Flash Boys (2014) is an investigation into the dark underbelly of the US financial markets. It also chronicles the birth of a new stock exchange, the IEX, created to counteract a rigged system that was facilitated by technological loopholes and a lack of transparency.
Table of Contents
At the flea market, you’re negotiating a price with the vendor for an item you like. You are about to wrap up your deal when someone rushes in, snaps up the item from the vendor and sells it to you for a slightly higher price, pocketing the difference. That happens on market exchanges thousands of times a day in the form of high-frequency trading (HFT). In this revealing, entertaining financial tale, Michael Lewis (author of Moneyball and other bestsellers) explains and criticizes this kind of algorithmic trading. He focuses on Brad Katsuyama, a former Royal Bank of Canada executive, who embarked on a tenacious quest to battle high-frequency trading. Seeing the field through Katsuyama’s lenses leads to personalized, somewhat black-and-white reporting, which may blunt the subject’s complexity. However, Lewis gives his interview subjects a full hearing, including their frequent F-bombs. Some critics allege that the book touts Katsuyama’s exchange (it does), and some question nuances of Lewis’s interpretation (various blogs both debunk the book and debunk the debunkers). Even given the esoteric subject matter, this is worth reading if only because Lewis wrote it; you’ll laugh, feel the excitement, and get engrossed and maybe a bit angry. We recommend this accessible, challenging saga as a great backgrounder for anyone interested in the workings of Wall Street and the whereabouts of their savings.
- After the 1987 market crash, machines began handling more stock market functions.
- High-frequency traders gain an informational advantage via speed.
- These traders optimized their wiring and switches to gain tight time margins; they placed their computers in stock exchange buildings to facilitate faster transmission.
- Royal Bank of Canada executive Brad Katsuyama sought to expose high-frequency trading’s harm.
- He and his team founded the Investors Exchange (IEX), which thwarts high-frequency trading’s unfair advantages.
- Fighting high-frequency trading (HFT) is difficult because too many investors benefit from it.
- Regulations to eliminate unfair market behavior often have exploitable loopholes.
- When programmer Sergey Aleynikov was jailed for storing computer code online, he was a victim of widespread ignorance about HFT.
- Experts said Aleynikov’s activities did not deserve punishment.
- Goldman Sachs became the first bank to send the bulk of its orders to IEX.
Introduction: Learn how the US stock market turned into a rigged game of speed.
What happens when you invest in the stock market? There was a time when the answer was relatively straightforward. You’d talk to a broker who would put out an order, and maybe it would involve some traders yelling numbers on the floor of the New York Stock Exchange.
Those days are over. Now it’s all done electronically, through a system of servers, codes, and algorithms. The New York Stock Exchange, which used to be the primary trading ground, is just one of dozens of public and private stock exchanges. By reducing the human element, electronic trading was supposed to make trading safer and more efficient. But as we’ll see in this very short summary, it opened the door to predators all too eager to exploit the investors who are the lifeblood of the market.
A new problem, a new solution
The moment Brad Katsuyama hit “Enter,” he knew there was a problem. It was 2007, and Katsuyama was working in New York for the Royal Bank of Canada (known as RBC). The problem was, whenever he hit Enter to place an order – like buying 10,000 shares of Intel – the price would suddenly go haywire. Thinking he’d be able to turn around and sell for $22 a share, the moment he pressed that button, the share price would plummet, leaving him with massive losses. Suddenly, Katsuyama could no longer trust the market.
The problem was compounded by the fact that the stock market had become so complex that even veteran Wall Street brokers were largely clueless about the finer details. But by gathering a team of experts in various fields and merging their minds, Katsuyama was able to figure out exactly what was going on.
The problem was that Katsuyama’s orders were being “front-run.” The instant a big order – like 10,000 shares of Intel – appeared on the market, the algorithms being used by high-frequency trading firms (known as HFT firms) were able to get ahead of that order before it was broken up and distributed to the various stock exchanges. We’re talking about milliseconds here: the time it takes for an electronic order to make its way from Manhattan to New Jersey. But that was enough time to bombard the markets with competing orders, which would cause the price to change before the transaction was complete. This is what’s known as “front-running.”
Now, thanks to expert knowledge of the fiber optic networks in the tri-state area, Katsuyama and his team were able to develop a tool known as “Thor.” This program could stagger the release of an order so that it reached the various stock exchanges at exactly the same time, effectively ruining any opportunity for front-running.
But as it turned out, Thor was a tiny band-aid on a widespread problem that was being enabled by some of Wall Street’s biggest banks. A complex system of incentives was in place that allowed HFT firms to earn as much as $160 million a day by essentially screwing over investors. A loophole in electronic trading had been discovered and was being ruthlessly exploited, with little consideration for the long-term damage it was causing to both investor confidence and market stability.
It was going to take more than Thor to fix this problem.
A brave new stock exchange
Brad Katsuyama’s solution was twofold. First was an education campaign. He met with some of the biggest and most influential investors and hedge fund managers and explained how they were getting ripped off in the market as it currently existed. But then he started thinking bigger: What if we created our own stock exchange that was fully transparent and could guarantee protection from the market’s predatory elements?
There were some roadblocks, however. As crazy as it may sound, when investors placed orders with banks and brokers, those investors had no real way of knowing which stock exchanges their orders ultimately went to. Banks largely benefited from this lack of transparency. Many banks had what are known as “dark pools,” which are essentially private stock markets where all kinds of business happened away from the prying eyes of the public. The more business, the better it was for the banks. And no one was doing more business than HFT firms – even if that business was getting in the way of more legitimate transactions.
But Katsuyama had a few things working in his favor. The 2008 financial crisis caused some banks to understand the potential pitfalls of short-term gains. Plus, there was an increasing number of flash crashes happening, like the one that occurred on May 6, 2010, when the market plummeted 600 points, only to bounce back a few minutes later. This kind of instability was becoming more frequent and it wasn’t hard to connect it to the predatory manipulations coming from the HFT firms.
When Katsuyama and his team created their own stock market, and opened it for trading on October 25, 2013, it was called the Investor’s Exchange, or IEX. It was a big risk. They needed a lot of trades to happen if they were going to last and make a difference.
Fortunately, Katsuyama was able to find an ally in Goldman Sachs. After the 2008 fiasco, this giant investment bank had an interest in being on the right side of history when the next crash occurred. So, on December 19, 2013, everyone at IEX breathed a huge sigh of relief when the first big Goldman Sachs order came in. Immediately, their upstart venture surpassed the American Stock Exchange in market share. They were instantly legitimized. They were making a difference, in the name of transparency and course-correcting a broken financial system.
Algorithms on the Rise
On October 19, 1987, the US stock market crashed, taking even Wall Street insiders by surprise. Nobody had foreseen it or could explain it. Some of the regulatory adjustments that followed the crash facilitated a still steam-rolling move from fallible human traders to computer trading.
Someone Is Always Faster
All his life, Canadian Brad Katsuyama prioritized fitting in over fulfilling his ambitions: Instead of attending a school for gifted children, he stayed with his friends. He turned his back on the best universities and opted for Laurier to be with his girlfriend and his buddies. After graduation, he began trading stocks at Royal Bank of Canada (RBC) – mostly for lack of an alternative idea.
“Someone out there was using the fact that stock market orders arrived at different times at different exchanges to front-run orders from one market to another.”
Not long after Katsuyama moved to New York to become RBC’s Global Head of Electronic Sales and Trading, he noticed irregularities affecting his work. After 2007, he could no longer buy or sell at the exact stock prices flashing on his trading screen. The market prices changed as he tried to make transactions. The frequency of these price jumps ruled out market news as a motivating cause. Unstable prices made assessing risk more difficult and Katsuyama became hesitant to trade.
“Every systemic market injustice arose from some loophole in a regulation created to correct some prior injustice.”
His team found an explanation. When Katsuyama pressed a button on his computer, it sent his order to various exchanges. Since exchanges are in different places, the electronic signal arrived at different times. The margin was milliseconds, but other market participants – high-frequency traders – picked up Katsuyama’s order for specific shares and beat him to other exchanges.
The Need for Speed
Ronan Ryan lacked Wall Street contacts that might open doors to a great job and settled for a position at a big telecom company. Although never particularly interested in technology, once he put his mind to it, he became a sought-after expert. At Radianz, he helped firms transmit signals at ever-increasing speeds. He became a witness to a mad war for speed.
“Brad Katsuyama… trusted the system; and the system…trusted Brad Katsuyama.”
Trading firms tried to lessen the distance – even by scant feet – that a cable travelled from their data centers to the stock exchanges. The exchanges offer “co-location,” letting traders place their computers in the exchange for a fee. When the traders couldn’t move their computers any closer, they demanded the latest materials or changed individual switches to gain microsecond increases in signal speed.
“The markets are rigged….the answer lay beneath the surface of the technology.”
What seemed random to Ryan made sense to Katsuyama, who recruited Ryan for his banking team. Ryan took a considerable pay cut to join RBC as head of high-frequency trading strategies. The title bore almost no relation to his actual job, which was to explain to Katsuyama in technical terms what was happening in the markets. As Katsuyama learned all he could about high-frequency trading (HFT), he came to understand the rules of the HFT game, its impact on the markets and its grip on the exchanges. Katsuyama decided to fight HFT and its ability to cut off other trading. He hoped to enlighten and educate other investors and to put enough pressure on the system to change it.
Well-Meaning Is the Opposite of Well Done
Before John Schwall joined Katsuyama’s team, he was a product manager at Bank of America. Deeply attentive to detail, Schwall ran the nitty-gritty specifications that trading programs required. When he learned that some market participants were, in effect, “front-running” others, he needed to find out why that was possible, or lawful. His research led him to some well-meaning legislation: Regulation National Market System, or Reg NMS for short. It required brokers to buy at the exchange that offered the lowest prices. Determining the lowest price required US exchanges to submit data to the Securities Information Processor, which calculated the National Best Bid and Offer (NBBO). This created a trading delay. HFT experts could calculate the NBBO much faster, and thus profit from a sneak preview of the market. The larger the time gap between the official NBBO and a privately calculated one, the more high-frequency traders made. The more price fluctuations a stock went through, the more opportunities high-frequency traders had to exploit those fluctuations.
“The team Brad was assembling at RBC didn’t have all the pieces to the puzzle…but they [were] willing to talk openly on the subject.”
The regulation made market behavior easier for high-frequency traders to predict, because brokers had less flexibility in how they placed orders. Reg NMS inadvertently created a loophole high-frequency traders could exploit. Schwab saw that whatever regulators did to improve market behavior, some people found a way to turn it to their advantage.
Battling HFT Illiteracy
Katsuyama encountered widespread ignorance about the workings of HFT. Some HFT supporters, including SEC employees, claimed that HFT “provided liquidity” in the market – since, by 2008, high-frequency trades made up about 65% of all trades. In Katsuyama’s view, however, high-frequency traders hijacked trades that would have taken place without it. Once they knew a buyer and a seller were in place, they profited from the trade without assuming any risk.
“The average size of IEX’s trades was by far the biggest of any stock exchange, public or private.”
HFT did not create liquidity, but undermined it. Traders like Katsuyama – who did provide liquidity – were less likely to assume the risk of trading if they could not rely on market information. Further, high-frequency traders benefited from volatile, fragmented markets. “The price volatility within each trading day in the US stock market between 2010 and 2013 was nearly 40% higher than in the most volatile days of the dot-com bubble.” HFT also contributed to fragmentation by “[encouraging] new exchanges to open.”
Goldman Sachs saw opportunities in HFT, but it did not reap any benefits; its systems were simply too slow to compete. Russian programmer Sergey Aleynikov’s job was to change that. The bank’s existing system suffered from too many layers, too many lines of code, too many patches and too much built-in bureaucracy. Aleynikov realized that Goldman Sachs’s best shot at a competitive high-frequency trading platform was to build one from scratch – but management wouldn’t hear of it.
“A small class of insiders with the resources to create speed were now allowed to preview the market and trade on what they had seen.”
Aleynikov’s programming skills were in high demand on Wall Street. He didn’t consider leaving Goldman Sachs until the manager of another hedge fund asked him to build a new trading platform from square one. He jumped at the opportunity. At Goldman Sachs, he had used open-source software code for his work. To his chagrin, the firm had forbidden him to release his changes to the code back to the open-source community. Goldman Sachs considered even minimal changes proprietary. Before he left, Aleynikov uploaded some of his code to a site where he could retrieve it later. If he needed to code something similar again, he thought that cache of code would help him reconfigure his earlier work. He knew his actions weren’t strictly legal, but he considered the uploading a minor crime – a programmer’s benign habit.
“Writing a program is like giving birth to a child…It is a creation. Even though it is technical, it is a work of art. You get this level of satisfaction.” (Sergey Aleynikov)
Goldman Sachs managers alerted the FBI, whose agents did not regard Aleynikov’s actions as minor at all. The Feds arrested Aleynikov and charged him with “violating both the Economic Espionage Act and the National Stolen Property Act.” Aleynikov was happy to confess. He believed that once the FBI understood what he had done, he would be free to go. The agent responsible for his case – as well as the jurors, prosecutors and most of the witnesses – clearly struggled to understand the nature of his offense, let alone the specifics of high-frequency trading.
“Dark pools were …private stock exchanges run by the big brokers…they were not required to reveal to the public what happened inside them…no one but the broker who ran it had any idea what was happening.”
Aleynikov “was sentenced, without the possibility of parole, to eight years in federal prison.” Experts asserted after the trial that his decision to upload his code was normal programmer behavior. The code wasn’t that valuable anywhere outside Goldman Sachs – especially since Aleynikov would have needed to use an entirely different programming language to create the new trading platform. He could have made money if he’d taken the bank’s “algorithmic trading strategies,” but he left those alone.
The Investor’s Exchange
In a gutsy move, Katsuyama and his team decided to leave their secure, well-paying jobs at RBC to open their own exchange, the Investors Exchange (IEX). They hoped their exchange would fix the loopholes that high-frequency traders exploited and would allow investors to trade on a fair exchange. To avoid “predatory trading,” IEX took several steps, including:
- A “350-microseconds delay” – IEX intentionally extends the time it takes for a traders’ signal to reach its matching engine, thus negating any speed advantage.
- No co-location – IEX does not allow any firm to put computers near its matching engine.
- No kickbacks or rebates – IEX charges everyone the same fee based on share volume.
- Limited types of orders – Some exchanges offer various order types catering to HFT. For example, a high-frequency trader could hide an order until someone else entered the same order, making the high-frequency trader first in line. IEX’s order types do not give faster traders an advantage.
- Owned by investors only – To avoid a conflict of interest or any hint of a conflict, only investors (such as pension funds, mutual funds and hedge funds) – not bankers or brokers – own IEX. Even the exchange’s founders have to work through a broker to trade on the exchange.
What Happens in the Dark Pool, Stays in the Dark Pool
A couple of months after IEX opened on October 25, 2013, Katsuyama had learned some valuable lessons. Other stock exchanges (not surprisingly) and big Wall Street banks (unexpectedly) did not welcome IEX. It received negative – and untruthful – word-of-mouth feedback. Opponents even threatened some IEX employees. When big investors, such as mutual fund managers, told their banks to manage their business via IEX, those banks bent over backward to avoid giving IEX any business at all.
“The picture…most people have of the markets is…a picture a human being might have taken. That picture is dated; the world it depicts is dead.”
A program that graphically showed IEX’s trading statistics helped Katsuyama interpret market behavior. He learned that some big banks were “pinging” IEX for shares. They would, for example, order 100 shares to see whether IEX had a matching seller. This was a way to get information without publicizing a high demand that might affect the share price to their disadvantage. Curiously, even if IEX did have a matching trade partner, the banks still wouldn’t trade on IEX.
“The speed with which trades occurred was no longer constrained by people. The only constraint was how fast an electronic signal could travel between…the data center…that housed Chicago Mercantile Exchange and…NASDAQ’s stock exchange in…New Jersey.”
Katsuyama saw that the banks were trading in their own barely regulated private exchanges, called “dark pools.” The law did not require banks to publish data on how the dark pools operated. This provided banks with opportunities and temptations to put investors at a disadvantage. Pinging IEX gave banks a double advantage: They gained a facade that made it look as if they had tried to trade on IEX. And, they could make IEX’s stats look bad: Investors read large average trade volumes as an indicator of a good exchange.
“More than 200 SEC staffers since 2007…left …government jobs to work for high-frequency trading firms or the firms that lobbied Washington on their behalf.”
By ignoring offers outside their dark pools, these banks also gave high-frequency traders– who paid for dark pool access – an opportunity to exploit customers’ orders. Katsuyama saw that the exchanges, banks and brokers all benefited from existing inefficiencies. Fixing the market would take far more than offering a fair exchange.
“The US stock market was now a class system, rooted in speed, of haves and have-nots.”
Katsuyama invited major investors, such as pension funds and mutual funds, to share his findings, and he praised the banks and brokers that refused to participate in unfair behavior. New management at Goldman Sachs, which earlier had Aleynikov arrested, understood that it could never compete with HFT professionals, and didn’t want to be part of it. Two influential Goldman Sachs managers saw IEX as a crucial milestone in financial history. In December 2013, the bank began sending many trades to IEX. This change of strategy and support was a ray of hope for Katsuyama. He saw that what he started could end up changing the market for good.
Starting in 2007, a small group of Wall Street insiders discovered that the US financial system was rigged. High-frequency trading firms, supported by influential banks, were manipulating orders and raking in hundreds of millions of dollars a day. Led by Brad Katsuyama, the insiders launched a new stock exchange based on transparency and fairness, in the hopes of fixing a broken system.
About the Author
Michael Lewis wrote Moneyball and other bestsellers. A contributing writer for The New York Times Magazine, he also writes for Vanity Fair and Portfolio magazine.
“Flash Boys” is a thought-provoking and insightful exposé on the inner workings of the financial industry, particularly the high-frequency trading (HFT) practices that have become the norm on Wall Street. Lewis, a renowned author and financial journalist, delves into the complex world of stock markets, revealing the ways in which HFT has distorted the market and created an unfair playing field for ordinary investors.
- High-Frequency Trading (HFT) Unveiled: The book provides an in-depth exploration of high-frequency trading, a practice where powerful computers and algorithms execute trades at lightning-fast speeds. Lewis explains the mechanics of HFT, its impact on the stock market, and how it has become a controversial and lucrative business.
- The Rise of the Flash Boys: Lewis introduces readers to a group of Wall Street insiders, including Brad Katsuyama and his team, who become the central figures in the story. These individuals, known as the “flash boys,” discover the unfair advantages that HFT firms have and set out to level the playing field.
- Uncovering Predatory Practices: Through meticulous research and interviews, Lewis exposes the predatory practices employed by HFT firms, such as front-running and latency arbitrage. He sheds light on how these practices exploit market inefficiencies and disadvantage traditional investors.
- The Impact on the Market: The book explores the wider implications of HFT on the stock market and the economy as a whole. Lewis discusses how the speed and complexity of high-frequency trading can destabilize markets, erode investor confidence, and contribute to market volatility.
- The Quest for Fairness: “Flash Boys” follows the journey of the flash boys as they develop a new stock exchange called IEX (Investors Exchange). IEX is designed to provide a fairer and more transparent trading environment by neutralizing the advantages of HFT firms and prioritizing the interests of long-term investors.
- The Human Side of the Story: Lewis skillfully brings the characters to life, showcasing their motivations, challenges, and the personal toll their pursuit of reform takes on them. He humanizes the story, making it accessible and relatable to readers.
- Regulatory and Legal Implications: The book also delves into the regulatory and legal landscape surrounding HFT. Lewis examines the response of regulatory bodies and the challenges faced in implementing meaningful reforms to address the issues raised by high-frequency trading.
- A Call for Change: “Flash Boys” ultimately serves as a call to action, urging readers to question the fairness and integrity of the financial system. It highlights the need for increased transparency, regulation, and ethical practices to protect the interests of all market participants.
The book centers around the story of Brad Katsuyama, a former trader who became disillusioned with the corrupt practices of his former employer, the Royal Bank of Canada. Through Katsuyama’s eyes, Lewis reveals the inner workings of the HFT system, which relies on sophisticated algorithms and superfast computers to execute trades in fractions of a second. These algorithms are designed to exploit tiny price discrepancies across various stock exchanges, often at the expense of long-term investors.
Lewis’s investigation uncovers a web of deceit and manipulation that undermines the integrity of the financial system. He exposes how HFT firms use their vast resources and influence to coerce exchanges into adopting favorable rules, which they can exploit to their advantage. He also shows how these firms engage in “layering,” or placing orders on multiple exchanges at the same price to create the illusion of market demand and boost their profits.
Throughout the book, Lewis highlights the absurdities and injustices of the HFT system, including the fact that some firms are able to execute trades faster than light, while others are left to suffer through slow and unpredictable markets. He also sheds light on the devastating consequences of the 2010 flash crash, which was caused in part by HFT algorithms gone awry.
The book highlights several ways in which HFT distorts the markets, including:
- Speed advantages: HFT firms use advanced technology and proximity to exchanges to receive market data and execute trades faster than other participants, giving them an unfair edge.
- Order types: HFT firms use complex order types, such as “flash orders” and “dark pools,” to trade undetected and avoid revealing their true intentions to the market.
- Market fragmentation: HFT firms exploit the fragmentation of the US stock market, which consists of multiple exchanges and dark pools, to profit from price discrepancies.
- Front-running: HFT firms use their speed advantages to front-run other traders, anticipating their orders and profiting from the resulting price movements.
- Quote stuffing: HFT firms flood the exchanges with orders and then cancel them, creating the illusion of market activity and influencing prices.
Despite the complexity of the subject matter, Lewis writes in an engaging and accessible style, making the book easy to follow for readers without a finance background. He also weaves in compelling narratives about the individuals involved in the story, including Katsuyama and other HFT insiders who have blown the whistle on their former employers’ unethical practices.
One of the book’s strengths is its ability to convey the moral urgency of the issue. Lewis argues that the current HFT system is fundamentally flawed and undermines the principles of fairness and transparency that are essential to a functioning financial system. He makes a convincing case that the only way to restore integrity to the markets is to reform the HFT system and level the playing field for all investors.
However, the book is not without its limitations. While Lewis provides a detailed expose of the HFT industry, he doesn’t delve as deeply into the underlying causes of the problem. He doesn’t explore the historical and regulatory factors that have led to the rise of HFT, or offer concrete solutions to address the issue.
Here are some of the pros and cons of the book:
- Well-written and engaging
- Provides a balanced perspective on a complex issue
- Does not shy away from asking tough questions
- Timely and relevant
- Some technical details may be difficult to follow for laypeople
- Some readers may find the book to be too long
- Lewis’s conclusions are not always supported by evidence
In conclusion, “Flash Boys” is a thought-provoking and well-researched expose that sheds light on the dark corners of the financial industry. Michael Lewis’s engaging writing style and compelling narratives make the book an enjoyable and informative read, even for those without a finance background. The book is a must-read for anyone interested in understanding the inner workings of the financial system and the need for reform to restore fairness and integrity to the markets.
Here are some additional thoughts on the book:
- Lewis does a great job of explaining the technical aspects of HFT in a way that is understandable to the lay reader. He also provides a lot of historical context for the development of HFT, which helps to put the current situation in perspective.
- I appreciate that Lewis focuses on the human stories behind the HFT phenomenon. He shows how HFT has affected the lives of ordinary investors, as well as the lives of the people who work in the HFT industry.
- I think Flash Boys is an important book because it raises awareness of the dangers of HFT. It is a wake-up call for regulators and for ordinary investors. We need to do more to protect the fairness of the financial markets.
If you are interested in learning more about HFT or the financial industry, I highly recommend reading Flash Boys. It is a well-written and thought-provoking book that will challenge your assumptions about the way the markets work.