Flash Boys: A Wall Street Revolt
W. W. Norton, 2014, 271pp
I am not a sports fan. I once attended a Seattle Mariners game — we had great seats, front row at third base. I was bored by the end of the first inning. I did enjoy a few Everett Giants games, but in the minor leagues the baseball is probably not the important part. Giants games were outdoors, they had far better hotdogs and beer than anything at the Kingdome, and the tickets were free because I only went when the Empress Larkin was in charge of the alto line in the national anthem. Oddly, I seem to actually enjoy sports movies; The Natural, The Replacements, Bull Durham, and Moneyball all come to mind. In the last case, I also read the book, and was somewhat surprised to learn that Michael Lewis could actually make baseball statistics interesting. When Flash Boys came out, relating to a somewhat more interesting subject, I had to take a look.
As the book opens, Lewis relates that 205 eight-man crews were laying fiber between the South Side of Chicago and Carteret, New Jersey. The crews had no idea what they were building, but if they had all gotten together to plot their work on a map they would have seen that they were laying a conduit along a straight line, therefore the shortest distance, between two data centers. The route had not been selected for speed of digging, in fact they spent a great deal of time boring through mountains rather than deviate from that path. a digital signal from the Chicago Board of trade and NASDAQ data centers required 16-17 ms to make the round trip. Some traders had discovered a Verizon route that cut the time to 14.65 ms and were able to make significant money on the times they found themselves on “The Gold Route”. Those crews were laying a conduit to carry 400 strands of fiber along a path that would require only 12 ms, and they planned to lease the use of the cable for millions. A high-speed trading firm wanting a pair of those fibers (one each way) was asked to pony up $300,000 a month and several million in start up costs. And they all signed up.
Why on earth would these brilliant players shell out that kind of scratch to save 2.35 to 5 ms to send a few messages from Chicago to Trenton? Well, it wasn’t a few messages, it was thousands per minute. And the high-frequency traders (HFTs) had discovered that if their connections were fast enough they could learn a buyer’s interest in a stock, including the price the buyer was offering, and rather than arrange the trade at the best price in the market, they would buy the shares for a penny or two less and pocket the difference when they delivered the shares to the buyer. So who cares about a few pennies? Well, just about anybody that can do it a million times a day. The HFTs could do that, and though there is no real accounting for their results, Lewis estimates that their advantage earned them over $10 billion per year. Even if investing holds no interest to you, that kind of money probably does.
Lewis identifies several participants in the marketplace who discovered and attempted to eliminate these games; one was a manager of electronic trading at Royal Bank of Canada (Brad Katsuyama), one a communications wizard who had worked for MCI, Qwest, and Level 3 but really wanted to be in finance (Ronan Ryan), and one a Russian programmer working for Goldman Sachs (Sergey Aleynikov). Katsayuma led a group that formed IEX, a trading platform based on introducing delays in transmissions to eliminate the time differences that some of the HFTs were using to exact their hidden tax on most transactions, some of which Ryan made possible. IEX is currently treated as one of the “dark pools” but with far greater transparency than any others in that group and is working on the process of becoming an actual exchange. Their current volume is similar to Deutsche Börse, higher than Hong Kong, but less than 5% of the size of NASDAQ. I see that IEX traded over 116 million shares on the 4th, they got a lot of attention when this book hit the market.
Lewis also looks at the risk of things like the “flash crashes” that have staggered markets a few times, but only in passing. The question that this book really addresses is whether or not the HFTs are a positive part of the market. As Lewis documents, they have been trading in ways that come close to theft but they have also forced the buy/sell price spread down which benefits everyone. Some argue that the HFTs contribute by “making a market”, but Lewis points out that they don’t actually perform that function when a stock is under pressure which is the only time it really makes a positive difference. My conclusion is that the HFTs may have been important in providing the volume that made today’s trading so inexpensive, but what the HFTs are actually doing on those networks is a net loss to the economy.
If you have a mind to learn how to play the HFT game for fun and profit, you could learn a lot from this book but it isn’t going to teach you the nuts and bolts of how to do it. Flash Boys does a great job of illuminating the processes of today’s markets for those that are interested, and like I said at the outset, Michael Lewis, who wrote a book that made baseball statistics fascinating, writes in a way that makes even the backrooms of the market’s heavy hitters sound interesting.