Sunday, August 16, 2015

Flash Boys - A Must Read!

I picked up a copy of Flash Boys before boarding a flight from San Francisco to Newark.  By the time we were over Yosemite, I was hooked.  The first chapter reads like an action adventure/thriller on the most unlikely of events, the conception, funding and installation of a fibre optic cable from the Chicago Mercantile Exchange to New Jersey.  One might think that this is a story only project managers and engineers would love, but Michael Lewis (The Blind Side, Moneybag, The Big Short, The New New Thing, Liar's Poker) is not just any storyteller and this, ladies and gentlemen, is no ordinary story!  Janet Maslin of the New York Times describes the story as, 'Guaranteed to make the blood boil.'

The fact that it is a true story is the most mind-blowing realisation among a romping tale of one extraordinary WTF! moment after another.  How could Wall Street Banks, with the help of (mostly) Russian programmers (even that is not made up!), create or knowingly or unknowingly allow the creation of trading intermediaries that would systematically skim millions and millions of trades on a supposedly 'fair' market system, i.e., the US securities (stock) markets?  But, from around 2009 onwards, that is what happened.  In Lewis' words:

"The US stock market was now a class system, rooted in speed, of haves and have-nots.  The haves paid for nanoseconds; the have-nots had no idea that a nano-second had value.  The haves enjoyed a perfect view of the market; the have-nots never saw the market at all.  What had once been the world's most public, most democratic, financial market had become, in spirit, something more like a private viewing of a stolen work of art." (p 69, emphasis in original).

The reason the have-nots could not see the market was due to the presence of high-frequency traders (HFT) intervening between buyers and sellers.  Using small fractions of a second advantage, HFTs would test the market for buyer interest, find it, then 'front run' to other markets, buy the shares of interest before the original buyer knew anything had happened. By the time the buyer's bid arrived on other markets, the price had gone up and the high-frequency traders had arbitraged a profit. All this takes place within less time than it takes to blink an eye.  The profit margins were small, but multiplied they added to billions of dollars (it is impossible to know for sure) of essentially a tax on investors, not just big hedge fund-type investors, but ordinary investors, whose pension funds relied on these markets to create wealth for ordinary people.

Of course the HFTs come off looking pretty bad, but the Wall Street banks were more or less (admittedly it seems to differing degrees) complicit with this behaviour, creating their own 'dark pools,' where the banks traders traded, at superior speed, against the banks' own customers!  There is a line that comes to mind from the movie, "A Few Good Men," where one of the court marshalled Marines explains to his co-defendent friend, We did do something wrong; we were supposed to protect Santiago (the victim).

The hero in this story is Brad Katsuyama, a Canadian working as a trader for the Royal Bank of Canada, who can't figure out why his trading screens change the minute he sends a buy order. Tenaciously following his curiosity, he searches for people who can help him understand what is going on in the stock markets.  In his quest, he finds incredibly smart computer programmers and others, like Ronan Ryan, a gangly guy from Dublin, who understood markets better than almost anyone and Zoran (their own Russian), who could sit stone-faced waiting for things to break in these complex systems and then fix them without crumbling, while the whole world watched, and John Schwall, a former Wall Street banker, who left in disgust after the GFC.  The team of insurgents grows until they finally make a bold attempt not just to understand the system, but to fix it!  To do this, they all quit million plus (and in some cases, multi-million dollar) jobs and bet the ranch on their creation.  But, it was never going to be easy.

"Some large amount of what Wall Street had done with technology had been done simply so that someone inside the financial markets would know something that the outside world did not.  The same system that once gave us subprime mortgage collateralized debt obligations no investor could possibly truly understand now gave us stock market trades that occurred at fractions of a penny at unsafe speeds using order types that no investor could possibly truly understand.  That is why Brad Katsuyama's most distinctive trait--his desire to explain things not so he would be understood but so that others would understand--was so seditious.  He attacked the newly automated financial sytsem at its core; the money it made from incomprehensibility" (p. 233).

To be fair, there are even two Wall Street bankers who display exemplary courage in the face of institutional pressure. Ron Morgan and Brian Levine, of Goldman Sachs, took the brave step of sending orders to Brad and co's exchange, even though they knew their company would reap less profit from trading on a more robustly fair exchange, the IEX.

Flash Boys has created considerable controversy and naturally the Wall Street banks and HFTs have launched several public relations campaigns to counter Lewis' story.  The Afterward in the new edition offers a summary of the fall-out from the story being told and includes a cautiously optimistic ending, namely that it is not remarkable that technology can be used to game a system, nor even that one of our most important systems (finance) has been corrupted by greed, but that amidst--indeed, from within--this system, a few brave characters decided to do something to make things better.  Now, that is a story that brings some hope.

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