Scalpers INC.

"Flash Boys – A Wall Street Revolt” by Michael Lewis, 2014

Lewis is a former 1980s Salomon Brothers fixed income trader who went rogue journalist, and pulled the cover off of some of Wall Street’s dirtiest secrets.  Here he does the same thing regarding the present practice of ‘flash’ or ‘high speed trading.‘ This is one of the main causes behind the increased volatility of the stock markets.  Computers are running the trading systems now, increasing prices and fees, trade volume, front-running, manipulation and complexity, while decreasing transparency and accurate regulatory oversight.  The majority of market trades are now done in ‘dark pools’ of the 9 main Wall Street banks or those of high-frequency trading firms (HFT), which skim off billions of dollars a year from investors.  The HFT’s act as riskless middle-men – almost never having a losing day.  Sort of like the attendant in the washroom who requires you to let him hand you the toilet paper, and requires a dollar for the service.

The story is vintage Lewis, though perhaps somewhat less funny than the portraits of Wall Street ‘wolves’ that he has painted in the past.

How have the HFT firms changed the industry?  The HFT firms already know the slow, ordinary buy bid, due to the speed of their computer lines.  They are able to ‘front-run’ the purchase because of this.  They jump ahead and get a higher price on some other exchange, if only fractions of a cent on large purchases.  But that adds up to billions over time.  Essentially they prove that ‘market knowledge is not equal or perfect,’ contrary to what the ideologists of capital claim. Lewis explains how it was done – something even most of the top people on Wall Street didn’t understand.  

This may seem like an arcane story, but if you have a 401K, an IRA, a mutual fund, a pension from a union, a company or the government, you are being skimmed too.  And not just on your ‘fees.’  This pattern went international, as these kind of exchanges are set up all over the world. 

More proof that, as Lewis puts it, “By the summer of 2013, the world’s financial markets were designed to maximize the number of collisions between ordinary investors and high-frequency traders – at the expense of ordinary investors, and for the benefit of high-frequency traders, exchanges, Wall Street banks and online brokerages.” In 2013 “38% of the entire stock market traded inside the banks’ own dark pools.”  Those pools are opaque ‘black boxes’ in which order and bid activity is invisible or never disclosed.  And they are still legal, thanks to our supine SEC.  Oddly enough, the banks found that ‘the best price’ on the 70% of the market they controlled existed a huge amount of the time in their own dark pools.  What are the odds, when there were 13 public exchanges and 40 secretive ‘dark pool’ exchanges just in 2007 in the US alone?

The ‘revolt’ in the title might be taking the term too far.  This a story of Brad Katsuyama, an Asian from Canada who worked for Royal Bank of Canada (RBC).  He found something severely odd when he tried to trade securities in 2007 in the U.S.  In 2007 “Reg NMS’ was a rule handed down by the SEC that mandated a ‘best price’ through a ‘best bid and offer’ - but it failed to regulate the speed at which this would happen.  What actually happened was that market technology took over and HFT firms were able to program algorithms that would essentially manipulate the market in fractions of a second.  As a trader, Katsuyama could not actually get a real price on his computer – they just disappeared.

Katsuyama looked into Wall Street history to get some perspective.  As Lewis describes what he found: “The entire history of Wall Street was the story of scandals… every systemic market injustice arose from some loophole in regulation.”  And there will always be loopholes.  So Lewis says there is zero chance that the problem will be solved by financial regulators.  This is where the ‘good guys’ from RBC came in - to solve a problem the bought-and-paid-for regulators won't.

What people saw when they looked at the U.S. stock markets – the numbers on the screens of the professional traders; the ticker tape running across the bottom of the CNBC screen - was an illusion.  Katsuyama said after the 2007 crash: “That is when I realized the markets were rigged.”

Katsuyama moved from Toronto to New York to work for RBC.  It was a tough transition.  “I met more offensive people in one year than I had in my entire life.”  In 2006 Royal Bank had a ‘no asshole’ hiring rule.  That is, until RBC bought Carlin Financial to gain some perspective on high-speed trading.  According to one RBC’er:  “There was a lot of gold chain attire.”  Lewis describes the situation:  “It was as if a tribe of 1980s Wall Street alpha males had stumbled upon a time machine and, as a prank, identified the most mild-mannered, well-behaved province of Canada and teleported themselves into it.”

Ultimately RBC got rid of Carlin and Katsuyama hired a group of technologically-saavy Wall Street misfits that looked into this problem and discovered that it was all about speed.  To foil the HFC firms they built a trading platform from the ground-up called “Thor,” which eventually gave a 350 microsecond delay into every transmission so that HFC firms could not game the offers.  In the process they brought the issue to the attention of the SEC – supposedly a ‘watchdog’ for investors.  In their meeting with the SEC, the SEC stood up for the HFC firms.  Later RBC did a study of SEC personnel and discovered that 200 SEC staffers had left jobs at the agency since 2007 to join HFT companies or their lobbying arms. In 2010, Judith King, head of the SEC’s Division of Trading and Markets quit to join GETCO, one of the largest HFC firms.  The SEC resembled every other agency in Washington- a revolving door with the firms they were supposed to ‘watch over.’

Later the group led by Kasuyama and an Irish techie named Ronan Ryan left RBC and went independent, building an exchange called the IEX, an exchange in which HFC firms allegedly cannot manipulate prices, make up bogus offers, skim fees or ‘payments for order flow.’  Katsuyama had to raise money for the new exchange.  He spent “spent six months running around New York faking greed he didn’t really feel, to put the money people at ease.”  No one would listen to him if he didn’t tell them how rich it would make him.  

One of the interesting side-lights in this story is the number of Russian and Chinese coders hired by Wall Street.  Several of them feature in this story, like Serge Aleynikov, who had the FBI called on him by Goldman Sachs for taking mostly open source code from Goldman.  Or the Croatian Zoran Perkov, who set up exchanges all over the world after his experience at NASDAQ, until he became disillusioned.  Or Allen Zhang, who built the code for the first successful dark pool.  They never quite understood the concept of ‘intellectual property’ or the obsession with money that most American Wall Streeters took for granted.  And they were looked down upon by the traders.  As Lewis says, “There are vividly clear class distinctions between tech guys and finance guys.” 

Lewis, led by the geek techies, here goes into complexity theory, which says that the more complex a system, the more risk is built into it.  A long string of Wall Street tech failures in 2013, and the notorious ‘flash crash’ of 2010 (really still unsolved) all indicate that there is another problem.  As Lewis puts it, “sensational technical glitches weren’t anomalies but symptoms” of the larger problem of complexity and fragmentation in market technology and rules.  Kaysuyama predicts that at some point, a euphemistic tech ‘glitch’ could become more like a black death star.

Lewis exposes the problems in Wall Street and shows that the ‘good guys’ are trying to make finance capital run better.  Sort of like the mechanic on a tank that is about to run over you anyway.  Humanizing capitalism is necessary when the serfs suddenly get the feeling that they are road kill. 

RBC runs many trades through IEX, promotes charities and good causes as marketing tools, and didn’t get bailed out by the Canadian or U.S. governments in the 2008 crash.  Nice, right? Ironically, they have a large commitment to a "Blue Water' Project" worldwide, which tries to protect our water supplies.  However, according to Canadian environmentalists, RBC is also the biggest funder of the mining companies in the Alberta tar sands.  This has resulted in water pollution and increasing cancer rates produced by mining tailings and chemicals in the McKenzie River basin.  Not to mention the carbon effect.  Many working-class Canadians are in debt to RBC, which holds their mortgages.  The clients of the U.S. arm, the ‘high net worth individuals’ that RBC Wealth Management slathers over, inherited their money or are mostly small businessmen or corporate managers who gained their money from the labor of working people.  RBC in reality is merely a parasite upon these parasites, though a far more polite one. 

In sum, the problems suggested in this book are much bigger than the ‘fix’ presented.  But that is not why we read books like this - it is for the factual information that capital tries to hide. And Lewis is one of the best explainers of those hidden facts.

Reviewed below: “Liars Poker,” and “The Big Short,” (both by  Michael Lewis).  Use blog search box, upper left. 

And I bought it at May Day’s excellent used/cut out/donated book section.

Red Frog

April 26, 2015