When I was a kid, I used to watch my father as he tried to handicap horse races to pick a winning horse. I loved it because I loved the way race horses looked and ran (still do), especially when he’d take me with him to the track. Along the way, I learned about some of the scams that were used in the racing game, the most crooked being “past posting.” This was done by some bettors connected enough to afford high-speed telegraph or phone lines wherein they would get the news of a race’s winner instantly, and then rush their bets to the bookie before he knew the horses were at the post (starting gate). If you didn’t get caught, you couldn’t lose. The smarter bookies, of course, refused late bets, but enough accepted them to make past-posting a going, if highly illegal (and sometimes dangerous) business.
It turns out that what has been happening on Wall Street in the past few years bears more than a little resemblance to past-posting. It’s called “front-running” and it’s the subject of Michael Lewis’ latest book, Flash Boys (Norton: 2014). Front running is done by “high-frequency traders” (HFTs), who manage to glean early information about trades from various sources, usually an exchange (there are now at least 13 stock exchanges operating in the United States) and then take advantage of that knowledge to buy or sell stocks on another exchange before the usual market can even operate. This ploy only makes them a few cents on each stock, but when multiplied by the $225 billion in stocks traded every day on the U.S. stock market, that comes to as much as $160 million a day in foolproof, no-risk profit.
Lewis’s story involves one trader, Brad Katsuyama, who, being a Canadian working for the Royal Bank of Canada, has a different set of ethics than your usual American trader. He was puzzled by the “disappearance of the market” when he placed an order, but once he found out what was happening—and it took him a very long time to figure out why his trades were ‘disappearing’ when he pushed the usual ‘execute’ button, and who was doing the scamming and, especially, how it was being done—Katsuyama made a stunning decision. Rather than join the scam to enrich himself, which he could easily have done, he decided to educate his investors about how they were being screwed. The story is long and complicated and involves several of the new stock market ‘geeks’ Katsuyama hired to figure things out, figure a way to defeat the scam, and eventually start a new and honest stock exchange named IEX, but it comes down basically to the aforementioned “past posting” and speed. The speed is the time it takes for computer signals to travel along fiber-optic cables, approximately light speed, from the order desk of a broker to the stock exchanges. What almost no one knows is that though Wall Street seems to be the center of the exchanges like the New York Stock Exchange, actually today’s exchanges, all electronic, are located in northern New Jersey. The key here is that it takes time, even at light speed, to get from a broker’s computer in or near Wall Street (or even farther away in Kansas) to the exchanges across the Hudson River. Distance is crucial, because milliseconds are also crucial. Once he found this out—and again, it took years and some of the smartest minds in the business to put it all together—Katsuyama understood what the scam involved.
A big investor like a mutual fund will place a buy order with a broker (or a Wall Street bank) for, say, 100,000 shares of Apple stock. Because of the latest rules from the SEC, that broker must seek the NBBO (National Best Bid and Offer) to match the order with a seller, and so is required (usually) to send it to all thirteen stock exchanges. The problem is that the exchanges are located in different places and so the order reaches them at different times (differing by milliseconds). But one exchange, BATS (Better Alternative Trading System, created by high-frequency traders) has its computer center in Weekhawken, just feet from the Lincoln Tunnel where the fiber-optic cables emerge from New York City. High-frequency trading firms located inside BATS thus get information about large trades first—again, by milliseconds. This is not the only place they get information, but let’s stay with this for now. They get advance information on stock prices by placing standing orders for 100 shares of every stock on the exchange (this costs them, as does placing their machines right next to the exchange computers, but it’s well worth it)—which allows them to legally find out who is trying to buy or sell what before anyone else. Once they know, they can then “front-run” buys or sells for the same stock on other exchanges, taking advantage of small price fluctuations, so they can either sell at a higher price or buy at a lower price than anyone else. Of course, they use high-speed computers to determine all this, and algorithms and fancy computer code, all of which work in milliseconds to give them risk-free buys and sells before the original stock order even gets posted. This might not seem to give them enough time to do any damage, but consider that shifts in the price of any stock (volatility) have become greater and greater, and have created risk-free opportunities for fast traders. One study showed that the price of Apple stock shifted 55,000 times in a single day. As Lewis puts it,
That meant there were 55,000 times a day a high-frequency trader could exploit the…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. (99)
That “slower footed investor,” by the way, is often a mutual fund operating on behalf of the retirement funds they invest for unions, or cities, or other ordinary people who have their life savings involved.
One way Katsuyama found out what was happening was by having his computer geek set up a trading program in such a way that all of his orders reached all thirteen exchanges at the same time. When this happened, his trading orders functioned normally (as opposed to when they all reached exchanges at different times) and were executed instantly at the best price, as they should. Katsuyama called this program Thor and thought he could use it to both expose the scam and cause traders to flock to his bank. He was wrong. The HFTs figured out what he was doing quickly. More seriously, when he met with SEC regulators to tell them about the scams and how Thor was able to stop the unfair practices of HFTs, one of the staffers shocked him with this statement: What you are doing is not fair to high-frequency traders. You’re not letting them get out of the way (105). As Lewis explains, “the SEC staffer argued that it was unfair that high-frequency traders couldn’t post phony bids…that Thor forced them to honor the markets they claimed to be making.” The footnote to this mind-boggling comment from a government regulator charged with protecting the fairness of markets is that most of these young SEC staffers knew where their future bread would be buttered—working for the very thieves they were reluctant to expose or regulate. Over 200 SEC staffers since 2007 have left government to work for HFTs, including the associate director of the SEC’s Division of Trading and Markets, Elizabeth King. King took a job with Getco, one of the very largest and most profitable high-frequency trading companies.
There is more detail to this revelatory book, not least the fact that Brad Katsuyama elevated himself almost to superhero status by actually succeeding in opening a new stock exchange, IEX, that actually reflects true markets and has begun to make a difference. Whether it can fully stop the scam, however, is something else again. When there is this much money to be made, the collusion spreads and expands and morphs into all sectors of the market. Thus, many of the big Wall Street banks operate what they call dark pools, essentially their own private exchanges that engender trades without any transparency whatever. No one can see who trades what, who buys, who sells, or at what price. More and more of the trading goes on in these dark pools (“Collectively, the banks had managed to move 38% of the entire U.S. stock market now traded inside their dark pools” 224), and it is clear that high-frequency traders have been able to buy access to many of these pools so that they can expand their nefarious business. Moreover, what Lewis reveals about the SEC and their so-called regulators seems to be a fair indication that meaningful regulation will not be forthcoming any time soon. And finally, Lewis notes that Brad Katsuyama, like all superheroes, has a weakness: “his inability to imagine just how badly others might behave.” That is,
He had expected that the big banks would resist sending orders to IEX. He hadn’t imagined they would use their customers’ stock market orders to actively try at their customers’ expense to sabotage an exchange created to help their customers. (225)
That is really the problem at the heart of Wall Street and our economy in general. As one of Brad Katsuyama’s new hires put it, “The game is rigged.” But most ordinary citizens have an inability to imagine that. Most of us still believe that, by and large, commerce proceeds generally under the same set of rules and ethics that personal lives do. People obey stop signs and stop at red lights. People shrink from exploiting children and stealing from their friends and neighbors. What Wall Street and the banditry of the last few years has shown us, however, is that maintaining those beliefs in the face of the evidence now before us could leave us all sunk in a new dark pool that has no bottom at all.