“There are three ways to make a living in this business: be first, be smarter, or cheat. Well, I don’t cheat. And although I like to think we have some pretty smart people here in this room, it sure is a hell of lot easier to just be first.”
— Margin Call
Compared to the latest celebrity scandal, we will freely admit that economics and fiduciary concerns can be a dry topic. So, we are always the first to celebrate when a book on economics or finance enters the cultural conversation. Furthermore, we are especially thrilled when a book of substantive ideas does more than entertain, but has the potential to affect the economic or regulatory environment.
The latest book with the potential for both engaging entertainment and changing the environment is Michael Lewis’ new book, “Flash Boys”. As high-minded as we like to be, we are a little sad to admit that some of the reason for the book’s entertainment value stems from its confrontational nature. This may be the only book on stock trading which spurred a virtual yelling match on CNBC between the author, his primary source – IEX head Brad Katsuyama, and the beleaguered President of BATS Global Markets, William O’Brien. Of course, this fight was verbal - it didn’t escalate into a fist fight - but it definitely crossed over the line of civil discourse. Moreover, it stopped trading on the floor of the New York Stock Exchange as market makers and specialists watched stunned at the brawl.
Let’s discuss the argument briefly: Michael Lewis’ new book, “Flash Boys” peers into the contentious world of high frequency trading. The heart of the debate is a simple question: What is high frequency trading? Is high frequency trading a legal version of arbitrage, in which traders find an identical asset in two separate markets trading at slightly different prices (usually just a penny) and make profits by buying it on the cheap market and selling it on the expensive market? On the other hand, does the premium speed granted to high frequency traders constitute a type of front-running, an illegal practice where traders get to trade ahead of the public and with faster pricing information? In other words, is trading with more up-to-date information simply being first? Or is it cheating?
The on-air argument, although heated, was not without substance. Each debater scored some fair points. For example, “Flash Boys” contends that the market is “rigged” to unfairly benefit those high frequency trading firms which have paid additional premiums to the market exchange. During the argument, William O’Brien asserts that the “rigged” accusation may be a needlessly provocative term. Even if you assume the worst, how “rigged” is the market: one penny per trade? How much inefficiency can a market reasonably accept? O’Brien points out that using such incendiary language is good for making headlines but needlessly frightening to the overwhelming majority of the investing public, which does not directly compete with high frequency traders. Perhaps, however, O’Brien is a little aggressive to accuse the author of corruption, by installing fear of markets like BATS to promote an alternative marketplace, namely Katsuyama’s exchange.
To its credit, Michael Lewis’ book has inspired a fresh and knowledgeable look at a business practice which deserves scrutiny. Under pressure from the New York Attorney General’s office, BATS has had to acknowledge incorrect information O’Brien gave during the on-air debate; specifically, O’Brien did not acknowledge that some market exchanges used slower information feeds, which could be outpaced by high frequency traders. In late June 2014, the US Senate opened a hearing on “Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets” to further analyze and discuss these issues. The key players from the on-air scuffle will be back to debate how high frequency trading affects the public – either through destabilizing the market as a whole or by siphoning returns from widely used investment managers who aren’t paying extra for premium access.
In short, this fight isn’t over.