A year ago, Michael Lewis inadvertently set a spark to a raging debate over high frequency trading with his book "Flash Boys."
His tale of a maverick group of Wall Street professionals seeking a better way for big institutions to trade stocks away from opportunistic middlemen quickly touched off a simplistic argument across media and finance over whether high-tech predators were picking the pockets of innocent little investors. Lewis’s own charge that the market was effectively “rigged” did nothing to cool the passions.
But to hear Lewis and his book’s hero, Brad Katsuyama, tell it, the story was less about one set of predators feeding off of helpless investors. Instead, it was about the way Wall Street had developed an overly complex, opaque system for trading stocks that levied a tax – an undemocratic, but ultimately voluntary tax – on investing.
As Lewis says in the attached video: “I thought what would be the takeaway from the book, if you are reading it as an outraged citizen, [is] that the targets of your anger would be banks and brokerage firms that were mishandling your orders or to put it more politely, responding to incentives in the marketplace to mishandle the orders. Exchanges that you think would be charged with creating a fair environment for investors to trade with each other that had actually sold advantages to one class of investor. And then thirdly, you might think about what the role some high frequency traders were playing."
“Instead,” he says, “everyone got furious with high frequency traders.” In part, no doubt, that was because “there was a lot of pent-up frustration and anger with high frequency trading that I tapped into.” Lewis, who is also the author of “Liar’s Poker” and “Moneyball,” elaborated on this thought in an Afterword in the new paperback edition of “Flash Boys,” also published in Vanity Fair magazine.
Not much has changed
Since then, much noise has been made by investor advocates, the electronic-trading industry mounted a counter-assault and regulators lobbed a handful of one-off enforcement actions, but little has changed in the way the market works.
So, upon a year’s reflection, what would Lewis and Katsuyama have regulators do to remedy the system’s shortcomings?
Not much, it turns out. Both of them suggest that trading venues should be more transparent about their rules, investors should be more educated about how to route their orders – including, of course, to the IEX trading network that Katsuyama founded, which welcomes all sorts of investors and traders who engage on roughly equal terms.
On the prospect for reform, Katsuyama says, “The hard part is trying to regulate technology and I think that's not really the role the regulators want to have, in terms of imposing their will as technology evolves. So part of it has to be by choice.”
IEX allows high-speed traders to participate in its market along with brokers and fund managers, but it doesn’t sell technology that allows them to gain a speed and pricing advantage over public orders.
Again, seeking to tone down the rancor that has enveloped this issue, Lewis says, “I always thought that the point of this was there's a chance for market-based reform, that the market can solve the problem, and that would be by far the best. So what needs to happen is investors need to vote -- and they are. There's a question about how long it takes or if they can attract a significant share of the market and so force the market to change.”
One could argue, of course, that this current measured tone also represents belated recognition that the situation was always more nuanced and less objectionable than perhaps “Flash Boys” portrayed.
For small retail traders, for instance, the system works rather well, furnishing instant, cheap trade executions thanks to heavy competition by wholesale market makers. A recent Barron’s study found that individual investors with, say, a Charles Schwab Corp. (SCHW) or Fidelity brokerage account tend to get better prices on their trades than they were willing to accept when they sent the order.
There is also evidence that the heyday of the HFT profit bonanza ended a few years ago, once big investment-management firms got up to speed on their own “smart” order routing technologies. It’s noteworthy that KCG Holdings Inc. (KCG), a big market maker that includes the business of pioneering HFT firm Getco, delivers unimpressive returns on its capital.
And, of course, for all of market history there has been a class of middlemen who tried to maneuver to profit from clues about where the order flow was headed. Some players have always operated at the highest frequency, however fast that was at the time.
What’s changed in the past 15 years or so is that largely successful regulatory efforts to narrow trading spreads and promote competition for order flow have combined with rapid advances in technology and decimal-based stock pricing to produce a maddeningly complex and decentralized trading arena.
Along the way, professionals with narrow interests managed to get certain order-handling rules written that created opportunities for them to profit from minute price changes over miniscule time frames. The appearance of competition doesn’t always mean deep liquidity, and dirt-cheap commissions don’t always capture the full cost of trading.
Tradeoffs were necessarily made among speed, liquidity and price. No one would suggest that this is the way we’d build a market from scratch, even if it functions pretty well for most participants most of the time. Maybe the next phase of the “Flash Boys” debate will address these issues with a bit more subtlety, as Lewis and Katsuyama suggest that it should.