I live a fairly insulated life, but even I couldn’t escape the press for Michael Lewis’s Flash Boys. For about two weeks around its release, an hour didn’t seem to go by without one of the 24-hour business news channels discussing the book’s basic premise with so many talking heads in so many split screens, I thought I’d temporarily been given a fly’s eyesight. Bar after bar, waiting room after waiting room, there it was, a question emblazoned across the screen’s bottom banner, just above the stock ticker: Is the Stock Market Rigged?
The coverage was sensational, as it usually is on channels with a 24-hour shaped hole to fill each day. But it’s worth asking the question: Are they right? Is the stock market really rigged, the way Lewis purports in this book? And if it is, how does that affect us, the small time investors?
Flash Boys concerns a group of Wall Street traders and technologists who find each other and form a ragtag team after being spooked by various unexplained occurrences in the stock market. The main protagonist, Brad Katsuyama, finds that when he tries to buy stock on his trading screen, that same stock disappears, almost as if a ghost rushed in and stole it from him. Another, a foul-mouthed Irishman named Ronan – a perfect Michael Lewis character who speaks profanity to power – starts to notice that companies are installing servers closer and closer to the stock market exchanges, and refreshing their hardware constantly to gain just microseconds of processing speed. All of these characters, alone and then together, learn that the new world of Wall Street is run by two new separate but entangled forces: High Frequency Trading (HFT) and Dark Pools.
To put it in basic terms, HFT firms use a speed advantage to perceive what is about to happen in the stock market and act first for a near-guaranteed profit. There are multiple stock exchanges where traders can buy and sell. And, due to regulations, which require that a broker try to get the best price for a client, each of these exchanges must be checked when an investor buys a stock. Even though this process of checking multiple exchanges can happen in milliseconds, a HFT firm is so fast that they can “see” this happening on the first exchange an investor checks, then quickly buy or sell stock from other exchanges, knowing that the price is about to change. These HFT firms don’t hold their stock and don’t add anything of value to the financial markets. In Michael Lewis’s telling, HFT trading acts as a type of tax on the stock market, shaving pennies off of the transactions of big time investors and small time 401(k) holders alike.
In addition, many large investment banks, including J.P. Morgan, Goldman Sachs and Credit Suisse operate something called Dark Pools. The nefarious-sounding name belies a simple concept: a Dark Pool is a private stock exchange, owned by an investment firm, that deals only in the stock traded by that firm’s customers. Meaning that if a big investor asks Goldman Sachs to purchase a large amount of stock for them (Microsoft, let’s say), Goldman will first put it in their Dark Pool to see if any of their other customers are looking to sell Microsoft. If the trade can’t be made internally, then it will travel to the public exchanges. These Dark Pools wouldn’t appear to have anything to do with High Frequency Trading, but there is a link: because they introduce another lag into the system of stock trading, and because HFT firms pay the big banks to have access to see the workings of these Dark Pools, they are another way which HFT firms can game the system for guaranteed profit.
Concerned that regulators either aren’t interested in prosecuting this behavior, or are unable to understand the problem, Brad Katsuyama and his group start their own stock exchange, IEX, and use a sophisticated piece of software to ensure that all orders go out to all exchanges at the same speed. Without a difference in speed, there’s nothing to game. Their ability (or inability) to succeed in this Sisyphean task forms the backbone plot of the book.
Michael Lewis writes this all with his trademark energy and love for the underdog. He is the only author I’m aware of that can make futures trading read like international espionage (one climactic event involves a trader poring over stock exchange data one millisecond at a time and it’s exciting). He has an ability to draw out of his interviewees the perfect expository sentence, such as when one character describes High Frequency Trading thus: “People are getting screwed because they can’t imagine a microsecond.” This is the rare book (though not rare for Lewis) that can be read by financial experts and laymen alike with equal enjoyment. As a pure story, I recommend it highly.
But I worry about what the non-experts will do with the information in this book. I hope it doesn’t cause them to pull their investments and put the cash under their mattresses. Because the answer to the question posed above, “is the stock market rigged?”, is: “yea, sort of”. But if you asked me what the average investor should do with this information, I’d say: nothing. The system isn’t rigged in a “you’re guaranteed to lose all your money eventually” way, like in a casino. It would be more accurate to say that the system, as Lewis describes it, is rigged at this point in time to shave a small amount of money off of transactions. It’s detestable, but it isn’t a reason to switch to an all gold portfolio. And it’s likely to change soon, as the market is always morphing through both regulation and market pressures.
There’s reason to think that it’s always been this way. At one point, one of Brad Katsuyama’s team members begins to research the recent regulation which in a sense birthed High Frequency Trading. He finds that this regulation was a reaction to another loophole in the system caused by a previous regulation. He then follows the trail into the past and finds a similar pattern: regulation, loophole, exploitation. He continues on, in what I believe is the most important passage in the book:
“Several days later he’d worked his way back to the late 1800’s. The entire history of Wall Street was the story of scandals, it now seemed to him, linked together tail to trunk like circus elephants. Every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice…The U.S. financial markets had always been either corrupt or about to be corrupted.”
To one way of thinking, this is endlessly depressing, a triumph of evil and a failure of regulation. But consider this: an investor who owned the Dow Jones Industrial Average stocks from 1900 to the present day would have seen their shares rise from $68 per share to $17,138.20 at the time of this writing. As angry investors shook their fists at scandal after scandal, they also would have seen their money grow over 250 times its original value, a hefty sum even after inflation. Those who pulled out at the wrong time or didn’t play the game at all suffered the real losses. If I were a talking head, I would suggest that, historically at least, the stock market has been rigged. In our favor.