The Time for Revolt is Now: On Michael Lewis’s Flash Boys: A Wall Street Revolt
The U.S. stock market is f*cked up. That’s not necessarily breaking news to anyone (and if it is, well, it shouldn’t be). There are a few obvious reasons for it being f*cked up: for starters, there’s the horrifying truth that nobody actually knows how it works. Even the smartest and most successful traders who spend their entire lives analyzing the market have no idea which way it’s going to go. Past this fundamental truth, there’s the equally horrifying fact that the stock market is being dictated by those stereotypical CEOs and bankers that immediately come to mind when you hear the words “Wall Street.” Yup, those coked up, Jordan Belfort-esque assholes do still exist at the top of big banking firms like Goldman Sachs, and their primary goal is to game the system in whichever way makes money. After all, the purpose of a firm on Wall Street is to make money in a system that can be accurately described as “glorified gambling.” Whatever is in bounds in the laws of the market will be exploited if it turns a profit, and those bounds will constantly be pushed. These surface level truths are just the tip of the iceberg that is the U.S. stock market. Beneath the water line, there is an incredibly complex network of reasons why the market is even more f*cked than you probably think it is.
It doesn’t take a Harvard degree or years of experience on Wall Street to begin chipping away at this iceberg. What it does take is a warm cup of coffee, a comfortable chair on your porch, and 3 hours with Michael Lewis’s Flash Boys: A Wall Street Revolt. Whether you’re the most successful trader at Goldman or a financially inept high school student, Flash Boys offers a thrilling read in which you’re guaranteed to learn practical information about the modern stock market without even knowing that you’re beginning to understand a deeply complex topic. In particular, the book digs into the rise of high frequency trading in Wall Street firms that started in the late 2000s.
To illustrate what high frequency trading (or HFT) actually is, imagine you really want to buy an apple — so much so that you’re willing to pay $10 for it. You go around looking for someone to sell you an apple for $10, but you’re having trouble finding a seller. Unbeknownst to you, your friend is selling apples for $8 each. Now, I, who happen to know that you want to buy an apple AND that your friend is selling apples, can buy an apple from you friend for $8, turn around and sell it to you for $10, and everybody ends up happy. You got to buy your apple for the price you wanted to pay, your friend sold an apple at the price they wanted to sell at, and I walked away with $2 from a virtually zero-risk transaction.
When it comes to HFT, the same exact scheme occurs, except each “apple” is a stock being bought or sold on different exchanges. In reality, the price differential is a lot smaller than $2 — think one share of Apple for $147.8001 on one exchange and $147.8002 on another — and that difference across exchanges only exists for a tiny fraction of a second. This is where the “high frequency” part comes in: what a high frequency trader will do is use a computer program to scan different exchanges and make these trades in a millionth of a second for a tiny profit, thousands of times a minute, all day long. Again, all parties walk away happy: buyers and sellers are connected through high frequency traders and everyone gets the prices they want… Right?
What Flash Boys unveils is that the introduction of this activity permanently changed the stock market for the worse. Michael Lewis places the reader in the shoes of a humble big player on Wall Street, Brad Katsuyama, as he experiences the market evolving right before his eyes due to high frequency trading. What he sees is that ordinary investors and Wall Street traders alike are unable to buy or sell stock at the prices they want, because by the time their order goes through, high frequency traders have already done hundreds of trades and the price of the stock has changed. In essence, these traders are stealing money from ordinary investors by intercepting their trades and turning prices against them. They’re also taking from peoples’ retirement funds and savings accounts when the banks who hold this money can’t trade stocks at the right prices either. As you progress through the book and uncover more and more of these facts, it feels like you’re reading a fast-paced mystery led by a lovable, heart-of-gold protagonist and his ever-growing team of impressive characters; as the quote on the back of the book describes, it “reads like a thriller.” You become engrossed in unraveling what high frequency trading is and what sort of impact it has, frantically turning pages in a desperate attempt to get to the bottom of this futuristic phenomenon and figure out a solution to its complications.
Yet, upon completion of the journey this piece takes you on, you’re left with a feeling of dissatisfaction from the incomplete response of its brilliant author. Flash Boys does an amazing job of educating its audience on an infinitely complex issue while keeping them wildly entertained. The book’s impact tapers off when the reader comes to the realization that its solution is incomplete: Lewis raises the red flag with his conclusion that high frequency trading is essentially a way of rigging the market for the benefit of big banks, but offers an ineffective path for the reader to take afterwards. With the suggestion of relying on heroes like Brad Katsuyama and his creation of a stock exchange that’s immune to high frequency trading, he fails to address the natural response of wondering why we even need those heroes in the first place. If high frequency trading truly does rig the market, why should the general public accept this truth and be at the mercy of a broken system? Why don’t we just ban high frequency trading?
A good place to start in answering these questions is looking at the weak solution that Lewis does offer. In order to slay the dragon that is high frequency trading, the humble cast of heroes in Flash Boys leaves their respective jobs to forge the golden sword that will kill the beast: the Investor’s Exchange. Using their combined knowledge of the stock market and high frequency trading, Brad Kutsayama and Ronan Ryan co founded the Investor’s Exchange (IEX) in 2012 with the mission of delivering to the people a fair stock exchange immune to abuse from high frequency traders. With an inherent delay programmed into every trade on the exchange, the speed advantages of traders at HFT firms are mostly negated, meaning the price you see as an ordinary investor is the price you actually get. After the exchange opened for trading on October 25th, 2013, Brad and Ronan drove their golden sword deep into the heart of the dragon as every other major exchange that allowed HFT started to lose market share to IEX at an unimaginable rate, far surpassing the hopes of its founders.
This is the climactic ending to the story that Flash Boys boasts at the end of its seventh chapter, describing the quick rise of IEX to 40 million shares a day within 4 weeks (Lewis 240). With this, our beloved heroes crack a $300 bottle of champagne and celebrate their success in slaying the dragon — but in reality, they had merely grazed it. While IEX was successful in creating an exchange that is essentially immune to high frequency trading, giving ordinary investors and big banks an exchange where they can buy shares at the price they intend to buy at, it barely scratched the surface in tackling the greater issue of HFT plaguing the largest stock exchanges and stealing billions from middle class Americans. A quick look at the IEX website today shows that the market share of the exchange sits at about 2.7% (“IEX Stats”). Indicating a trade volume of a little over 300 million shares per day, this is certainly no small feat: I mean no disrespect to the Investor’s Exchange and all that it has accomplished over the last 10 years. The fact of the matter is, with only 2.7% of market activity occurring on the biggest exchange that’s immune to high frequency trading, it’s clear that the remaining 97.3% is still happening on exchanges that allow HFT, and that’s no coincidence: the exploitation of ordinary investors through high frequency trading is very much still taking place in the vast majority of the market. 10 years later, the golden sword has proven to be more like a 3rd grader’s slingshot.
The most immediate reaction to this understanding is that a more powerful weapon is needed to take down high frequency trading: one that cuts deep and kills the weed at the root by banning HFT in the market. After all, if it’s so clear that the cons of this activity outweigh its minimal pros and it enables big firms to rig the market as Lewis argues, why should it be allowed in the first place? Activity on the U.S. stock market has evolved past its original laws and guidelines to a point where it’s not serving our economy and our people in the way it was intended to, meaning it’s time to account for that evolution and return the market to order. The unfortunate truth is, Brad Kutsayama tried to lobby for a ban of HFT over 10 years ago, and the SEC wouldn’t budge.
One way to restore fairness to all ordinary investors without completely banning high frequency trading outright is to impose a regulation that would take away most of its power: eliminating order ID’s. Part of what gives HFT firms such an upper hand is their ability to prey on large stock orders that are being placed through the presence of an order ID on their data feed. Being able to keep track of an ID on a certain order “may assist a fast trader in deducing whether a large institution lurks behind a small order” (On Tomorrow’s Secret Meeting to Plot the End of High Frequency Trading). These order ID’s are programmed into HFT algorithms to assist in identifying large orders and front-running movements in the market. As Ray Pellecchia with the New York Stock Exchange argues, “without the order ID, we don’t think anyone could map the order to any other information to divine that it is part of something larger.” If the presence of these order ID’s were to be eliminated, then the volume of trades that HFT firms have control over would decrease greatly and that beneficial effect would trickle from large banks and funds down to ordinary investors.
This is the kind of suggestion that Flash Boys leaves readers begging for. After being exposed to the injustices of high frequency trading, the audience needs a solution to rally for that can actually bring it down, one that seeks to solve the problem instead of working around it. Yet, while eliminating order ID’s seems to attack HFT at its roots, this solution suffers the same pitfall as ordinary investors turning to IEX to make their trades. By seeking a fix through imposing a regulation, it doesn’t tackle the systemic issues that allow corruption in the first place.
Herein lies the deeper problem, and likely the reason why Michael Lewis sugarcoated his ending with a triumphant victory scene. Adding regulations to the market, whether those regulations mitigate the negative parts of high frequency trading or eliminate it completely, is a backwards approach of solving the issue and would in fact only open the door to further manipulation of the market. As Ricky Cooper and colleagues from Business Ethics Quarterly argue, “in a purely transactional arena such as the financial markets, almost any regulation (other than the most basic) will create a moral hazard. Any proposed change in regulation creates an incentive for the affected parties to seek to influence the final rule” (Cooper, Davis, Ben 3). Patching regulation after regulation onto the market will only result in further avenues through which people will seek an opportunity to immorally game the system. If the method through which certain traders are making their money becomes banned due to new regulations, it becomes easier for that trader to try and find another loophole in those new boundaries to continue the previous practice than to completely adopt something new. In other words, an elimination in order ID’s might slow down high frequency trading in the short run, but before long they would find a new way of identifying large orders and their front-running would continue. What Cooper and colleagues suggest instead is that keeping regulation to a minimum is the best way to ensure moral practice: the less regulations there are to get around, the less immoral loopholes there will be.
Lewis touched upon this theme in his epilogue when mentioning the morally corrupt nature of traders on Wall Street. As humans it’s only natural to seek the easiest way to accomplish tasks even if it means taking moral shortcuts, especially when that “task” is earning money. As he states, “Once very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system up further, or to remain silent as they watch it being screwed up by others” (266). This conclusion applies directly to the prominence of high frequency trading in the stock market, but it also raises a concern with our monetary system as a whole. Capitalism and the practice of a free market have opened the door for a corporate path of logic that preys on the welfare of the general population in order to turn a profit. They have bred us to believe that taking loopholes in the financial system that steal money from the middle class is somehow a rational practice. Somewhere along the way, the idea of economic freedom turned into a means of justifying completely immoral and unethical practices that ultimately harm the development of our society. Being incentivized to “screw up” the market should not be something that naturally exists.
This concept is easily extrapolated to almost every aspect of our economy, beyond the walls of stock exchanges on Wall Street. Very smart people are being paid huge sums of money to exploit flaws in a wide array of industries. As Robert Hinkley from the Pittsburgh post argues, “Plenty of big companies harm the public interest in other ways. The emission of pollution and greenhouse gasses, the exploitation of Third World sweatshops, and the killing of 5 million people every year from the effects of tobacco products are other examples where capitalism produces profits at the expense of the public interest” (Hinkley 2). Allowing high frequency trading to exist in our “free market” is no different from allowing the tobacco industry to kill 5 million people a year for profit. It is a practice that, though “legal,” steals from your parents’ retirement fund and puts it into big pockets at Goldman Sachs and Morgan Stanley. Whether it’s a flaw in the financial system that allows for a high frequency trader to take money from investors without risk or the incentive for companies to hook the population on substances that harm it, the story remains the same: our monetary system has bred us to ignore the blatant damage we are causing ourselves in exchange for money. I am not suggesting that we abandon capitalism, because at its core this system was made to further the best interests of society. However, what I am suggesting is that the people of our nation are abusing this system in a way that needs to be addressed. If the best way to do this and ensure morally just market activity is to keep adding regulations to the system, maybe the system we’re working with needs to be changed at its core.
In truth, what this reaction means is that Flash Boys accomplished its mission. Michael Lewis wasn’t looking to offer a complete solution to the problem of high frequency trading — in fact, he couldn’t have, because a complete answer to the colossal questions that this problem invites cannot exist in 286 pages. What can exist is a compelling and thrilling story that introduces a broad audience to the nature of this systemic flaw and raises a massive red flag to the people of the United States. The only way to begin a reform of the system that would eliminate this issue is by gaining the support of the masses: a task which Michael Lewis effectively and elegantly accomplishes.
Works Cited
Cooper, Ricky, Michael Davis, and Van V. Ben. “The Mysterious Ethics of High-Frequency Trading.” Business Ethics Quarterly, vol. 26, no. 1, 2016, pp. 1–22. ProQuest, http://libproxy.usc.edu/login?url=https://www.proquest.com/scholarly-journals/mysterious-ethics-high-frequency-trading/docview/2209585482/se-2, doi:https://doi.org/10.1017/beq.2015.41.
Hinkley, Robert C. “GOOD CAPITALISM VS. BAD CAPITALISM REQUIRING CORPORATIONS TO BE BETTER CITIZENS MUST BECOME A HIGH PRIORITY.” Pittsburgh Post — Gazette, Jan 16, 2012. ProQuest, http://libproxy.usc.edu/login?url=https://www.proquest.com/newspapers/good-capitalism-vs-bad-requiring-corporations-be/docview/916141918/se-2.
“IEX Stats.” IEX, 8 Nov. 2022, https://iextrading.com/stats/.
Lewis, Michael. Flash Boys: A Wall Street Revolt. W.W. Norton & Company, 2015.
On Tomorrow’s Secret Meeting to Plot the End of High Frequency Trading. Newstex, 2010. ProQuest, http://libproxy.usc.edu/login?url=https://www.proquest.com/blogs-podcasts-websites/on-tomorrows-secret-meeting-plot-end-high/docview/756150816/se-2.
