(April 9, 2014) — We always kind of knew it, right? We knew trading volumes hadn’t skyrocketed without reason. We knew that our smartest private-equity friends hadn’t been pouring capital into high-frequency trading (HFT) firms on a whim. We knew that “liquidity”—the stock response to queries about HFT’s purpose—wasn’t the actual reason that these firms were minting millionaires.
We just needed Michael Lewis to tell us what we already suspected.
He’s made a habit of such revelations. Be it The Big Short, Moneyball, or The Blind Side, Lewis has made a career of exposing inefficiencies in markets from baseball to BATS (the stock exchange, not the wooden variety). With almost every piece, he gives us the “Aha!” moment—and despite grumbles from Wall Street that he is oversimplifying the world of HFT, he has done it once again.
The abridged version of Flash Boys’ thesis is this: After the passage of rules forced brokers to get the best price possible for trades executed on behalf of their clients, large sell or buy orders were rarely executed on one exchange. Instead, a buyorder— placed by a pension fund through a Wall Street broker, for example—for 100,000 shares of IBM would first be routed through a venue like BATS (on New Jersey’s side of the Lincoln Tunnel), where it would be partially filled; it would then be routed to any number of exchanges physically further away until all 100,000 shares had been bought. The problem: HFTs would be lurking within BATS’ system (where they bought access). These HFTs would see the large buy-order on BATS and, knowing demand for IBM was increasing, would race ahead to other exchanges and buy shares in preparation for the arrival of the pension’s slower order. They did it in the most straightforward way possible—buying straighter fiber-optic cables between two points—and they made, and make, billions.
While Lewis glosses over the fact that, at its most basic, this is simply modern-day arbitrage, he does at least point out something we’ve all suspected on some level: There is a cost to HFT, and there are victims. Those victims, as astute market watchers will know, are largely asset owners. Eventually, every cost is certainly passed on to these massive institutions, and this “HFT-tax” is just as surely passed on to them.
Lewis’ narrative vehicle is IEX—an exchange, started by former RBC employees, that attempts to be unexploitable by HFTs. While the firm only opened late last year, it has apparently seen success. Goldman Sachs, for one, has reportedly started routing many customer orders through IEX. Why? It’s insane in its simplicity: Because the asset managers and owners who use Goldman wanted them to.
While it’s hardly the book’s focal point, Lewis should be applauded for his advocacy of the buy-side—and massive pension funds in particular. In this he has hit upon a central tenet of modern-day finance, one that we have always understood, but still needed someone to point out, anyway: The buy-side has the power. If they want change in the way financial markets are run, they must only decide to use it.