Michael Lewis' 'Flash Boys' and the Continuing Story of Computerized Trading

High-frequency trading (or “HFT”) is suddenly the financial market scandal of the day. Michael Lewis has published a book that was featured on Sunday in a 60 Minutes report and in a story in the New York Times Magazine.  HFT is the use of high-powered computers, blazing fast connections with exchanges, and sophisticated trading algorithms to transact in time frames measured in milliseconds or shorter. The book, Flash Boys, recounts how a young executive on the trading desk at the Royal Bank of Canada detected and defeated the HFT firms that were using their speed to trade ahead of more conventionally equipped traders, like those who invest trillions of dollars for individual Americans, by anticipating the desire to buy or sell and then driving prices up or down over tremendously short time frames to profit at the expense of the target.

The reports refer to the fact that automated trading dominates the stock markets. But the regulators of the derivatives markets report that more than 90% of the exchange trades in that far larger market are executed by “trader-bots.” And trading in the derivatives markets is measured in the tens of trillions of dollars each year.

This type of activity has concerned many of us who believe that predatory and extractive behavior by Wall Street have burdened the economy affecting the American public for years. The methods described in Flash Boys are just a fraction of the ways that HFT extracts value from the markets while providing no benefits. The defenders of HFT claim that the trader-bots provide valuable liquidity to the market, meaning that they place orders that give assurance that investor transactions will be fulfilled. However, orders designed to detect a desire to sell and orders at rigged prices are not the kind of liquidity that benefits investors.

Lewis points out that the HFTs not only have to be faster than their targets; they also have to be faster than other HFT competitors. The first predator to the prey will feast. As a result, an “arms race” toward faster and faster capacity has caused the automated traders to invest billions in speed, driving trade times to a few milliseconds. This may be the best indication of how profitable this activity is.

Arguably, and shockingly, this behavior is legal. As with many other areas of the Wild West trading markets, the Dodd-Frank Act did nothing to curb automated trading. HFT is thought to be an unimportant threat to the financial system. Nonetheless, a flaw in the HFT system can be catastrophic. The infamous “Flash Crash” in 2010 saw almost $1 trillion of value evaporate from the stock markets, only to be mostly recovered all in a span of 40 or so minutes. Other lesser events have shut down exchanges and cost enormous amounts.

But it is not just that the regulatory regime does not prohibit the HFT scams. Years ago, the SEC got the idea that allowing multiple exchanges would foster competition. A separate system that searches the various exchanges for the best price was thought to assure investors of an optimal result. However, it takes time to search among the exchanges for the best price. That delay was precisely what the HFTs described by Flash Boys exploited. Similar multiple exchanges are used in the new derivatives markets mandated by Dodd-Frank.

A recent study out of the University of Chicago looks at transactions in financial instruments that should be priced exactly the same, but trade on exchanges in Chicago and New York. The study finds that if one examines price changes of the two financial instruments over short enough time scales, their price movements are uncorrelated. By operating at these small time intervals, HFTs can extract the value of this anomaly without appreciable risk. This is nothing but a burden on the capital markets.

It is not just that this costs investors money. Investors are aware that the markets are crawling with predators. In anticipation of this, they are driven to adjust prices that they demand to compensate for the inevitable costs. This means that every business, government and household that depends on the capital market for capital funding is penalized, having to pay more for capital funding. Thus, the public as a whole, whether they invest or not, pays a price.

Flash Boys describes a portion of the harmful behavior of HFTs. However, there are many activities other than HFT that the financial sector engages in that similarly cost the economy hundreds of billions each year. Dodd-Frank was long on measures designed to prevent another total market meltdown, though it was far from perfect on that score. However, it was much less focused on preventing legalized theft from the economy. The regulators and Congress have plenty of work to do if they are to solve that problem.

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