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.
Lawrence DiStasi
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