly to an answer: the only thing ‘wrong’ with the system is that like everything else on the Street that isn’t nailed down, access is for sale. And those who pay for that access can be just enough of a jump ahead of our Canadian friend (and every other trader for that matter) to skew the market.

The term of art for this practice is High Frequency Trading (HFT) but it’s actually legitimized, third-party front running. That’s the practice where a market maker buys for its own account in order to sell to an already identified buyer at an even higher price.

The HFT crowd places small orders on multiple exchanges to tease out larger orders from other buyers. Then they buy for their own account and race ahead to the next exchange to sell to the big buyer at a higher price. The timeframe is microseconds and it’s made possible by technology: multiple stock markets, fast computers, fiber optic cable run in as straight a line as possible, even buying a premium location for a server inside the exchange’s building–in fact right next to the exchange’s trading engine–is possible.

Oue heroes, the guys that set out to save the market from itself.

Oue heroes, the guys that set out to save the market from itself.

What makes HFT kosher, at least in the eyes of the Street, is that the front running prohibitions apply only to  brokers executing trades. A third-party in the middle is not bound to any standard beyond buying low and selling higher.

Why should that matter? HFT, the story goes, adds pricing efficiency to the market. But in reality. on large volumes, a fraction of a penny, or even a full cent, per share amounts to serious cash. Lewis terms this is a tax and in a very limited way that’s true as long as tax is defined as a drag or economic friction. It’s especially true if a tax is something that someone else pays.

What hath HFT wrought? In a word: volatility. The May 10, 2010 flash crash, illustrated.

What hath HFT wrought? In a word: volatility. The May 10, 2010 flash crash, illustrated.

When I last worked on a piece of bank business, more than a dozen years ago, the great fear was disintermediation, the beast unleashed by the emergence of the Internet. Transparency would make pricing discrepeancies apparent and drive down costs.

Well, like so much else in the age of Web 2.0, HFT is a case of back to the future, inserting new intermediaries where you would be expecting them to disappear. (Uber anyone?) The only bad intermediary, it seems, is one that I or some other shareholder/tech visionary doesn’t have an interest in.

So I’d use a different word than Lewis chose to: skimming. Perhaps our author friend doesn’t want to intimate that there’s something illegal going on. I think he might even agree that the real crime is that none of this is illegal. The part of the book that should capture the attention of any apologist for the status quo, though, is this: two HFT firms, in describing their performance, note, between them, one losing day in 5 years.

Anatmoy of a crash. The fingerprints of HFT in the market. microsecond by microsecond.

Anatmoy of a crash. The fingerprints of HFT in the market. microsecond by microsecond.
To get the full effect, click the image to see this fullsized.

Where I come from that’s a called a rigged game. So what’s an honest guy to do? Start a stock market of course. So our heroes do, building a system that disables the features that HFT takes advantage of.

Eventually some of the larger players on the Street seem to align with our underdogs. Don’t get all teary-eyed. It’s enlightened self-interest. They can’t keep up with small, technology focused-firms so they’ll muscle them aside one way or the other.

I suppose that’s how it is on the Street. Even as Lewis sucks us into rooting for the good guys I had to remind myself these guys are the 1%, with annual pay packages that total my income for a lifetime in the workforce. So I heavily discount their altruism.

Yet it did me good to know you could still try to do the right thing, no matter what your motivation.

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