By JIM MCNIVEN
“I Stole It Fair and Square.” I have sometimes used that quote to describe what went on in much of the United States’ land policy with respect to Native Americans. An awful lot of land was acquired from various ‘chiefs’ who were deemed by the American authorities to have the legal right to sell property presumably owned by their tribes. Often the ‘purchase’ was made for a pittance, especially from chiefs who were largely unaware of the import of what was being discussed, since in their world view no one could own the land. Treaty in hand, the ‘buyers’ would then move in and evict the tribe from the land, survey it, and sell it off in parcels to eager settlers, all legal and proper-like.
Cross this with another story: that of Nathan Rothschild in London in 1814. Two hundred miles away, across the English Channel, British and Allied forces were meeting the French army at Waterloo, near Brussels. The outcome would affect the British financial market. Rothschild had operatives in Brussels who reported the outcome to him, not with the standard technology of the time, of fast horses and Channel sailing ships, but through semaphores and carrier pigeons. He got advance information, and did well out of it.
Now, ratchet these two early 19th century stories forward 200 years and we arrive at Michael Lewis’ latest book, Flash Boys. It is the 21st Century version of the story of those British financiers who lost out to Rothschild, and of trying to figure out how he did it. Today, semaphores and carrier pigeons have been replaced with fiber optic cables and microwave towers. There is nothing illegal in getting to the market microseconds ahead of the other guy by using up-to-date technology yet, in the aftermath of the trauma of the crash of 2008, the unethical and the illegal easily flow together, especially when too much of this modern ‘front-running’ might result in another crash.
Flash Boys seems to be more hurriedly written and published than other of Lewis’ books, as if the author had caught the speed virus he documents. He attempts to portray the stock market as being ‘rigged,’ as if front-running were not a fairly familiar occurrence. Advance information, when gathered or bought from corporate officers, is illegal and is known as insider trading, but the play he documents depended on simply beating traders to the market through sophisticated technology.
The market as a whole is supposed to be based on the idea that everyone has the same access to relevant information, a worthy objective that is honoured more in the breach than in the observance. Lewis notes that whether it is in the ‘dark pools’ of exchange facilities inside the major investment houses themselves, or in the technical arrangements inside the now-numerous shareholder-owned stock exchanges like the NYSE or NASDAQ, all the sizable brokerage institutions on Wall Street are involved in some sort of shenanigans that do not work to the advantage of investors, big or small.
The story unfolds in a number of directions which, had Lewis taken the time to think them through, would seem to come out like this: There are the bad guys, the exchanges and the high frequency traders (HFTs). There are the sort of not-so-bad guys, namely Goldman Sachs. And there are good guys, a bunch of traders and techies who are led by a trader from the Royal Bank of Canada’s (RBC) New York operation.
The good guys find themselves being discomfited by something the bad guys are doing to their trades. The bad guys (HFTs) have this technology that gives them a kind of detailed advance knowledge of all the major shares’ probable movements and, like Rothschild, buy and sell in such a way to always win, not just on big news like Waterloo, but every day, all the time. The good guys are being taken advantage of, not just once but every time they trade and on every share they trade. They are modern Native Americans losing their financial territory. Lewis’s story revolves around what they try to do about it.
The normally-lucid Lewis is not at his coherent best when describing what it is that the bad guys are doing. Here is what I think was going on: The good guys try to puzzle out how the HFTs are able to mess with electronic trades, which are, for all practical purposes, instantaneous. The trick lies in the qualifier to instantaneous. Somebody named Einstein figured out that the fastest anything can travel is at the speed of light, 186,000 miles per second. A Chicago trader named Dan Spivey figured out that if one fiber optic cable were shorter than another, then a 186-mile differential between HFT and an exchange would mean a time advantage of a millisecond, or 1/1000th of a second. Reduce the time advantage to a microsecond, or a millionth of a second, and the distance from the exchange shrinks to under a quarter of a mile. If an HFT computer running a certain type of program were to be co-located with, say, the NYSE computer, then there would be scads of time from the computer’s viewpoint to front-run any and all incoming stock orders. Given the billions of shares traded each day, even a cut of a penny a share would really add up.
Of course, it helps if no one on the outside suspects or knows what you are up to. Brad Katsuyama, a Canadian at the RBC New York office, tried to figure out why his trades seemed to flash off and then on at a slightly higher price all the time.
The body of Lewis’ book concerns first Brad’s search, then his decision to open up a new exchange, the IEX, and finally his assembling a team to manage it. Setting up a new exchange was, in principle, easy and cheap, since trading activity was no longer located on a ‘floor’ with real people shouting and waving pieces of paper, but inside a powerful computer/server system tended by a staff of techies.
The purpose of the IEX was that its design allowed all trading information to arrive in such a way as to negate the HFT advantage and revenue skim. Brad and his team expected to be boycotted by the big players, who were both beneficiaries of HFT ‘crumbs’ and also victims of their practices. In effect, both the traders and their houses were involved in different ways of preying on investors — the banks having their own ‘dark pools,’ where they could make trades that were profitable on both the buying and selling sides, but they paid the HFT toll if they had to go outside for shares to make a trade.
Enter Goldman Sachs. The firm’s traders had accused one of their techies, whose group was excluded from knowing what their work was for, with stealing a piece of code as he left to work for another firm. Goldman, the FBI, the trial judge, the lawyers and the jury had no clue what the implications of the code were, but assumed that it had to be important so the techie, a Russian who also did not understand what the problem was either, went to jail. A couple of years later, he was exonerated in a new trial, after it was discovered the code was both ‘open source,’ or public, and trivial. Goldman had no right to even put its ‘property of’ stamp on it.
Apparently this and other things convinced the higher-ups in the company that they were unlikely to beat the HFTs at their technology game, so they swung their considerable business behind IEX, began to complain to the authorities about the HFTs’ practices and made Brad Katsuyama and his team successes.
The good guys won, at least as of the end of 2013. King Phillip, Tecumseh, and Crazy Horse must be dancing in the clouds while, below them, Rothschild is rolling in his grave.
Lewis got his story out quickly: it was on the shelves by April, 2014. He is an engaging writer and it is a fascinating story, but it is a bit disjointed because it was written and produced so fast. The second printing will be better organized, I’m sure.
Copyright © 2014 James D. McNiven
Contact: j.mcniven AT dal.ca
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