If Michael Lewis’ work has one overriding theme it’s a broad exploration of the idea of value and what things are really worth. However, if he has a second theme, it’s the people who identify that value. Lewis’ protagonists tend to all fit the same mold: brave, smart people who have gone against conventional wisdom and identified what is valuable in a certain situation whether their peers agreed with them or not.
As such, Lewis’ most recent release, Flash Boys, seems to cut against the grain. The math-oriented, technologically-superior high-frequency traders (HFTs) would, at least on the surface, seem to have more in common with Oakland A’s GM Billy Beane or hedge fund manager Steve Eisman than the slow, inept thinkers who are usually depicted as the antagonists of Lewis’ stories.
Seeing an opportunity to squeeze in between trades and create arbitrage opportunities worth billions by exploiting a network of investment funds that barely understood the nature of the trades they're making would seem like the sort of behavior Lewis has previously championed.
However, Lewis seems to have a more passionate take on the subject matter of Flash Boys than he’s held on in the past. His respect for his subjects, and disdain for inefficient systems, is nothing new, but Flash Boys seems to read like an entreaty for a broader crusade in a way his past works haven’t.
This isn’t to say that Liar’s Poker didn’t go to great lengths to detail the corruption and exploitation taking place behind the trading desks at major Wall Street firms, or that the incompetence leading up to the housing crash in 2007 wasn’t treated with disdain in The Big Short, or that the way the crushing poverty of Memphis was sapping America’s talent pool wasn’t presented as an indictment of our entire society in The Blind Side.
But in Flash Boys, the strident, angry tone that Lewis strikes does seem like at least a partial departure for him. His description of the predatory nature of HFTs, their cozy relationship with the exchanges and big Wall Street banks, and the way they were skimming profits off of trades made on behalf of millions of average investors all seem to vibrate with an anger that Lewis has at least attempted to filter through some degree of objectivity in his past works.
Are the Markets Rigged?
Flash Boys focuses on the way the permanent shift to electronic trading by American stock exchanges opened up an opportunity for HFTs to routinely take advantage of lagging connection speeds and the relative inefficiency of a system with over 30 interconnected exchanges.
HFTs, utilizing the fastest possible connections, wait until certain sell and buy orders trigger their algorithms and then beat buyers to the other exchanges. So, if a 10,000 share buy order for Apple (AAPL) stock goes to the BATS exchange, BATS will most likely be able to fill only a portion of this order. The HFTs, noting the player buying up shares, will race ahead to other exchanges, buy up shares of Apple before the newly created demand can hit those markets, then sell the shares to the initial buyer at a higher price. All of this happens in thousandths of a second, with the HFTs who are microseconds faster than the next guy reaping all the profits.
It’s ultimately a way to make pennies on each share traded, sometimes just fractions of pennies, but it’s virtually risk free and consistent in a way no other investor or trader could ever dream of. And in doing so, HFTs have been able to skim a few percentage points off the top of the entire stock market. However, while at first blush this seems like a simple case of expertise and superior technology being used to create arbitrage, Lewis’ book also exposes a dark underbelly to HFTs.
HFTs cut deals with exchanges to place their computers right next to the exchange’s servers, shaving valuable microseconds off of their trade times; they convinced exchanges to maintain a complicated and corrupt bid-ask and maker-taker systems that allowed them to continue exploiting investors; and they paid off major investment banks to give them access to bank “dark pools” (private exchanges that were supposed to solely contain that bank’s clients).
In the end, while HFTs displayed considerable ingenuity and drive (the book describes one effort to build a fiber optics cable from Chicago to New Jersey taking as direct a route as possible to shave milliseconds off of the time it would take to move information on prices), they also purchased access and influence. And it was that cozy relationship with exchanges and major brokers that allowed them to extract huge sums of money from average investors.
The protagonist, in this case, is one Brad Katsuyama, a trader with the Royal Bank of Canada (RY) who first noticed the odd trading patterns and took a closer look. Katsuyama discovered that the complicated nature of trading stocks remained a mystery to the biggest traders on Wall Street, and it was this general ignorance that opened the door to corruption and exploitation.
Katsuyama decided he wanted to do something about it, ultimately leaving RBC along with a merry band of like-minded individuals to found his own exchange, the Investors Exchange (IEX). There, by using coiled fiber optics and a limited number of options for offering bids and asks, the exchange works to ensure that investors can purchase the shares they want at the best price the market is offering without HFTs slipping in between them and their trade.
A Market Solution for a Market Problem
As noted earlier, previous Michael Lewis works have gone to great lengths to present certain people in a positive light while indicting others for showing a lack of understanding. However, Flash Boys displays a clear taking of sides that was less explicit in previous works.
And in part, it appears as though Michael Lewis’ moral outrage derives from that of his protagonists. Katsuyama and his associates describe how they got angry with what they discovered about the markets and decided to do something about it. If there’s one criticism of the book worth voicing it’s that it potentially lacks objectivity and goes to too great a length to paint HFTs as villains while pumping up Katsuyama and his coworkers.1 It’s ultimately hard to read Flash Boys as anything other than a whole-hearted endorsement of IEX and its creators. Which could explain, at least partially, why Lewis ultimately saw HFTs in such a different light from his previous subjects who took advantage of imperfect value systems for their own gain.
The anger that anyone would be permitted to do what HFTs have done clearly bleeds from Katsuyama et al into Lewis’ prose. However, the fact that Katsuyama and the other founders of IEX sought out a market solution rather than attempted to change the legal structure probably indicates why Lewis was so willing to promote their cause.
The book describes how each system used to exploit investors was addressed by a new law or laws that ultimately gave rise to the next system used to exploit the average investor, dating back to the beginning of the stock market. Reg NMS, for instance, is a legal requirement that brokers must seek out the best available price on any stock secured for their clients. It clearly has investors at heart, but that didn't stop it from becoming the framework that allowed HFTs to prey on investors by forcing brokers to seek trades across the different exchanges to seek out that best price.
Can Katsuyama Succeed in Remaking the Stock Exchange?
Where the investors in The Big Short zigged, using the discoveries they made about a woefully corrupt system for their own personal gain, Katsuyama zagged, seeking out a solution that would create a fair market that the average investor could count on.
This isn’t to say that Katsuyama isn’t set to profit immensely should IEX ultimately catch on, but the emphasis in Flash Boys isn’t on his capacity to personally benefit in the way it was for the protagonists of Moneyball or The Big Short. No, Katsuyama falls more into the mold of the Tuohy family in The Blind Side, struggling to make right despite a system virtually designed to prevent one from doing so.
It could be that this particular subject gets such a pointed response from Lewis that speaks to just how strongly he feels about it. Lewis himself started in the world of finance and, while Liar’s Poker certainly paints much of that world in a negative light, he does seem to have maintained a respect for the Jeweler’s Eye that the most respected traders possess.
Lewis admires those who understand value and refuse to let tradition or corrupt systems cloud their perception of that value. And in Katsuyama, it appears as though Lewis has found his champion. Katsuyama isn’t just a person who displays that Jeweler’s Eye but a man committed to creating a market where anyone can attempt to apply their own idea of value without falling prey to forces they cannot anticipate or counter. For Lewis, it seems IEX isn’t just about one man’s quest to find value, it’s about building a place where success for all is defined by their ability to spot it.
Lewis often seems almost wistful in describing Wall Street, at once horrified by its lack of ethics and enamored with how close it comes to creating a true meritocracy. While refusing to embrace Wall Street, he’s never been able to completely reject the potential that its open markets contain, as evidenced by the fact that it's the subject of three of his five books. And as such, it’s not hard to see how Lewis could view Katsuyama as his champion.
Can Lewis and Katsuyama ultimately move the needle on this? It wouldn’t be the first time. The revolutionary concepts explored in Moneyball have ultimately made their way into every front office in Major League Baseball (save maybe the Mets), and it’s hard not to at least partially credit Michael Lewis for this sea change.
Only time will tell if Lewis can help usher in an era of truly free markets, but the attention already being paid to Flash Boys seems promising. A fight between Katsuyama and BATS President Bill O’Brien on CNBC got a lot of attention, and the FBI and State of New York have already announced probes into HFTs. And certainly, enough exposure to the fair nature of practices on IEX could ultimately overcome the resistance of bad actors and force brokers to trade there.
Ultimately though, whether you completely agree with the book or not, it remains a fascinating read. It includes an exploration of some of the simplest transactions that take place on an exchange, transactions that occur millions of times a day but still remain a mystery to most people. Even if you ultimately disagree that HFTs are ruining our markets, you’ll at least leave with a much better fundamental understanding of how our exchanges and stock trading work. One that’s likely to be valuable as the ongoing debate over the book and its content rages on.
1 If there’s a second it’s that Lewis may overstate his case. Referring to the markets as “rigged” implies a total lack of fairness, but the price of stocks is only being moved a small fraction of their total by HFTs. While they’re arguably unfairly exploiting the system, the cost to each individual investor is most likely going to represent a relatively small portion of their portfolio and the broader shifts in the market continue to be driven by much larger factors. What’s more, the willingness to portray large institutional buyers and hedge funds as representatives of the average investor is defendable but somewhat problematic in nature.
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