Aug 19, 2014 Book Review

by Canadian MoneySaver

John Prescott  

 

BOOK REVIEW – by John Prescott 


 

Flash Boys: 

A Wall Street Revolt. 

Michael Lewis. W. W. Norton and Co, 2014. 

C$32.95

Michael Lewis has written so well about the financial shenanigans of Wall Street, and his new book is no exception. It has the pace of a thriller, and by the end the villains have just been exposed although not brought to justice. Michael Lewis

The long history of Wall Street is one of continuous financial scandals, and the rise of high frequency trading (HFT) represents just the latest way in which Main Street and even much of Wall Street itself is being scammed. The Canadian link is that the hero of Flash Boys is Brad Katsuyama, a decent and honest Torontonian who worked on Wall Street for the also virtuous Royal Bank of Canada before eventually starting his own stock exchange in an attempt to beat the HFT pirates. 

It’s complex, but one of the things HFT does is exploit differences in the price of shares quoted on the Securities Information Processor, which compiles all the information on prices from the different exchanges. Compiling this takes milliseconds and HFT works in microseconds (which are millionths of a second). The HFT computers in this way “see” the market before it appears to happen, so they can predict and exploit this knowledge. 

HFT, which now accounts for about 65% of Wall Street trading, crookedly exploits loopholes in security regulations. It does this in multifarious ways— for example through a process of actually owning exchanges for the main purpose of identifying the size and provenance of orders; using numerous different complex order types including some designed as non-executable “probes” of the market; and paying brokers for orders and banks or private exchanges for access to their “dark pools.” These all have the intent of getting ahead of and “reading” the market. 

HFT is associated with increased market volatility, decreased order size (most are simply “probes”), and market fragmentation; there are now nearly 60 public and private exchanges operating on Wall Street, and some seem to be essentially traps and hidden passages designed for the benefit of HFT activities. Lewis estimates that HFT adds $10-22B a year of extra cost to the US stock market; by comparison, Wall Street banks make about $12B from executing customers’ stock market trades. The actual cost will never be known, since it’s easier to get into the Pentagon than into an HFT operation in any of their heavily guarded venues in anonymous buildings in New Jersey. 

The stock market has become a war of robots, with trading speed measured in microseconds. In one memorable visual illustration of the impact of HFT, Katsuyama’s team showed a group of users their exchange trading patterns slowed down to milliseconds. Viewers could see an order come through on the screen, to be immediately followed by a feeding frenzy of activity as the HFT computers detected the order and ran in front of it to the other exchanges. Such activity is totally undetectable to the unaided human eye. 

For readers of the Canadian MoneySaver, the book will increase their understanding of what can happen in the milliseconds after they press the “Submit Order” button on their computer screens. It may also keep them pressing for the single national financial regulator that Canada needs so that these predatory and parasitic practices can be controlled if they are found to be occurring here. 

John Prescott, Guelph, ON finds investing fascinating.

 

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