- How high frequency trading works against investors.
- Highlighting the sleuthing efforts of Brad Katsuyama to bypass the digitization of Wall Street.
- Using a financial transaction tax (FTT) to curtail HFT.
Flash Boys by Michael Lewis, WW Norton, New York, 2014
It has fallen to celebrity author Michael Lewis to bring to wider public attention the predations of high frequency trading (HFT). I reviewed Sal Arnuk and Joe Saluzzi's Broken Markets (2012) and Scott Patterson's Dark Pools (2012) and hoped that these well-researched books would gain some traction and lead to new SEC rulings to address the speed-up and computerization of Wall Street and how the SEC's well-intentioned Reg NSM had helped usher in this restructuring of equity markets. Even Saluzzi's high-profile interview on CBS 60 Minutes (2010) in a well-researched segment seemed to have little effect, and reforms were bogged down in the SEC's ineffective attempt to explain the May 2010 flash crash.
Even the SEC had its own internal problems of outdated technology and its own staff defections joining the HFT firms. How can retail investors and the public learn the truth about the electronic takeover of Wall Street and the complicity of the NYSE, NASDAQ and the proliferation of new exchanges in all the new games: maker-taker markets, the latency and co-location battles, diverted order flows, flooding exchanges with orders and split millisecond cancellations, phishing and front running?
Enter Michael Lewis. In Flash Boys, Lewis uses his enthralling story-telling skills to probe ever deeper into this unhealthy transformation of Wall Street and its hopeful implications. The electronic disintermediation I have been forecasting has now eliminated the role of human intermediaries in Finance! For full disclosure, my spouse of over 25 years Alan F. Kay was arguably the first computer expert to bring computerized trading of large blocks to Wall Street with his company AutEx, even before the US taxpayers had funded and developed the internet. By 2012, AutEx had been acquired by Thomson Reuters and, Kay in an editorial aired his dismay at how computers were being misused along with all the publicly funded public infrastructure: satellites, communications networks, R&D in fiber optics and the internet itself. Kay had begun to rue the day he launched AutEx in 1967. Michael Lewis confirmed all these misgivings in Flash Boys.
Kay and I decided in 1995 to promote at least one instrument to slow the speed of equity markets, a financial transaction tax, first proposed by James Tobin in the 1970s and later endorsed by Larry Summers in his 1989 paper When Financial Markets Work Too Well: A Cautious Case for a Securities Transaction Tax. Our paper, Introducing Competition to the Global Currency Markets, in Futures (UK) in 1996, examined the burgeoning FOREX markets then trading some $1 trillion daily and called for currency exchange taxes and other reforms. We elicited many expert comments as members of the Global Commission to Fund the UN, documented in its report, The UN: Policy and Financing Alternatives, which I co-edited (Elsevier Science UK 1995). After fierce pushback by then Treasury Secretary Larry Summers, the World Bank, the IMF and many Wall Street grandees, all claiming that collecting such a tax was impossible, Kay and I patented our Foreign Exchange Transaction Reporting System (FXTRS) showing how to bring transparency to FOREX markets and collect the .001% tax we proposed.
Lewis followed, with relentless logic from his in-depth reporting, the role of the book's unlikely hero, Brad Katsuyama, an unusually motivated trader in the New York office of the Royal Bank of Canada (R B C). Katsuyama's detective work on why his trades and some of the biggest banks and smartest hedge fund players kept getting "scalped" led to his uncovering the extent to which human intervention had been bypassed by electronic routers programmed by algorithms and targeted by HFT players to the best-paying maker-taker platforms with the winning latencies, co-locations and shortest fiber optic cables.
This disintermediation of whole sectors of the US economy due to the march of digitization is documented by former Microsoft (NASDAQ:MSFT) chief scientist Jaron Lanier in Who Owns the Future (2013) and by MIT experts Erik Byrynjolfsson and Andrew McAfee in The Second Machine Age (2014). These authors document how earlier stages of automation of agriculture then factories have now led to the recent digital takeovers of newspapers, media, retailing of eBay (NASDAQ:EBAY), Amazon (NASDAQ:AMZN), Microsoft, Oracle (NYSE:ORCL), Cisco (NASDAQ:CSCO) and later the rise of social sites Google (NASDAQ:GOOG), Facebook (NASDAQ:FB), Twitter (NYSE:TWTR), LinkedIn (NYSE:LNKD) and YouTube. Their business models take the personal information provided by their users and sell this to advertisers or pass it on to the NSA. These authors' dire warnings of jobless growth went unheeded as white collar jobs: lawyers, accountants, travel agents, insurance agents, bank tellers, fell to computer programs.
Michael Lewis in Flash Boys fleshes out how digitization of Wall Street actually happened - and led to mini-repeats of the 2008 financial crises and the May 2010 flash crash and all the other smaller crashes since. Early computer reform efforts to create electronic trading platforms that were more transparent and less subject to human traders' games had gone wildly awry. Clearly Lewis shows that humans are no longer needed on Wall Street to intermediate between buyers and sellers. Brad Katsuyama's dogged pursuit of the truth and his creation for UBS of its Thor system provided a safe haven for many financial firms sick of being scalped or front-run in electronic markets they no longer trusted. Lewis points out the ignorance of even the biggest Wall Street players. While they played head games with quants and fancy math-based risk models, they overlooked the physical realities of their own technology: the routers, the hardware and those fiber optic cables and now microwave towers. Lewis shows how the "masters of the universe" were on a head trip in their illusions of abstraction and obsolete economics. Their technology staff were considered "plumbers" and paid far less than the prop traders and often uninformed sales staff.
Will Flash Boys reach a wide enough audience to force the SEC to finally address these HFT issues and ban electronic forms of front-running? The regulators will need to suit up to play and are already getting the same kind of push back as author Lewis as well as the other crusading authors mentioned earlier. Lewis describes in detail the "win-win" outcome for society and small investors as well as large institutional funds which is Brad Katsuyama's brainchild, the IEX platform. This new investors' exchange is pioneered to block all HFT traders and operate exclusively for "plain vanilla," honest, transparent trading between buyers and sellers directly. Many traditional Wall Streeters are furious that Katsuyama's crusade to reform markets turned into a profitable and growing market opportunity. Markets cannot function without trust, and I'm hoping IEX succeeds in its reform mission. Traders need to buy this book soonest!