Rather than more regulations, it’s technology, human ingenuity, and ultimately market forces that will fix Wall Street, says Michael Lewis.
“The United States stock market, the most iconic market in global capitalism, is rigged,” Lewis said during his interview with CBS. It only takes the former Salomon Brothers salesman about a minute to explain how.
In short, a handful of computerized trading firms have leveraged lightning speed, black-box algorithms, and special treatment from exchanges to skim fractions of pennies off “everybody who has an investment in the stock market.”—from investment banks to ordinary investors to your grandmother’s retirement fund.
HFT supporters argue that these strategies boost liquidity and reduce spreads (which means lower fees), deferring to, in their eyes, indisputable data. Lewis counters that, if firms aren’t taking material risks, the liquidity is a mirage, and that these predatory tactics—which represent only a portion of computerized trading as a whole—don’t create real value, while adding unnecessary complexity and instability to the market.
The fiery tension between the two sides is best summed up in a 23 minute CNBC debate—described as “the fight that stopped trading on the floor of the New York Stock Exchange”— between Lewis, the book’s protagonist Brad Katsuyama, and William O’Brien, president of the BATS exchange—which was prominently called out in the book.
The industry is understandably tetchy about being labeled the bad guys, pointing out that Lewis is being provocative to promote his book and Katsuyama is on the offensive to market his own exchange.
If HFT players feel hard done by, they have a point. On the one hand, Flash Boys paints a compelling picture of a market gone awry and is undoubtedly an entertaining read with Lewis’s signature, page-turning clarity. On the other, Lewis hasn’t unearthed much that anyone who follows finance doesn’t already know.
What Lewis has achieved is attracting mainstream attention to an important issue (by making an immensely complex topic deliciously digestible—no small feat), but it’s also the book’s populist appeal that’s potentially problematic. By dismissing HFT as the Machiavellian bad guys, the underlying moral position dramatizes a gripping narrative in a way that will resonate with Main Street but likewise romanticizes reality.
Because that’s the nature of markets—a jungle where everyone’s looking for an edge and exploiting a loophole, a game where winning supersedes being nice and players live and die by the system’s inherent incentives. It’s also a place, for better or worse, where morality simply doesn’t exist. If HFT is the villain, then so is Apple for barely paying any taxes.
Lewis insinuates that the ugly side of HFT isn’t beneficial but doesn’t convincingly substantiate his case. Vultures are a key part of the ecosystem even if they aren’t particularly nice to look at. One could also argue that the rise of HFT accelerated the development of computerized trading—which contributes undeniable value.
No matter how you spin it, poor public opinion is a small price to pay for billions in profits. It’s worth mentioning that no one’s being accused of breaking the law—at least as of yet. Various investigations by government agencies are ongoing. Last fall, New York Attorney General Eric Schneiderman called the practice “Insider Trading 2.0.”
To Lewis’s credit, it’s the regulatory component that he nails—since the true scoundrel here is the Law of Unintended Consequences. The history of Wall Street is one etched by a neverending cycle of rules and loopholes and new rules to address new loopholes. For market participants, every regulatory action offers fresh opportunity. In the case of HFT, it was Regulation National Market System or Reg NMS, a set of rules created to insure that investors got a fair price. Instead, it allowed robo-traders to pick off just about everyone in a matter of milliseconds.
Our tale does have a hopeful ending. Where regulations only perpetuate the problem, it’s possible that the market, if given a chance, will arrive at an effective solution on its own. In Flash Boys, Katsuyama, a trader that reverse-engineers the alleged scheme, creates a so-called “fair” exchange, called IEX, to battle what he and his team perceive as systematic injustice—one that promotes efficient trading and makes predators obsolete:
Schwall’s final point was more aspiration than insight. For the first time in Wall Street history, the technology existed that eliminated entirely the need for financial intermediaries. Buyers and sellers in the U.S. stock market were now able to connect with each other without any need of a third party. “The way that the technology had evolved gave me the conviction that we had a unique opportunity to solve the problem,” he said. “There was no longer any need for any human intervention.” If they were going to somehow eliminate the Wall Street middlemen who had flourished for centuries, they needed to enlarge the frame of the picture they were creating. “I was so concerned that we were talking about what we were doing as a solution to high-frequency trading,” he said. “It was bigger than that. The goal had to be to eliminate any unnecessary intermediation. (Flash Boys, 160)
If that excerpt sounds familiar, it should—as it perfectly articulates the essence of the cryptocurrency movement. Just as IEX delivers a more fair and efficient destination for institutional traders, technologies like Bitcoin and Ripple have the potential to distribute that same sort of empowerment to individuals.
And maybe that’s the real moral of the story—because the innovation of decentralized protocols takes this ideal one step further, eliminating the need for a central authority altogether, good or bad. Why should the world be divided? In the end, we’re all in this together.