TED Talk: Agorithms and The Anti-Christ
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High-frequency traders use dedicated data cables and specialized algorithms to trade milliseconds ahead of the rest of the market.
March 31, 2014
In the spring of 2007, Brad Katsuyama, a rising New York banker at the Royal Bank of Canada, realized something was funny with the markets. He was trying to buy 10,000 shares of Intel, offered at $22. But the moment he pushed the buy button, the offers vanished. It was as if the market were reading his mind and adjusting the prices just before he made his trade. He wasn't far off.
Wall Street has always attracted more than its share of scammers and bandits. Today's prime exemplars, argues Michael Lewis in "Flash Boys," are high-frequency traders—or HFTs—who nickel-and-dime investors by exploiting a technological arsenal of servers, fiber-optic cable and microwave transmission towers to trade milliseconds ahead of everyone else in the markets. They have turned the exchanges into a computerized monster churning up unprecedented market volatility. All this has happened since the 2008 financial crisis, a period in which the markets were supposed to have been under closer scrutiny than ever.
Back in the day, if an investor wanted to buy or sell a stock, he would call a broker, who would find a way to execute the trade as efficiently as possible by talking to other human beings. The arrival of computerized exchanges slowly eliminated people from the process. Instead, bids and offers were matched by servers. The shouting men in colorful jackets on the exchange floors became irrelevant. In theory, this meant that the cost of trading fell and that the markets became more efficient. But the effects of technology are rarely so simple.
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Flash Boys
By Michael Lewis
(Norton, 274 pages, $27.95)
(Norton, 274 pages, $27.95)
In 2002, 85% of all U.S. stock-market trading happened on the New York Stock Exchange and the rest mostly on the Nasdaq. By early 2008, there were 13 different public exchanges, most just stacks of computer servers in heavily guarded buildings in northern New Jersey. Now, if you place an order for 1,000 shares of Microsoft, it pings from exchange to exchange claiming a few shares at each stop, seeking the best price until the order is completed. But the moment that it hits the first exchange, the HFTs see it, and they race ahead to the other exchanges, buy the stock you want, and sell it back to you for fractionally more than you hoped to pay. All in a matter of milliseconds, millions of times a day to millions of investors—your grandmother and hedge-fund titans alike. These tiny but profitable trades, Mr. Lewis writes, add up to big profits for firms like Getco and Citadel. He cannot put a hard number on the size of the industry, suggesting only that many billions are involved.
If this sounds like the old Wall Street scam of front-running the market, that's because it is. Except, in this case, it is entirely legal. Indeed, Mr. Lewis suggests, the strategies of high-frequency traders were the unintended consequence of well-intentioned regulation. Back in 2005 the SEC, in an effort to ensure greater fairness for investors, changed a key rule. Once, brokers had to perform the "best execution" for their clients. This meant taking into account factors such as timing and likelihood of completing the transaction, as well as price. Now they have to find the "best price," as determined by regulators' own creaky computers, scanning the bids and offers available on the various exchanges. But traders could do the same analysis more quickly using their own networks, and make trades in the milliseconds between an investor placing an order, the SEC establishing the best price and the broker executing the trade.
A decade later, the HFTs do such big business that they have begun to influence the operations of the exchanges that depend on them. The exchanges take fees from the HFTs for access to the flow of orders, as do investment banks that run their own private exchanges, called "dark pools." Exchanges bend their rules to the bidding of the high-frequency traders: The HFTs wanted an extra decimal place added to stock prices, for instance, so they could mop up every thousandth of a penny in price fluctuations; the exchanges obliged. "By the summer of 2013," writes Mr. Lewis, "the world's financial markets were designed to maximize the number of collisions between ordinary investors and high-frequency traders—at the expense of ordinary investors."
"Flash Boys" is not as larky as "Liar's Poker" (1989), Mr. Lewis's memoir of working at Salomon Brothers during the lead-up to the 1987 crash, or as accessible as "The Big Short" (2010), his jaw-dropping take on the subprime meltdown. It may end up more important to public debate about Wall Street than either, however, in exposing what one of his central characters calls the "Pandora's box of ridiculousness" that financial exchanges have become.
Mr. Lewis wants to argue, though, that the markets are not just ridiculous, but rigged. The heroes of this book are clear: Mr. Katsuyama eventually assembles a team of talented misfits to create an HFT-proofed exchange called IEX, where a price is a price is a price. It's backed by leading hedge funds and banks (and Jim Clark, the co-founder of Netscape and the subject of Mr. Lewis's 1999 book, "The New New Thing"). Mr. Lewis gives the reader extensive insight into how his heroes see the market, but the alleged villains of the piece—HFTs themselves—are all but silent in their own defense. "Flash Boys" is a decidedly one-sided book.
Yet there are reasonable arguments to be made that the frenetic trading by HFTs leads to greater liquidity and more efficient pricing. Or, God forbid, that they are not nearly so harmful to investors' returns as Mr. Lewis makes out. Their rise has coincided with a historic bull market. It is not hard to imagine a different book by Michael Lewis, one celebrating HFTs as revolutionary outsiders, a cadre of innovative engineers and computer scientists (many of them immigrants), rising from the rubble of 2008 and making fools of a plodding financial system. "Flash Boys" makes no claim to be a balanced account of financial innovation: It is a polemic, and a very well-written one. Behind its outrage, however, lies nostalgia for a prelapsarian Wall Street of trust and plain dealing, which is a total mirage.
Mr. Delves Broughton's latest book is "The Art of the Sale: Learning From the Masters About the Business of Life."
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"On A Rigged Wall Street: Milliseconds Make All The Difference"
NPR
http://www.npr.org/2014/04/01/297686724/on-a-rigged-wall-street-milliseconds-make-all-the-difference
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