Friday, April 4, 2014

Lewis' Back-door Move

Lewis takes on black-box traders
Talking about the blind side.  Best-selling author Michael Lewis, who wrote the book Blind Side about football and the book Moneyball about baseball, slipped through the back door this week and published his new book Flash Boys about electronic stock trading. Right away, the publication stirred the world of stock markets, exchanges and high-frequency trading.  Lewis had spent a year or so studying, learning and asking questions about electronic trading and the dynamics of high-frequency trading, the lightning-quick activity conducted by a small circle of black-box firms that explains most of the trading volume in equity markets in the U.S.

Lewis draws conclusions in the book. He claims a band of high-frequency traders have rigged markets, slicing bits of profits (measured in morsels, or cents per share) from billions of trades from innocent and often unknowing participants--mutual funds, pension funds, and, yes, moms and pops.

In the wake of sudden appearances on CBS-TV's Sixty Minutes and PBS's Charlie Rose, Lewis's book, his claims and conclusions have spurred loud voices on both sides of the looming questions:  Is the market rigged? Do high-frequency traders serve an important role?

When Lewis speaks (or has something to write about), a financial audience will pay attention. His track record gives him an audience each time he publishes something new. He often tackles intriguing subjects and asks questions many don't know how to pose.   His The Big Short a few years ago explained how traders and hedge-fund investors reaped billions in complex credit derivatives by betting on the demise of mortgage markets.  His book Liar's Poker, now decades old, still ranks among the most popular books ever about Wall Street trading floors. 

And now all of a sudden, Flash Boys will become a spring-time must-read, if only for market participants to decide if Lewis' claim is fair or if only to permit outsiders to understand the revolution in the way stocks are traded and market values are determined. Contrast today's stock market (or markets, since trading occurs on dozens of venues) with the old vignettes of humans (Wall Street specialists) wrestling for space in the Great Room of the New York Stock Exchange, amidst mountains of pieces of paper.

Those days are gone, although specialists and traders still show up at the Exchange and still go through motions pretending they influence markets.  These days, it's the hum of computers and black boxes and the atomic-swift movement of data through fiber optics and microwaves that dictate volume, activity, and volatility in equity markets.

Lewis' book portrays the experiences of a head equity-desk trader, Brad Katsuyama, at RBC Capital Markets in Toronto and New York. Katsuyama's team, puzzled about not getting orders filled at prices they hoped for, went on an investigative hunt and concluded that high-frequency traders were "front-running" their orders on electronic exchanges, taking advantage of RBC's expressed intent to buy or sell stocks.  The traders exploited that advantage, forcing RBC to buy or sell at less-than-optimal prices, even if just a few cents a share.

Lewis, as the interested bystander on this journey, tries to explain electronic trading and the amorphous, varying role of high-frequency traders.

Already, many in the industry say there is little new in the book. What's new to most is that Katsuyama at RBC eventually decided to beat back high-frequency traders by joining them.   He decided to set up his own exchange and is implementing techniques to change protocol. His exchange, he says, will discourage high-frequency traders from rushing ahead of the pack. It will slow them down. It's "trust" he says he is selling, as he encourages asset managers, funds, and investors to send their trades his way. He formed his exchange, IEX,  and seeks to match buyers and sellers without the involvement or  intervention of brash, bold electronic dealers.

The issue is complex.  Lewis and cohorts show how markets might be rigged.  But the big stock exchanges themselves--from Nasdaq to BATS to the New York Stock Exchange--enable such traders, encourage their activity, and even invite and induce them with pay-outs or reduced fees to boost volumes and liquidity on their respective platforms.

These are different times. In old days, stock exchanges were few. They were non-profit marketplaces, overseen by members and member institutions, run by tight rules and regulation, operating within comfortable 9-to-4 time frames, and respectful of gentlemanly ways and traditions.

Today, exchanges are abundant (at least a dozen in the U.S.). Regulation NMS from the mid-2000's facilitated the new environment.  It permitted (or encouraged) the formation of new exchanges and instructed brokers, traders and investors to roam exchange platforms in search of the best price and the best, quickest execution.

Exchanges in these times, profit-seeking enterprises, generate revenues from brisk activity.  Therefore, they must be creative in attracting volumes of share activity from traders and investors--any legal way to lure volume to generate fees.  High-frequency traders, therefore, become their best pals, favorite participants for whom they offer privileges, advantages, a slight edge (vs. all other participants) to ensure sufficient levels of activity at all times.

So here is how the high-frequency traders and explain their side of the argument. (Over the past decade, they have included such firms with names like Getco, Jane Street, Allston, Quantlab, Sun, and Jump.)

(a) They provide market liquidity, active markets, and ready buyers and sellers.

(b) They provide "price discovery" with bids and offers updated continuously during the trading day.

(c) They provide "best prices," opportunities for buyers and sellers to search venues to find the best price for a particular stock.

But here is how factions like Lewis, other asset managers, and Katsuyam's IEX frame the issue:

(a) Unlike the stock specialists in the past, they disappear when markets become too volatile, too slow, or too boring. There is no moral (or legal) commitment to participate or make markets. They balk or refuse to participate at certain times. 

(b) They don't always provide honest, good-faith bids and offers. Sometimes they show their hands and wander away before execution (fake orders, or orders they cancel as quickly as they show their hands). 

(c) Skipping from venue to venue (exchange to exchange) with less-than-sincere bids and offers, they often try to trick or deceive markets to gain information advantages--advantages that extract profits from retail- and long-term investors.

Flash Boys elevates the debate to the front pages of the business media and encourages market overseers and regulators to move faster, if they have been investigating market practices. Some suggest if the rules changes, high-frequency traders won't disappear. They'll simply tweak their boxes, recalibrate the economics of trading, and proceed accordingly.

For Lewis, Blind Side and Moneyball eventually became popular movies.  Is a movie version of Flash Boys on the horizon?

Tracy Williams

See also:

CFN:  High-Frequency Trading, 2012
CFN:  Dark Days at Knight Capital, 2012
CFN:  Financial Technology, 2014

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