Michael Lewis’s book Flash Boys has become a lightning rod for the storm around high-frequency trading. The sparks started to fly with the March 30th airing of 60 Minutes when Michael Lewis said the “Stock market is rigged.” As most in the industry know, Lewis did the usual book tour stops. He landed on the NCBC program Power Lunch with Brad Katsyuama, the founder of IEX and hero of Flash Boys, and Bill O’Brien, the president of Bats Global Exchange, where, in the words of Bob Pisani, “a food fight erupted.” For nearly 25 minutes Bill and Brad went tooth and tong over market structure. Before we dissect the food fight let’s take a moment to review the story in Flash Boys and then see if these assertions make any sense.
Flash Boys is composed of eight chapters and an epilogue. The first chapter is about the Spread Network which cost $300 million and took 3 milliseconds off the transmission time from Chicago to New Jersey. The book ends with an anecdotal visit to a microwave tower that is part of a set of towers that will replace the need for the Spread Network. Technology marches on. The fifth and eighth chapters relate the saga of Sergey Aleynikov, the programmer who was indicted and convicted for stealing code from Goldman Sachs. Lewis gives this story the credit for his interest in understanding the inner workings of the stock market and leading him to Brad Katsyuama of IEX.
Each of the five chapters about IEX tell the story of the company by profiling five of the early employees including the founder Brad Katsyuama. We learn about Brad’s history at RBC and the development of Thor, a special trading product RBC developed to be able to “hit” all the markets at the same time.
Behind the development of Thor is Brad’s sense that institutional orders sent in by traders were being gamed and exploited by HFT. After some success with Thor and further contemplation about the issues of execution in the highly electronic markets, Brad took the very bold step of leaving RBC and committing himself to the startup of IEX where the IEX team would plan to build an exchange friendly to institutional orders. We then learn a bit about the early days of IEX and the difficulties of a startup.
It is interesting to note that the regulatory environment that later is given blame for allowing HFT to rig the market is the same regulatory environment that allowed and encouraged IEX. Fast forward to 60 Minutes where Lewis says he was trying to figure out what was going on in the stock market. When he asked institutional investors, they said, “There has been one guy who has come around and told us the truth — Brad Katsuyama.” So Michael Lewis looked him up and decided to write Flash Boys.
Where’s The Data?
Taken as a novel, Flash Boys is descriptive, easy to read and does a lovely job of portraying the character and personality of the IEX team. Looking at it as a treatise on market fairness and market structure it is significantly lacking. There are obvious defects in Lewis’s research: He has no discussion with the exchanges or with other ATSs (which IEX technically is); no discussions with anyone connected to high frequency trading; and no, I mean none, zero, data analysis that might have helped to clarify the problem.
Yes, there are some anecdotal guesstimates of the billions of dollars that HFT could be ripping off assuming they could steal a penny on every share that trades but those numbers are highly inflated and conflict with the actual earnings of the HFT crowd. HFT earnings are dramatically lower than the estimates of the book, the actual earnings of the HFT traders is three to five hundredths of a penny per share, nowhere close to the quoted penny per share. Earnings estimates for all of HFT trading have dropped from $7.4 billion in 2009 to an estimate of $1.3 billion in 2014, according to TABB Group estimates.
Also missing was any historical perspective or discussion of the efficiencies that electronic trading has brought to the market place. It is universally agreed that the costs to execute have collapsed which benefits all investors. “Equity Trading in the 21st Century: An Update” a white paper by James Angel, Lawrence Harris and Chester Spatt released June 2013, shows that by 22 different data driven metrics the equity markets are still improving and have never been better for investors. The improvement in these metrics is precisely what the regulators wanted to achieve with their rule changes.
The competition and innovation in the marketplace have created the most efficient capital market in the world. Multiple investment managers, those that enter their orders into the market and could fall prey to HFT, have stated publicly that the market is not rigged and that there has never been a better time to invest. Clifford Asness and Michael Mendelson wrote and excellent editorial for the Wall Street Journal, published on April 2, 2014, and it concludes that for the first time in history the market is rigged for Main Street and not for Wall Street.
Joe Brennan, global head of Vanguard’s equity investment group, said that only a minority of high-frequency traders may be hurting other investors and that efficiencies from technology advances have lowered costs of execution. Vanguard handles assets worth over $2 trillion. In a letter to the SEC in 2012, Vanguard estimated that high-frequency traders had helped to reduce transaction costs in the previous 10 years by 1 percentage point for every “round-trip” transaction, which includes a buy and sell. On a $10,000 investment over 30 years, the difference between a 9 per cent annual return and an 8 percent annual return is about $32,000, according to the Vanguard letter. This was reported on Bloomberg on April 3, 2014.
Some Editorial License
There are also issues with what I will call editorial license. There are three that merit mention. The first is the concept of “riskless profits.” These are referred to as the life blood of HFT. Riskless profits are an urban legend. Every order entered into the market creates risk for the initiating side and tremendous amounts of resources have been consumed keeping up with risk management both pre and post trade. It is common to say that the algorithms “know” how big the orders are and how much they will pay but they are actually guessing. Knowing and guessing reflect very different degrees of risk. Second, the markets are “dehumanized”. Even though algorithms are used for execution and stat arbs may use complex formulas to monitor and trade relationships between stocks, the principal valuations come from the very human portfolio managers at places like Vanguard that decide on individual companies’ prospects and which ones should be included in their portfolio. Lastly, and this is not unique to Flash Boys, the comment that dark pools are not regulated. This is just plain false. All dark pools are ATSs, all ATSs have to be broker dealers and all broker dealers are regulated by FINRA and the SEC who perform regular audits of all broker dealers.
Flash Boys does make two excellent points. During his research on the markets John Schwall comes back to report that “every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice.” This is very true and is a warning to us all that we need to be very careful and thoughtful about making hasty changes in market regulation. The last point is a tip of the hat to Michael Lewis for sharing the story of Brad and the team at IEX who have seized the American Dream to solve a problem and build a business.
Those of us at PDQ have been on a parallel path and we believe that we offer an excellent solution to market structure issues and wish IEX all possible success.
Bio: D. Keith Ross, Jr. is CEO of PDQ Enterprises, LLC.
