"Flash Boys" Triggers Debate: HFT and Fairness

Michael Lewis’ interview on the CBS news magazine “60 Minutes” is provoking strong reactions from Wall Street traders and analysts who are refuting his allegations that the market is rigged.

The author of the new book "Flash Boys" told "60 Minutes" correspondent Steve Kroft “the iconic U.S. stock market is rigged by a combination of stock exchanges, Wall Street banks, and high frequency trading firms.”

Lewis, a former bond trader, argued that ultra-fast computerized trading is skimming a penny here or there, but when done millions of times a day, is costing investors billions of dollars. He also pointed out how high-speed firms are spending hundreds of millions of dollars to get access to price feeds ahead of other investors.

Some of the reactions on Twitter ranged from criticism for not checking his facts on HFT since their profits have been declining — to wanting to return to the “horse and buggy whip.” They also noted that Lewis never mentioned the role played by regulators, particularly, where was the SEC in all of this.

On “60 Minutes,” Lewis argued that this is a form of “legalized front-running” and struck out against the complexity of the stock market – which he said was invisible since humans have been completely removed from the process.

“They are able to move faster than you. They will see your order and play it against other orders in ways you don’t understand. They are able to front run you order. It means they’re able to identify your desire to buy shares of Microsoft and buy them in front of you and sell them back to you at a higher price,” said Lewis on "60 Minutes."

Some see the overall system of speed combined with incentives provided by exchanges for HFT as being at fault. In today’s New York Times, Deal Book editor Andrew Ross Sorkin blamed the “perverse system on Wall Street allowing certain professional investors to pay hundreds of millions of dollars a year to place their servers close to stock exchanges, so they can trade milliseconds ahead of others.”

While much of the information about the race to zero latency race and colocation of servers in data centers is common knowledge in financial markets, this could be news to the average American viewing 60 Minutes after a basketball game. He tells the story through the experiences of former RBC trader Brad Katsuyama – a former head of trading at RBC Capital Markets who figured out that his customers’ orders were being skimmed (front run) by HFT firms that could identify its orders before they arrived at each exchange.

By showing a map of the data centers in New Jersey – 60 minutes was able to illustrate the trajectory of electronic orders sent by brokers like RBC to the data centers in northern New Jersey where the exchanges’ black boxes are located. Katsuyama had to hire a telecom specialist, Ronan Ryan, who figured out that their orders were being front run because they were landing on BATS, the closest exchange first where all the HFT firms were waiting, and then could beat his orders to the other exchanges. “They were able to jump in front of his orders and buy the same stock and drive up the price before his order arrived driving up the price one or two pennies,” explained Lewis. So Ryan and the RBC team created a software program (Thor) allowing the orders to reach all the exchanges at the same time. [They have since quit their jobs and left to from IEX- a dark pool that delays all orders by 350 microseconds to level the playing field].

But some observers felt that Lewis was exaggerating the negatives in the market structure. Electronic trading has brought more liquidity, they argue. HFT firms are serving as market makers and since they account for 50 percent of stock market volume, their liquidity would have to be replaced by something else- a topic that no one addressed on the show.

Michael Lewis could not be more wrong when he says the stock market is not a fair or safe place for investors #FlashBoys (1)

— William O'Brien (@obrienedge) March 30, 2014

"The stock market had become grotesquely unjust and badly needed to change.." #flashboys Michael Lewis pic.twitter.com/9NZfC2ZGyZ

— Eric Scott Hunsader (@nanexllc) March 28, 2014

Is the Retail Investor being Harmed?

However, some Wall Street professionals are skeptical that the retail investor is being harmed. Steve Ehrlich, the former CEO of Lightspeed Trading, told Bloomberg Surveillance that this [the skimming] is not about the retail investor – it’s all about block traders. “Individual investors are protected by the order protection rules,” said Ehrlich.

“Most retail traders are using retail platforms and are sending it to a market maker like Knight or a firm using an HFT strategy, and those orders are protected by the order protection rules,” said Ehrlich on Bloomberg Surveillance.

In fact, Ehrlich said that retail investors are doing better today- since he can remember paying $150 to execute a 100-share order, and now he pays less than $10. He also noted that prior to decimalization we had spreads that were 1/4s and 1/8s wide.

On the same program, Stephen Roach, a retired global economist with Morgan Stanley objected to the term rigged. “It sounds like they are deflating the prices in the U.S. stock market. That is just patently incorrect. This is about margins on transactions, not price levels.”

Critics of high speed trading are praising Lewis for shining a light on the latency advantage that HFT have over the mainstream investor. Sal Arnuk, managing partner at Themis Trading, told Bloomberg that Flashboys is not about an indictment or vilifying of HFT. “It’s about this complex crazy system of enablers that are set up with conflicting interests to cater to this one class of traders.”

Billionaire investor Mark Cuban appearing on CNBC seemed more concerned about the risk of software bugs creeping into the market than retail investors. “The risk is not all about the small investor or any investor. The risk is all these different algorithms and high frequency traders playing a game to try and trick one another to get in front of one another to make ttat trade. Because we don’t know all the algorithms, the n-factorial of all the different ways they may interact and the negative consequences that can occur, that introduces a market risk,” said Cuban on CNBC.

Regulators are starting to pay attention. Two weeks ago, New York Attorney General Eric Schneiderman opened an investigation into exchanges and alternative trading systems to see if they are proving improper advantages to high-speed trading firms. Schneiderman has also pressured some service providers to stop selling data to high-speed traders in advance of general release.

Now the Federal Bureau of Investigation is reportedly looking into whether high-speed firms are trading ahead of others.“The FBI is encouraging traders and stock exchange workers to step forward and blow the whistle on possible front-running and manipulation by high-speed computers,” according to Bloomberg. While Michael Lewis has stirred conversation, it will be interesting to see if Flash Boys is a catalyst for change.

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio