Imagine if, every time you tried to place an order on the stock market, someone snooped on your transaction, and bought up the share before you could. Then, when you noticed that the stock was sold out at its original price, that sneaky trader turned up, all smiles, to sell you the shares he happened to have on hand, at a price just pennies above what you would have originally paid.
In his new book, Flash Boys, Michael Lewis builds a case that high frequency traders have been pulling a slightly more complicated version of this trick with no consequences. He’s hawking a solution, too, IEX, a new stock exchange designed by his protagonists and opened in late October of 2013. Lewis’s book introduces the lay reader to a complex topic with all his usual flair and clarity, but the book leaves the reader in suspense; the publication date means the fate of IEX and HFTs aren’t resolved by the end of the book.
By skimming tiny margins off of trades, Lewis argues, high frequency traders (HFTs) have reaped profits in the billions of dollars without providing a real service to investors. What is more, he claims, HFTs have shaped the infrastructure of our markets, so that stock exchanges are now designed to serve the interests of HFTs rather than other traders.
The NASDAQ and other trading floors have abandoned, well, their trading floors in favor of warehouses that look more like a Google server farm, full of HFT machines plugged into the exchanges from just feet away, to minimize waiting times and get the jump on ordinary consumers. IEX tries to restore the old balance, by introducing deliberate delays and simplifying the kinds of orders that can be placed, thus eliminating many of the advantages that HFTs enjoy at other exchanges.
But, as Lewis goes on a media tour that feels as much like an infomercial for IEX as for his book, some critics are raising questions. Felix Salmon thinks Lewis overstates the relevance of HFT to ordinary investors while Mark Levine, a columnist at Bloomberg View, thinks that, in a different Michael Lewis book, these high frequency traders, and the coders who support them would be perfect Lewisian heroes.
In my alternative Michael Lewis story, the smart young whippersnappers build high-frequency trading firms that undercut big banks’ gut-instinct-driven market making with tighter spreads and cheaper trading costs.
The numbers-driven, confusing-the-old-guard HFT teams do bear a certain resemblance to Billy Beane’s team of sabermetricians, who upended baseball in Moneyball. By building models and trusting statistics, the Oakland A’s stole a march on the other major league baseball teams. However, once the A’s tricks caught on, they lost their advantage. They had found a market inefficiency, but others applying their data-driven approach patched it, and left them once again out in the cold.
Lewis thinks that HFT are creating inefficiencies, not fixing them; they’ve been able to hang onto their advantage because no one else in the market understands how they’re being bilked. Lewis finds no shortage of bankers and traders at reputable firms who have been wrong-footed to the tune of hundreds of millions, and, this time, his sympathies are with the old guard.
IEX is designed to stop frontrunning and other abuses, but Lewis’s book came out months or a year too early to judge if the new exchange will have a positive effect, or any effect at all, on trading. Lewis’s own interviewees explain that it will take about a year to find out if their exchange has staying power, and more than once, Lewis’s narration reminds the reader that the ultimate question is whether any possible loophole was missed.
During the very beginning of IEX’s existence, it was difficult to tell if there was anything for a clever trader to game, since banks and brokers stayed out. Some brokers refused to place their clients’ orders on the exchange, even when the clients requested it. Others appeared to be trading in bad faith, placing their orders in small blocks of 100 shares, which drive down the average order size of IEX, a common Wall Street metric for reliability. Matt Trudeau, a member of the IEX team who had previously set up and opened exchanges around the world, had never run into these kinds of issues before.
These kinds of interference may be the most compelling evidence that the Flash Boys really are up to something as revolutionary as Lewis argues. The IEX is, at base, just another dark pool, albeit an unusually simplified and transparent one. If a transparent market is enough of a threat to be worth sabotaging, instead of just ignoring, it’s a lot more plausible that some people are making money by deliberating generating complexity and confusion. But it’s too soon to know if IEX will destabilize that strategy.
With Flash Boys, Lewis has departed from his usual role as the great geek historian. His latest work doesn’t clinch the case against HFT or for IEX, but it richly deserves to be the first chapter in a new discussion of market rules and abuses. Lewis raises troubling and necessary questions, and by releasing his book before the story ends, will play a needed role in finding the answers.