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I am not sure quite what constitutes a ‘No1 International Bestseller’, but the non-fiction author and financial journalist Michael Lewis has one with his latest book ‘Flash Boys’ – an account of the impact of ‘high-frequency trading’ on the US stock market. And it has certainly created a bit of a stir in the world of finance.
The timing of its release has also been impeccable. There are currently several investigations into this type of rapid electronic trading in the States by the New York Attorney-General, the FBI and the US Department of Justice. And a high frequency trading (HFT) company called Virtu Financial delayed a planned equity fund raising due, in part, to the controversy caused by the book.
There is something deliciously ironic about the information in a book that took months to create disrupting a business that deals in information in milliseconds. I suppose when your main business activity is akin to looking through an investment microscope at thousands of minor financial imperfections, it’s hard to notice an author creeping up behind you and about to slap you around the head with the literary equivalent of a big wet fish.
The inside sleeve of the book promotes itself as follows:
‘If you thought Wall Street was about alpha males standing in trading pits hollering at each other, think again. That world is dead.
Now, the world’s money is traded by computer code, inside black boxes in heavily guarded buildings. Even the experts entrusted with your money don’t know what’s happening to it. And the very few who do aren’t about to tell – because they are making a killing.
This is a market that’s rigged, out of control and out of the sight; a market in which the chief need is for speed; and in which traders would sell their grandmothers for a microsecond. Blink, and you’ll miss it’.
That, to put it mildly, sounds quite serious. And there is plenty more hyperbole throughout the book, which follows a traditional Hollywood path of good versus bad.
On one side we are told about the secretive development of the hardware and software to support the need for trading speed between the HFT firms and the various exchanges – who collectively are our ‘baddies’. On the other, we have our real life heroes led by Brad Katsuyama, an equity trader at the Royal Bank of Canada in New York.
Having finally worked out how the HFT firms are using the speed of their systems to pickpocket his own trades, Katsuyama seeks to level the playing field. First by getting his team to design an order routing system for his own clients that negates the HFT speed advantage and finally by attempting to set up, with others, his own fairer exchange.
There are other supportive subplots and by the end of the compelling narrative you are likely to feel enraged at the status-quo but hopeful something is being done about it.
It’s a great read, but is it fair and accurate?
To answer that let me give you a brief history of electronic trading to better explain where we are today and what the problems are.
As the book itself points out, the move towards electronic trading worldwide has been evolving over some time and is almost complete – bar a small amount of activity on what remains of the New York Stock Exchange floor. The London Stock Exchange made the switch in 1986 and in Tokyo the option to trade all blue chip stocks electronically began in 1991.
I was in Tokyo at that time as the head of stock index products for a broker called James Capel and this was an important development. It meant it would be possible to instantly replicate the Nikkei 225 index by simultaneously trading in all 225 of its constituent stocks. And it set off a bit of a race between the competing brokers to develop their own systems to do just that.
When I say race, it was less of a ‘Space Race’ and more like the Red Bull Flugtag challenge. There were some pretty basic and expensive mistakes being made.
The main problem was that you had to find a solution to communicating with the Tokyo Stock Exchange hardware that each broker had in their offices. Our solution was just one evolutionary step up from two tin cans and a piece of string as our owners, HSBC, decided the technology budget was closed for the year. So the local chairman and I decided to pay for it ourselves.
And it worked. It involved a set of 3 weighty Toshiba laptops that together had far less processing power than your current mobile phone. One machine generated a floppy disc with the orders on that was then thrown across the office to be put in the Tokyo Stock Exchange kit, the others were for amending orders and retrieving prices.
By modern standards it was patently archaic, but within a month our little team executed the largest client order ever taken by the company in Asia at that time. And our domestic staff were especially happy as the large order screens that adorned every dealing room in Tokyo were filled with 225 trades slowly scrolling upwards with the words ‘James Capel’ next to each one.
Fast forward to today and the equivalent of throwing a floppy disc across a trading room is now done in milliseconds. In the States there are also now 13 different exchanges and 40 dark pools (mini exchanges within brokers that match their own inventory). However, the time it takes to communicate with each exchange is different by a tiny but, as Katsuyama found out, significant amount.
What Katsuyama discovered was that in the time it took his orders to reach the different exchanges, the market appeared able to react. The book alleges HFT firms were ‘noticing his demand for stock on one exchange and buying it on others in anticipation of selling it to him at a higher price’. And he puts this down to the speed advantage paid for by the HFT firms in order to link the exchanges together efficiently and make a ‘killing’. It also is why the book and Katsuyama himself have claimed the system is ‘rigged’.
You might ask, if this is correct, why don’t current regulations prevent this? Well the irony is that the current rules were established in 2007, two years after five specialist firms based on the floor of the New York Stock Exchange were fined $241m in penalties for trading ahead of customer orders. One of the rules mandates the equivalent of a supermarket price-match between the exchanges, but the time lag in its calculation gives HFT firms a window in which they can “make rapid and often risk free trades before the rest of the market can react” – to quote Eric Schneiderman, New York Attorney General.
Whether or not the book is fair and accurate will depend in part upon the outcome of the current investigations and there is clearly a serious case to answer. However, I certainly doubt that the gulf in morality between the two sides is as wide as is portrayed. As just one example, all our heroes are introduced via their individual emotional experiences of 9/11. No doubt, there are HFT employees with equally harrowing tales to tell.
For their part, the HFT companies say their activities are legal and add significant liquidity to markets and have lowered the cost of trading for everyone, especially smaller investors. By liquidity they mean that prices are more fluent and volumes are higher – in other words, when you want to trade you can.
My own experience is that the smaller investor is currently paying less, but market liquidity will prove to be as fickle as ever if volatility increases. And given the current stretched market valuations, that is certainly possible. For larger investors and those managing the money of others the book has represented something of an embarrassing awakening and the resulting concern has meant some, such as Fidelity, are seeking to establish their own trading platforms. Others are calling for the return to one central exchange as a utility.
But not all large investors are negative. Bill McNabb, the chairman of Vanguard and a champion of low cost index funds for small investors, backed HFT in an article in the FT saying it had helped cut trading costs and the overall market isn’t rigged. The head of the same company’s index group was a little less sanguine, suggesting some undertake activities that are “arguably legal but not necessarily right”.
In terms of overall cost, I am far more concerned about the systemic issues HFT can potentially create. Their strategies have to be written in code in advance and systems that can place orders in milliseconds can also withdraw those orders in milliseconds and make errors in milliseconds. We had the Flash Crash in 2010 and in 2012 HFT firm Knight Capital managed losses of $440 million in less than an hour due to a trading error.
For private investors, this is just another reason why you need to be disciplined and there is more than one approach to achieving this aim. However, they all require a long term outlook. It is difficult to keep emotions in check with so much apparently easy money to be made but, as I wrote in my last blog, it’s time for a little caution – time to be a little less ‘flash’.
- past performance is no guide or guarantee of future returns;
- the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing.