The book “Flash Boys” (Amazon, Apple) by Michael Lewis tells the story of how our current stock market works, how it is being manipulated, and what a group of guys who figured it out are trying to do about it. Like all good Michael Lewis books, it focuses on one central character to provide the narrative structure as he teaches you about what is going on. In this case, the character is Brad Katsuyama, a trader at the Royal Bank of Canada (RBC). By focusing on one character, Lewis’ books become page-turners, though it does tend to leave some of the technical details out in the interest of advancing the story. I find this perfectly acceptable, because it gives you enough of a window into how things work that you can then dive into the deeper, and let’s face it, drier, technical details of the subject if you are so interested. Lewis himself mentions these books in his notes, so you have get a good heads up on where to go for further reading.
While the book focuses on Brad and his colleagues, it gives a fascinating insight to how our modern stock market actually works, and really made me not want to be a part of it at all. As an example, I think we all have an idea that there are these limited quantity of hard, fixed pieces of real estate, called the NYSE or Nasdaq, and there are people running around on the floor shouting at each other as trades get made. If you wanted to trade Apple stock, you went to the NYSE (as that is where it was listed). If you wanted to trade Intel, you went to Nasdaq (because that is where it was listed). Yes, there are computers, and maybe some of this “people yelling at each other” is antiquated, but the NYSE is still a place where this stuff happened. If you turn on CNBC, you see the floor of the NYSE and you see people walking around.
However, this is not how things work anymore. That trading floor you see on CNBC, and the celebrities or CEOs doing an IPO that ring the opening bell? That’s just a set piece, nothing goes on there. And there aren’t 2 or 3 exchanges (Amex being another). There are 12 or 13… and you can trade any stock on any one of them… and those are just the public exchanges. Banks like Goldmann Sachs have their own, private exchanges, called “dark pools”, where their clients can trade. And these new public and private exchanges aren’t loaded with people, but rather are just large arrays of computer servers running algorithms. And you don’t just have trades like “buy” or “sell”, or even things as simple as “limit orders” (buy/sell if the stock hits such and such a price). You have dozens of order types that are complex and hard to describe, because the types are really meant as triggers for the computer algorithms running on the servers in these multiple exchanges.
OK, wait… what?
The world is a much different place, not only from the Wall Street immortalized in the Oliver Stone movie of the same name, but even from the market of the late 90s that you or a friend of yours participated in when they quit their job to be a “day trader”, and even from the market that existed when the financial crisis hit.
Why are things so different, and how come we didn’t know about it? That, basically, is the crux of the book. This change in the market was all transparent to you and me when we go onto our Fidelity web page to trade a stock, because these changes weren’t about you and me. They were about a group of people called “high frequency traders” or HFT. These changes were made to turn the stock market into a complex Rube Goldberg machine, because the more complex the machine is, the easier it is to find inefficiencies in it to exploit. Much like how the financial crisis occurred because people who traded in mortgage backed securities were trading in an opaque market of strange, hard to decipher rules, the new stock market is complex, opaque, and confusing, which allows the people who know how to spot a fissure in the rules to swoop in, unbeknownst to the rest of us, and take some money.
In the olden days, stock trades did happen based upon speed, but it was a regulated speed. You might have a really good stockbroker who has a stacked Rolodex or excellent memory, and when he (or she, but let’s face it, it is mostly he) trades a stock on your behalf, he can get you the best deal because of this. He can find the seller willing to sell for less than he really wanted (so as to get you the best buy price) or find the buyer willing to buy something for more than he wanted to buy (so as to get you the best price) or, perhaps, do great horse trading so that you split the difference.
For example, say you want to buy a stock and make a bid at $10. And somebody else wants to sell the same stock and makes a sale offer for $10.02. A good broker might be able to get you that $10 price because of whom he knows and how fast he works, such that you don’t have to pay $10.02. Conversely, if you were the seller, your broker was so good he could get you the $10.02 price so you don’t have to sell at $10. Or, he works it out such that the stock trades for $10.01. The better the broker, the more you are likely to get your price.
Now, in this old-timey Bud Fox market of guys in rolled up white buttoned shirts and ties yelling on the phone, if your broker instead interjected himself, such that he bought the stock for $10 that you asked for, but turned around and sold it for $10.02 back to you, that would be illegal. He was using his knowledge to make the seller think the only offer for his $10.02 sales price was $10, and to make the buyer think the only stock available for his $10 ask was $10.02. He pocketed the difference. That’s a no-no and a quick ride to jail (well, fines… maybe… depending on how crappy the government feels like operating)
But in the new world order of computer based algorithmic trading, this is not illegal, as long as it is the computer doing it. A computer can make this trade, independently. And the way it works is like this. Your Bud Fox-type broker isn’t getting a phone call… what he is doing instead is taking a bunch of money from an HFT (through fees), which lets the HFT see what the incoming stock price bids/asks are ($10 and $10.02). The HFT sees this information, and has his computer sit closer physically (as in, with shorter wires) to these stock exchanges “matching engines” where the trades occur. Because he is closer, just by rules of physics, he gets to the matching engine before you, and can do the trade with you opposite of the way you hoped. To you, it looks like you didn’t get your price. But the thing is… neither the buyer nor the seller got their price. The seller thinks he had to sell for $10, and the buyer thinks he had to buy for $10.02. The HFT made a 2-cent profit (some of which he paid to the Bud Fox brokerage firm in fees).
Now, that sounds simple and all, and it is. Because, couldn’t the HFT equally “lose” as well as win here? He could, in theory, end up buying at the wrong price and selling at the wrong price, and lose just as easily as he could win. And this would be true, but that gets us back to all those complicated order types. You don’t just have “buy” and “sell” or “limit” orders. You have orders you can make that you can cancel unless certain, wild and crazy and difficult to explain in English conditions are met. And since these orders can be cancelled, they allow you as the maker of the order to tease out what the real buy and sell prices are, which you can use to then cancel the main order, and come in right after it with a “better” order that you do complete. You are thus, in essence, making free money.
Keep in mind, this is all legal. And this legality is not an accident. The people who have made it legal? They made it legal explicitly so they could do this. The “it’s illegal if it is a human but legal if it is a computer” thing is not a mistake – it is part of the plan.
The crux of the story, once you learn this, is what Brad and his colleagues did with the information – they created yet another exchange that can combat these HFT algorithms. Their exchange slows down the orders such that an HFT can’t sneak in. Their exchange has much simpler order types. And finally, they got clients to demand from their banks doing trades (such as Goldmann Sachs) to use Brad’s new exchange when they placed their orders. Like every other exchange, they make money when trades happen on their exchange. They might make less than other exchanges as they aren’t selling access to HFT, but the hope is that by being the “fair” exchange, they will get more volume over time and thus do just fine.
One other fun note… as with the mortgage based financial crisis, Brad didn’t just set out to create his exchange as soon as he figured it out. He went to the SEC to let them know what was going on, with the hopes that maybe this would stop on its own with some rule changes. He was a happy, and rather wealthy man, doing trades at RBC. He wasn’t an entrepreneur with dreams of starting his own exchange. But, just like with what happened in the financial crisis, he found deaf ears at the SEC. They didn’t seem interested in stopping what was going on. Brad’s team did some analysis of this, and as it turns out, the sheer number of SEC employees who later quit the SEC to go work for HFT firms was astounding. In other words, the SEC knows what is going on, but just didn’t care. I know… my head slammed on the desk reading that, too.
As with all Michael Lewis books I have read, this book was very good. Lewis doesn’t feel it is his role to provide answers about how to make Wall Street change, any more than he felt it was his role to make Wall Street change when he wrote “The Big Short”, about the mortgage backed securities fiasco. Lewis instead writes a book that is entertaining as well as educational. It has heroes you root for, and villians you cannot believe exist outside of fiction. As with The Big Short, he succeeds.