Fascinating. That’s how I’d describe everything about “Flash Boys,” Michael Lewis’s latest book about Wall Street and the rise of high-speed computerized stock trading.
Ever since the publication of “Liar’s Poker” in 1989, his hilarious take-down of bond traders at the old Salomon Brothers, Lewis has been the best business and financial journalist of his generation, with an uncanny knack for finding fascinating characters and crafting dramatic narratives that explain, in more entertaining and powerful ways than the rest of us, exactly what is going on in business, or finance, or professional baseball or wherever else his catholic curiosity leads him.
Lewis’s sense of timing is impeccable. In “Liar’s Poker,” he caught Solly Brothers just before the bond-trading scandal that led to its fall from grace, and just before its top bond trader launched a hedge fund named Long-Term Capital Management whose miscalculations nearly brought the entire financial system to its knees.
In “The New New Thing,” he captured the entrepreneurial energy, inflated optimism and excessive wealth of Silicon Valley just before the bursting of the tech and telecom bubble. And in “The Big Short,” he exposed the clever chicanery and herd behavior behind the giant mortgage bubble that nearly took down the global economy when it burst in 2008.
Now in “Flash Boys,” Lewis reveals how a new crop of investment firms has conspired with the big banks and the stock exchanges to use high-speed computers and complex software algorithms to skim pennies from the real investors who provide equity capital to the economy.
The story is told through a motley cast of characters who come to understand this high-tech scalping operation, and try to do something to thwart it. There’s Brad Katsuyama, an earnest, determined if somewhat colorless Canadian sent by the Royal Bank of Canada to run its equity trading desk in Wall Street, who can’t understand why stock offered for sale on his computer screen disappears a nanosecond after he tries to buy it.
There’s Ronan Ryan, a foul-mouthed Irishman who wondered why hedge funds and banks would pay him incredible sums to build and locate telecom systems that would trim milliseconds from the time it takes to move orders and pricing information around the market.
And there’s John Schwall, a blue-collar kid from Staten Island whose insatiable curiosity led him to discover how all the pieces of the new computerized trading system were cleverly and secretly manipulated for the benefit of insiders. Starting in 2012, they and a band of geeky geniuses came together to launch IEX, a new stock exchange that would protect investors from the predation of high-frequency traders.
Almost as fascinating as Lewis’s story is the way he has gone about marketing it. By declining to distribute review copies prior to publication, he managed to send every business columnist and blogger scrambling to lay their hands on a copy and dash off a review before it was too late. He managed to land on the cover of the New York Times Sunday magazine and book himself onto “60 Minutes,” “John Stewart” and “Charlie Rose” to talk about an arcane financial subject that would make most eyes glaze over, then embroiled himself in raucous debate on CNBC that nearly stopped trading on Wall Street. Not surprising, “Flash Boys” tops Amazon’s best-sellers list.
The irony is that in publishing a book about too much speed on Wall Street, Lewis may have gone too fast himself, rushing into print with a tale that drags at points while needing more context and industry voices in others. In truth, it’s not his best book.
Most fascinating, however, has been the vigorous push back to the book from Wall Street and its apologists. They complain that the Lewis narrative is an oversimplified morality tale that ignores the bigger reality: that computerized trading has dramatically reduced the cost of buying and selling stocks for all investors. They harp on his overblown claim that it is mom-and-pop retail investors who have been disadvantaged, when in fact it is the trades of the big money managers. And they dismiss his story as “old news” that has since been overtaken by a dramatic drop in the profits and trading volume from high-frequency trading.
What you haven’t heard, however, are any denials that they have been doing exactly what Lewis describes — namely, creating a system that allows a small group of traders to get an advance peek at trading orders of other investors that allows them to interpose themselves between buyers and sellers and shave a penny or two from billions of transactions. When this kind of thing is done by human beings, it is called “front running” and it is illegal. When it is done by high-speed computers programmed by Russian emigres, it’s celebrated as financial innovation.
It may be old hat to the insiders on Wall Street, but the rest of us find it rather scummy that stock exchanges pay kickbacks to big banks and brokerage houses to send them their customers, even when customers request that their trades go elsewhere. We find it scummy that exchanges sell premium positions in or near their own computers so that they can get a leg up on competitors by knowing things first and shaving a millisecond off their trading speed. And we find it scummy that exchanges allow traders to post small orders to buy and sell every listed stock for the sole purpose of finding out what others want to buy and sell, and allow them to withdraw those orders as soon as anyone wants to complete the trades.
When trying to explain the social utility of all this games-playing, proponents of high-frequency trading argue that it adds to market liquidity, which as Lewis explains, is “one of those words Wall Street people throw around when… they want brains to go dead and for all questioning to cease.” The same rationale is trotted out any time a new instrument is criticized for excessive speculation or market manipulation.
Here’s the thing about liquidity. Yes, markets tend to work better when there are more buyers and sellers. But like most good things from money to sex, there is a diminishing return with liquidity — and you can be pretty sure that high-frequency trading has gone beyond that point now that it represents 50 percent of all stock trading and 99 percent of all trading orders.
Moreover, there is the useful kind of liquidity offered by genuine investors bringing permanent capital to real businesses, and the not-so-useful kind offered by those who use inside information to insinuate themselves between buyers and sellers who would and could do a computerized trade without them.
Which brings us to one final point of fascination — namely, how this whole system has developed in plain view of the Securities and Exchange Commission, whose original purpose was to ensure a level playing field for all investors.
As Katsuyama and his crew discovered, it was an earlier SEC effort designed to break up the old Wall Street cartel and ensure that investors got the “best price” for trades that, unintentionally, created the market structure in which high-frequency trading would develop and prosper. As Lewis brilliantly describes it, the history of Wall Street can be seen as an unending series of scandals, “linked together tail to trunk like circus elephants,” with each new scandal emerging “from some loophole in a regulation to correct some previous injustice.”
In the wake of “Flash Boys,” the SEC chairman has announced that her agency has a number of active investigations into high-frequency trading, which seems to me to pretty much sum up the problem right there. For as long as the agency views itself primarily as a prosecutorial agency for punishing wrongdoing, it is doomed to be five steps behind the Wall Street wise guys who are always working on the next scam.
Indeed, looking back at all the recent market scandals, you could argue that most could have been prevented if the SEC had thought of itself less as the sheriff on the beat and more as a real-time policymaker focused on rewriting the rules of financial markets in response to rapidly changing technology and market behavior. SEC officials will tell you that it’s all a lot more complicated than that. What Michael Lewis has demonstrated once again is that — really — it’s not.