Michael Lewis lets the cat out of the bag on HFT trading in this explosive shocker
Saturday 22 November 2014 10:15:27 PM
Archived under Finance
The funny thing with modern financial markets is that the next crisis always appears to be lurking right around the corner. World barely seems to have climbed out of the mess it got itself into six years ago. Weekly, there are news of financial impropriety and insider chicanery from across the world. With glib con men and slippery raconteurs peddling their convoluted wares, the financial markets of today have come to resemble a serpentine labyrinth. The crazy machinations only grow in number as financiers' obsession with quarterly targets, bottom-lines and fat bonuses, multiplies. 'Flash Boys' narrates the story of one such fraudulent practice called 'High Frequency Trading' (HFT). Michael Lewis, author of bestsellers such as 'Moneyball' and 'The Big Short', recounts the trials and triumphs of a motley group of professionals whose activism helped expose the dark side of the HFT and subsequently, devised an honest alternative for the less-informed investors.
High frequency trading first shot to infamy in May, 2010 when on one fine day, the Dow Jones Industrial Average (DJIA) plummeted southward and before anybody could get a drift, roughly $1 trillion in market capitalization were evaporated from the markets. Just as shocking the nosedive was, the recovery was even more bamboozling. Much to the shock of outsiders, the DJIA bounced back to its normal only after 20 minutes of wreaking mayhem. While what had precisely caused the tumble remains unclear to this day, the aftermath of the event, for the first time, turned the spotlight on the role of algorithms-driven stock trading.
Lewis yet again demonstrates his knack for explaining technical matter with lucidity and unrivaled intelligence. For the starters, HFT is a platform where without any human intervention, algorithms embedded in the computer systems do the trading. HFTs rely on complex algorithms to buy and sell shares in milliseconds. Mainly, these firms make money from practices such as arbitration - buying and selling millions of times in a single day on different exchanges, thus, making large cumulative profits towards the end of the day.
Brad Katsuyama, the brains behind America's newest stock exchange IEX, quarterbacks this against-all-odds story. A financial services executive with the Royal Bank of Canada (RBC), Brad found purpose in exposing financial fraudulence. Notwithstanding the uneventful encounters with computerized trading in his early days as the Head of Global Electronic Sales at RBC, Brad Katsuyama became the unlikely sachem of a group of non-conformists who ran the gauntlet on the American financial system.
Lewis through the eyes of Brad Katsuyama narrates the metamorphosis of the US financial market from a humans-led enterprise into a maze littered with optical fibres underneath and computer servers above. Scarier part of Lewis' expose is the confounding nexus of the stakeholders running amok at the expense of unwary investors. If Lewis' condemnations are not mere rants, then the emerging picture is nothing short of a dystopian nightmare. You have banks and their ominously named spawns called Dark Pools playing Russian roulette with their clients' money without the latter even having a whiff. Dark pools operate like black boxes wherein only the brokers inside have the knowledge of what's happening to the trades. Banks pass on the client orders to their respective dark pools where the business gets done without the public markets knowing about it. So far, so good. What's shocking is that these pools further move the information to the HFTs who now armed with the tip-offs jump the queue and front run the banks' customers orders. So you have banks allowing the cannibalization of their own customers at the hands of the HFTs. Worse, all this happens right under the nose of the regulators.
Stock exchanges, not frequently a target of public outburst, come in for heavy criticism from Lewis for purportedly rigging the markets. Lewis alleges that HFT firms pay huge commissions to stock exchanges for getting preferential access to buy and sell orders before the information goes public. If that does not shake you up, consider this: US stock exchanges flout all the transparency norms by renting out their space to the HFTs for faster access. Wall streeters call this arrangement Co-location. What this eventually does is, it allows the high frequency traders to front-run orders from one market to another.
'Flash Boys' makes for a great reading even if your knowledge of financial markets borders on the tangential. Credit goes to the author who never lets the complexity of the subject matter interfere with the intriguing narrative. Some of what Lewis unearths is well known by now, but I doubt if anyone else could have pursued this story so exhaustively. Having said that, let me say that it's is not a perfect book - Lewis' affection towards Brad Katsuyama and his venture, IEX, comes across as too embellished in some parts of the book. Also, a couple of developments in the final few chapters feel shoehorned. Nevertheless, the book does propel a plaguing issue to the fore and since its release, 'Flash Boys' has managed to kick off a worldwide debate on the ills of high frequency trading. I hope that Lewis' work shakes regulators off their slumber and averts a bigger flash crash. Finally, while the jury is still out on the severity of the downside of algorithmic trading, a lot of what Michael Lewis says makes utmost sense. 'Flash Boys' is worth spending your time and money on.