This is another story about well-intentioned regulation going awry. It is also an example of something that lots of people are concerned about: the rise of the robots. We are often told that new technologies are on the way that will displace huge numbers of jobs. Technology may have replaced only manual workers in the past, but we will now see plenty of skills becoming obsolete. Flash Boys suggests the robots are already here.
The story begins with cables being straightened and new ones being laid, drilling through mountains and under roads, always with the imperative of being shortened and carrying data as quickly as possible.
Initially, technology is deployed to automate a trading activity that is centuries old: cash-futures arbitrage.
When I started in financial markets, cash-futures trading was done by guys (almost always men) wielding nothing more than an ability to do lightning-fast mental arithmetic.
A futures market is where we buy or sell promises to deliver commodities, equities, bonds and almost any other asset some time in the future. The cash markets are about trading today. There is a simple formula that aligns the two markets.
Sometimes the price of a futures contract slips slightly out of line with the prices in the cash markets. The prosaic reasons for this are usually to be found in human behaviour and the physical separation of where these trading activities take place.
In the US, historically, the futures markets have typically been in Chicago and the cash markets have been in Lower Manhattan. Quick traders spot the pricing anomalies and “arbitrage” them away: they buy one and sell the other until prices come back into line, making a guaranteed profit. At least, that is what they used to do.
Today, this activity – and most trading – is no longer conducted by smart young men. It is done machine to machine. The image of buying and selling we have of people in bright jackets yelling at each other is almost totally wrong. The Dan Ackroyd and Eddie Murphy movie Trading Places could not be made today: it would be a complete anachronism.
Shenanigans in the markets
Machine-driven cash-futures trading is simply a logical development; there is nothing sinister to worry about, unless you are one of the young men made unemployed (and there are lots of those). Flash Boys goes on from this story into something far more murky, focused almost entirely on shenanigans in the cash markets.
Essentially, there used to be two stock markets in the US: the Nasdaq and the New York Stock Exchange. Microsoft shares, like any other company stock, were traded exclusively on just one of these exchanges.
Now there are lots of exchanges, shares can be traded on any of them and they are almost always fully automated. In the good old days we could see (either on our screens or via a telephone call) where prices were trading. Investors had transparency about what was going on.
The central characters in Flash Boys became suspicious only a few years ago that transparency was not what it seemed. As did many other investors. Suspicions grew that the prices we could see were not "real".
The rise of something called “dark pools” gives the game away: something is not called “dark” if transparency is the name of the game.
The proliferation of new stock exchanges gave rise to high-frequency trading, so-called because the average length of time that “investors” hold on to their shares is 11 seconds.
Deploying algorithms to buy and sell huge quantities of shares throughout the day, high-frequency traders go home at night owning nothing other than their profits. Nobody knows quite how they do it, because most of the computer code is secret.
Lewis tells us how one of the programmers at Goldman Sachs, Sergey Aleynikov, goes to jail for eight years, without parole, for emailing himself some lines of software.
While the cash-futures thing is understandable, what goes on today inside the vast computer centres (which is what the new stock exchanges are) is a mystery. Lewis is able to shed some light on this and how some traders (the good guys in this story) think they have figured it out. A lot of the evidence is compelling but, inevitably, circumstantial.
Follow the money
The 1976 movie about the Watergate scandal taught us to follow the money: the obvious existence of vast amounts of cash being made by the flash boys should be evidence enough of something going wrong, even if we don't quite know how they do it.
Firms whose names we have never heard of boast of years of trading where there is not a single day when they have lost money. The only way that they can do this is by possessing an information edge that ordinary investors do not. Poor regulation means that this is not illegal, but in the opinion of many it should be. The profits of the flash traders are a tax on ordinary investors – anyone with savings or a pension fund. There are negative consequences for companies, implications for how they, in turn, invest in the real economy. We are all affected. As many others have observed, the social value of all of this is, at best, zero.
The physicists, telecom engineers, mathematicians, software developers and assorted PhD scientists behind all of this could – should – be doing something far more useful with their talents. But the financialisation of our economies dictates otherwise.
It is tempting to call for more and better regulation. But the central message of Flash Boys is that such efforts are always doomed to failure. The robots have taken over, and we don't know what they are up to.
As always, Lewis writes beautifully and convincingly. The industry is already fighting back, claiming that high-frequency trading improves liquidity and lowers transactions costs. Their profits strongly suggests these claims are bogus. Bizarrely, they criticise Lewis for not understanding the true nature of their trading. They should be made to reveal it.
