Friday, August 22, 2014

Flash Boys by Michael Lewis

 As in his earlier books, Lewis tackles a subject that is probably mind-numbingly complex to most Americans, and turns it into an interesting narrative. In Flash Boys he digs into the story of high frequency trading, or HFT, and how its growth has created a hidden "tax" on all investors.

The basic idea is that sometime shortly after the advent of fiber optic cables which transmit stock trading information between brokerages, banks and exchanges some traders realized that the amount of time information took to reach its destination could vary, depending on the length of the path taken, and that "All optical fibers were not created equal; some kinds of glass conveyed light signals more efficiently than others." Therefor, if they  paid for connections to the exchanges with very short physical distances, they could see the information on price changes and orders being placed before anyone else, and take advantage of that information in various ways to make money.

"The race they (high speed traders) needed to win was not a race against the ordinary investor, who had no clue what was happening to him, but against other high speed traders."

For a vastly simplified example, a large investment firm might want to place an order to buy a million shares of Coca Cola stock, and as a prelude to that order, they would begin by placing a small order, just to find out what the current market price is. A high frequency trader who is in the position to see that small order being placed before any other sellers see it can immediately place orders of their own which drives up the demand, which drives up the price, and they make a profit on the spread between the two.

Brad Katsuyama, who worked for the investment arm of the Royal Bank of Canada, discovered that somehow "the market" seemed to be anticipating his stock orders, and between the time he got a price quote, and then actually placed the order, only seconds later, the price had risen. This was costing his bank and its clients a great deal of money. As he began to investigate things to try to figure out why this was happening, he uncovered the entire murky business of the high frequency traders, and embarked on a crusade to make the market "fair" once again for all investors.

If you're thinking that you shouldn't care, because it's just the big banks getting played, and they make lots of money anyway, you need to remember that every small investor with a 401K plan has their money with some brokerage firm or bank, and every time the mutual fund in that 401K buys and sells stock, it costs more and sells for less, because of the HFT folks. We all get skinned.

One little interesting tidbit:
"During World War II his (Brad Katsuyama) Japanese Canadian grandparents had been interned in prison camps in western Canada."

I thought only the big bad U.S. interned its own citizens during the war. You mean to tell me that other nations thought their foreign born citizens might be a security risk, too?

Lewis also talks about "dark pools" a bit. A dark pool is an internal stock exchange run by a big bank in which one client is able to sell to another client very quietly, without the public exchanges becoming aware of the transaction, while the bank takes a cut of the transaction.

"The amazing idea the big Wall Street banks had sold to big investors was that transparency was their enemy. If, say, Fidelity wanted to sell a million shares of Microsoft Corp. - so the argument ran - they were better off putting them into a dark pool run by, say, Credit Suisse than going directly to the public exchanges. On the public exchanges, everyone would notice a big seller had entered the market, and the market price of Microsoft would plunge. Inside a dark pool, no one but the broker who ran it had any idea what was happening."

I rather loved this quote from one of the Irish-born programmers, Ronan, who went to work with Brad in his crusade to take down the HFTs.

 "I'm making thirty-five and they're making a buck twenty and they're f**king idiots."

And in the spirit of the corruptocracy that our nation has beome:

"...more than 200 SEC staffers since 2007 had left their government jobs to work for high-frequency trading firms or the firms that lobbied Washington on their behalf. Some of these people had played central roles in deciding how, or even whether, to regulate high-frequency trading." 2011 RBC study

Talking about why Russians seemed to end up programming for the HFTs,

"Good Russian programmers, they tend to have had that one experience at some time in the past - the experience of limited access to computer time."

I remember those days, myself. We used to have to make our programs lean and mean, because they ran on shared resources, which we were allowed to use only in specific time slots. With apparently unlimited data storage space and massive amounts of RAM available on inexpensive computing platforms these days, it's no wonder code multiplies indiscriminately.

This book was both fascinating and a bit worrying. Lewis never does come right out and say, "Brokerage A and Bank B have the programs in place to not get taken advantage of by HFT" and I really wish he had, so I'd know where to place my bets.

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