Michael Lewis‘ newest book, Flash Boys: A Wall Street Revolt, is ostensibly an expose of high-frequency trading — Wall Street’s latest method for ripping off the retail investor — but it ends up highlighting the unethical cesspool Wall Street has become today and the desperate need for real reform of our financial system.
The history of high-frequency trading (HFT)
The history of high-frequency trading stretches back to 2006. Lewis writes, “The financial markets were changing in ways even professionals did not fully understand. Their new ability to move at computer, rather than human, speed had given rise to a new class of Wall Street traders…People and firms no one had ever heard of were getting very rich very quickly.”
When Baupost, the $30 billion Boston-based hedge fund now managed by Seth Klarman, was founded in 1982, it was launched with a core set of aims. Q4 2021 hedge fund letters, conferences and more Established by Harvard professor William Poorvu and a group of four other founding families, including Klarman, the group aimed to compound Read More
At first, HFT was limited to a small group of technically knowledgeable people in smaller firms, but within a couple of years HFT had turned in to a kind of “arms race”. Every major bank and trading firm wanted to get involved, and everybody was willing to spend top dollar to get the latest and fastest IT equipment in search of a fraction of a millisecond trading edge.
Eventually all the large and most of the smaller trading firms had at least a toe in the HFT waters. “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,” Lewis writes.
The story of RBC’s Brad Katsuyama
The protagonist of Flash Boys is Brad Katsuyama, a stock trader for Royal Bank of Canada (NYSE:RY) (TSE:RY) who moved to New York to represent his firm. When he arrived, he began to notice that every time he tried to execute a trade, the market seemed to be reading his mind, with stock values shifting the instant he presses the key, making it impossible to get orders filled at the price he just saw.
It turned out Katsuyama was being “front-run,” with an HFT trader noting his bid for stock on one exchange and buying up the stock on other exchanges in order to sell it to him at a higher price.
The central theme in the plot of the book is Katsuyama’s plan to outfox HFT traders by creating a new HFT-proof exchange. Katsuyama’s idea to build a new exchange in which the HFT tactics won’t work comes after being stonewalled in his complaints to government regulators. He needs to get big Wall Street firms involved in his endeavor, but as Lewis writes, he must “prove to investors that an explicitly fair exchange yielded better outcomes for investors than all the other exchanges.”
Lewis’ book proves to be more than just an expose of HFT and how it is used to rip off retail investors, it is also a cautionary tale of 21st century Wall Street where regulators are captured and almost anything goes.