Flash Boys May be Yesterday’s Story

by Roy C. Smith

Michael Lewis’ newest Wall Street bestseller, Flash Boys, claims that equity markets are “rigged” by high frequency traders who invested millions in fiber optic cables that enabled them to shave microseconds from the time it takes to trade stocks. Launched just a week ago in a blizzard of TV interviews with unknowing, uncritical journalists, it is the latest bomb to drop on an industry still struggling to regain its balance after the financial crisis of 2008.

Like his two other very popular books about financial firms and markets (Liar’s Poker and The Big Short), Flash Boys, tells a compelling, if improbable story of how a few really smart tech guys, investing millions in their own high speed cables, have outwitted the usual bunch of dull institutional investors by hijacking billions of dollars of other people’s trades.

After Lewis’ launch, the US Attorney General, Eric Holder, announced he has directed the Justice Department to investigate high frequency traders for insider trading violations. He joins the SEC, the CFTC and the FBI, which say they are also investigating the market-rigging allegation.

Few people know enough about High Frequency Trading (HFT) to be able to take Lewis’ book apart, but many of those who do have chimed in to complain, about his conclusions.

Academics who have followed HFT as an innovation in market microstructure generally seem to believe that (a) it increases competition and has contributed to lowering trading costs, (b) the innovation was enabled by continuous deregulation in financial markets over the past 20 years that has increased transparency and forced traders to search among various market makers for the best execution price, and (c) HFT probably adds to market liquidity, but not necessarily under especially stressful conditions.

Competition has eroded away much of the big profits that HFT operators made in the past, and that are featured in Flash Boys. According to Larry Tabb, a securities market consultant, revenues from HTF that were $7.2 billion in 2009 will be only a little more than $1 billion in 2014.

Such a revenue swing is typical of disruptive technologies – the first ones in with the new idea benefit disproportionately until competition catches up.

Trading technologies have been very disruptive in Wall Street, especially to large broker-dealers that act as intermediaries between clients. A surge in trading volume in the late 1960s forced brokers to computerize back offices, and many that didn’t manage the transition well failed. NASDAQ, an electronic over-the-counter marketplace was established as an alternative to the NYSE in 1971, and has been the second largest trading venue in the US ever since. Michael Bloomberg introduced his computerized black box for comparing bond prices in 1982, and forced the entire industry to adopt trading practices based on the new technology.

In the 1980s and 1990s, enhanced data processing capabilities led to the development of securitized mortgages, to a variety of hedging tools using futures, options and other derivative instruments, and to trading strategies using solely quantitative analytical processes. These innovations were enormously important to the development of efficient, low cost financial markets, and very profitable for the firms that first introduced them. But Wall Street is famous for being able to copy new ideas quickly and erode profits from them.

In 2000, Goldman Sachs acquired Speer, Leeds & Kellogg for $6.5 billion to improve its equity market making capabilities, which it did for a while but even these improved capabilities were later overtaken by technology developments in the industry. Goldman recently announced it was selling the firm for virtually nothing.

In  2001, Liquidnet was formed as an alternative institutional marketplace, now one of several so-called “dark pools” that allow institutional investors to trade directly with each other. Between them, the dozen or so dark pools now account for 36% of the global equities trading market.  Liquidnet operates in 41 markets on behalf of 700 asset managers with $12.5 trillion under management. The New York Stock and Exchange and NASDAQ between them now comprise only 33% of the market, according to Thomson Reuters.

And in 2002 Virtu Financial was formed as a “technology enabled market maker and liquidity provider.” In 2013 it had revenues of $624 million from trading 10,000 different securities on 210 exchanges in 30 countries, and profits of $243 million, a margin of 39%. It is hard to see how all this activity could be based simply on laying down their own fiber optic lines, or buying trading information from the dark pools as Lewis alleges.

Virtu, which has been staked by Silver Lake, a tech oriented venture capital firm, is one is 20-30 privately owned HFTs in the US and Europe. Virtu had made a preliminary filing for an IPO later this year, the first for this industry niche, but has since postponed it due to the controversy surrounding Flash Boys.

Lewis based Flash Boys on a story that began in 2009. It may already be out of date. Things change fast in technology, and in financial markets where every trader is looking for an edge. Sometimes the edge is in quicker hardware, or in better software, or in newer mathematical algorithms that reveal arbitrage opportunities. Sometimes it’s in an ability to get around rules that moves transactions into territory previously unchartered by regulation.

Several Wall Street banks set up HFT operations in its early days, but most of these have been since shut down or phased out. Goldman Sachs was reported recently to be also considering closing down the sizeable dark pool operation it established in 2006. The economics of these business made be changing, but even if they are not, it may be that they are too technologically sophisticated (and error prone), too expensive to carry on the books of a bank with heavy capital requirements, or too out of step with their public relations message to want to hang on to them. So, in this case anyway, the big boys move on, leaving the field to the less visible smaller guys who compete fiercely with each other for as long as their trading edges last.

Even so, the powerful reaction to Lewis’ book demonstrates that exotic new things like flash trading (or derivatives, or CDOs) are suspect, and the more difficult they are for the public to understand, the more certain people are that their purpose is to rig markets or otherwise take advantage of others.

It is very difficult to actually rig markets when they are as large and competitive as global markets are today. Holder and the regulators will be trying to find what rigging they can, and if they succeed, the regulators will have to tighten up the rules. But HFT, an opportunistic innovation that has improved markets, will no doubt continue -- at least until the next innovation.