A new trader could leap into a market and trade frantically inside it without adding anything of value to it. Imagine, for instance, that someone passed a rule, in the U.S. stock market as it is currently configured, that required every stock market trade to be front-run by a firm called Scalpers inc. Under this rule, each time you went to buy 1,000 shares of Microsoft, Scalpers Inc. would be informed, whereupon it would set off to but 1,000 shares of Microsoft offered in the market and, without taking the risk of owning the stock for even an instant, sell it to you at a higher price. Scalpers Inc. is prohibited from taking the slightest market risk; when it buys, it has the seller firmly in hand; when it sells, it has the buyer in hand; and at the end of every trading day, it will have no position at all in the stock market. Scalpers Inc trades for the sole purpose of interfering with trading that would have happened without it. In buying from every seller and selling to every buyer, it winds up: a) doubling the trades in the marketplace and b) being exactly 50 percent of that booming volume. It adds nothing to the market but at the same time might be mistaken for the central player in that market.
This state of affairs, as it happens, resembles the United States stock market after the passage of Reg NMS. From 2006 to 2008, high-frequency traders’ share of total U.S. stock market trading doubled, from 26 percent to 52 percent—and it has never fallen below 50 percent since then. The total number of trades made in the stock market also spiked dramatically, from roughly 10 million per day in 2006 to just over 20 million per day in 2009.
Michael Lewis has written about Wall Street before. His books Liar’s Poker and The Big Short describe 80s excess and the 2008 financial crisis, so this book can be thought of as the third part in that saga: what happens when high finance meets high technology and well-intention but flawed government regulation? The answer is high-frequency trading, which is described in the analogy above.
Flash Boys is the story of a group of finance and technology people who come together to make an honest stock exchange, one impervious to high-tech middle men taking advantage of the millisecond lag-time in traders’ internet connection. In other words, “a tool whose only purpose was to protect investors from the rest of Wall Street.”
If you ever need proof that even Wall Street insiders have no idea what’s going to happen next on Wall Street, there it was. One moment all is well; the next, the value of the entire U.S. stock market has fallen percent, and no one knows why. During the crash, some Wall Street brokers, to avoid the orders their customers wanted to place to sell stocks, simply declined to pick up their phones. It wasn’t the first time that Wall Street people had discredited themselves, but this time the authorities responded by changing the rules—making it easier for computers to do the jobs done by those imperfect people. The 1987 stock market crash set in motion a process—weak at first, stronger over the years—that has ended with computers entirely replacing the people.
Up till then, Brad had taken the stock exchanges for granted. When he’d arrived in New York, in 2002, 85 percent of all stock market trading happened in the New York Stock Exchange and Nasdaq combined, and some human being processed every order. The stocks that didn’t trade on the New York Stock Exchange traded on Nasdaq. No stocks traded on both exchanges. At the behest of the SEC, in turn responding to public protests about cronyism, the exchanges themselves, in 2005, went from being utilities owned by their members to public corporations run for profit. Once competition was introduced, the exchanges multiplied. In early 2008 there were thirteen different public exchanges, most of them in northern New Jersey. Virtually every stock now traded on all of these exchanges: You could still buy and sell IBM on the New York Stock Exchange, but you could also buy and sell it on BATS, Direct Edge, Nasdaq, Nasdaq BX, and so on. The idea that a human being needed to stand between investors and the market was dead.
All he knew for sure was that the stock market was no longer a market. it was a collection of small markets scattered across New Jersey and lower Manhattan. When bids and offers for shares sent to these places arrived at precisely the same moment, the markets acted as the markets should. If they arrived even a millisecond apart, the market vanished, and all bets were off. Brad knew that he was being front-run—that some other trader was, in effect, noticing his demand for stock on one exchange and buying it on others in anticipation of selling it to him at a higher price.
The U.S. 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 nanosecond 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.
Inside BATS, high-frequency trading firms were waiting for news that they could use to trade on the other exchanges. They obtained that news by placing very small bids and offers, typically for 100 shares, for every listed stock. Having gleaned that there was a buyer or seller of Company X’s shares, they would race ahead to the other exchanges and buy or sell accordingly. (The race they needed to win was not a race against the ordinary investor, who had no clue what was happening to him, but against other high-speed traders.) The orders resting on BATS were typically just the 100-share minimum required for an order to be at the front of any price queue, as their only purpose was to tease information out of investors. The HFT firms posted these tiny orders on BATS—orders to buy or sell 100 shares of basically every stock traded in the U.S. market—not because they actually wanted to buy and sell the stocks but because they wanted to find out what investors wanted to buy and sell before they did it. BATS, unsurprisingly, had been created by high-frequency traders.
The deep problem with the system was a kind of moral inertia. So long as it served the narrow self-interests of everyone inside it, no one of the inside would ever seek to change it, no matter how corrupt or sinister it became—though even to use words like “corrupt” and “sinister” made serious people uncomfortable, and so Brad avoided them.
Given an excuse to feel loyalty for his company, he seized it. September 11, 2001, for instance. Schwall’s desk was in the North Tower of the World Trade Center, on the eighty-first floor. By sheer fluke he had been late to work—and he’d watched the first plane hit, thirteen floors above his desk, from the window of a distant bus. Several of his colleagues died that day, and so had some Staten Island firemen he’d known. Schwall seldom spoke of the event, but privately he believed that, had he been at his desk when the plane hit, his instinct would have been to go up the stairs rather than go down them. The guilt he felt for not having been on hand to help somehow became, in his mind, a debt he owed to his colleagues and to his employer. Which is to say that Schwall wanted to feel toward a Wall Street bank what a fireman is meant to feel toward his company.
Reg NMS was intended to create equality of opportunity in the U.S. stock market. Instead it institutionalized a more pernicious inequality. A small class of insiders with the resources to create speed were now allowed to preview the market ad trade on what they had seen.
Thus—for example—the SIP might suggest to the ordinary investor in Apple Inc. that the stock was trading at 400-400.01. The investor would then give his broker his order to buy 1,000 shares at the market price, or $400.01. The infinitesimal period of time between the moment the order was submitted and the moment it was executed was gold to the traders with faster connections. How much gold depended on two variables: a) the gap in time between the public SUP and the private ones and b) how much Apple’s stock price bounded around. The bigger the gap in time, the greater the chance that Apple’s stock market price would have moved; and the more likely that a fast trader could stick an investor with an old price. That’s why volatility was so valuable to high-frequency traders: It created new prices for fast traders to see first and to exploit. It wouldn’t matter if some people in the market had an early glimpse of Apple’s price if the price of Apple’s shares never moved.
Apple’s stock moved a lot, of course. In a paper published in February 2013, a team of researchers at the University of California, Berkeley, showed that the SIP price of Apple stock and the price seen by traders with faster channels of market information differed 55,000 times in a single day. That meant that there were 55,000 times a day a high-frequency trader could exploit the SIP-generated ignorance of the wider market. Fifty-five thousand times a day, he might buy Apple shares at an outdated price, then turn around and sell them at the new, higher price, exploiting the ignorance of the slower-footed investor on either end of his trades.
Several days later he’d worked his way back to the late 1800s. 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. Second, there was zero chance that the problem would be solved by financial regulators; or, rather, the regulators might solve the narrow problem of front-running in the stock market by high-frequency traders, but whatever they did to solve the problem would create yet another opportunity for financial intermediaries to make money at the expense of investors.
The Royal Bank of Canada was running away with the title of Wall Street’s most popular broker by peddling a tool whose only purpose was to protect investors from the rest of Wall Street.
After the meeting, RBC conducted a study, never released publicly, in which they found that more than two hundred SEC staffers since 2007 had left their government jobs to work for high-frequency trading firms or the firms that lobbied Washington on their behalf. Some of these people had played central roles in deciding how, or even whether, to regulate high-frequency trading.
In early 2013, one of the largest high-frequency traders, Virtu Financial, publicly boasted that in five and a half years of trading it had experienced just one day when it hadn’t made money, and that the loss was caused by “human error.” In 2008, Dave Cummings, the CEO of a high-frequency trading firm called Tradebot, told university students that his firm had gone four years without a single day of trading losses. This sort of performance is possible only if you have a huge informational advantage.
Constantine was also Russian, born and raised in a city on the Volga River. He had a theory about why so many Russians had wound up inside high-frequency trading. The old Soviet educational system channeled people away from the humanities and into math and science. The old Soviet culture also left its former citizens oddly prepared for Wall Street in the early twenty-first century. The Soviet-controlled economy was horrible and complicated but riddled with loopholes. Everything was scarce; everything was also gettable, if you knew how to get it. “We had this system for seventy years,” said Constantine. “People learn to work around the system. The more you cultivate a class of people who know how to work around the system, the more people you will have who know how to do it well. All of the Soviet Union for seventy years were people who are skilled at working around the system.” The population was thus well suited to exploit megatrends in both computers and the United States financial markets.
For a moment, Brad looked at Don, and at the view that he only partly concealed. In that moment, he might as well have been, not on the inside of his new exchange looking out, but on the outside looking in. How did they seem to others? To the people out there? Out there, where the twin symbols of American capitalism once loomed, reduced in a few hours to a blizzard of office memos and ruin. Out there, where idealism was either a ruse or a species of stupidity, and where the people who badly needed them to succeed hadn’t the faintest idea of their existence. But out there a lot of things happened. People built new towers to replace the old ones. People found strength they didn’t know they had. And people were already coming to their aid, and bracing for the war. Out there, anything was possible.
But by the time Don approached Zoran, it had grown clear that the investing public had lost faith in the U.S. stock market. Since the flash crash back in May 2010, the S&P index had risen by 65 percent, and yet trading volume was down 50 percent: For the first time in history, investors’ desire to trade had not risen with market prices. Before the flash crash, 67 percent of U.S. households owned stocks; by the end of 2013, only 52 percent did: The fantastic post-crisis bull market was noteworthy for how many Americans elected not to participate in it. It wasn’t hard to see why their confidence in financial markets had collapsed. As the U.S. stock market had grown less comprehensible, it had also become more sensationally erratic. It wasn’t just market prices that were unpredictable but the market itself—and the uncertainty it created was bound to extend, sooner or later, to the many foreign stock markets, bond markets, options markets, and currency markets that had aped the U.S. stock market’s structure.
The restaurant was one of those old-school Wall Street places that charge you a thousand bucks for a private room and then more or less challenge you to eat your way back to even. Food and drink arrived in massive quantities: vast platters of lobster and crab, steaks the size of desktop computer screens, smoking mountains of potatoes and spinach. It was the sort of meal cooked decades ago, for traders who spent their days trusting their guy and their nights rewarding it; but this monstrous feast was now being served to a collection of weedy technologists, the people who controlled the machines that now controlled the markets, and who had, in the bargain, put the old school out of business. They sat around the table staring at the piles of food, like a conquering army of eunuchs who had stumbled into the harem of their enemy.
High-frequency traders when home every night with no position in the stock market. They traded in the market the way card counters in a casino played blackjack: They played only when they had an edge. That’s why they were able to trade for five years without losing money on a single day.
The relationship of the big Wall Street banks to the high-frequency traders, when you thought about it, was a bit like the relationship of the entire society to the big Wall Street banks. When things went well, the HFT guys took most of the gains; when things went badly, the HFT guys vanished and the banks took the losses.