The economic crisis of 2008, which brought to a crashing halt the exuberant expansion of the previous decade, with effects felt in India, as in the rest of the world, was apparently caused by over-smart ‘rocket scientists’ (such as, for example, maybe an IIT graduate, with post-graduate qualifications from Harvard) who were lured into finance by hyper-capitalist Wall Street. There they operated without any sense of the real world, building ever more complicated financial instruments, until they were selling for enormous aggregate amounts of money, worthless stuff dressed up to look extremely attractive to greedy investors who couldn’t understand any of it, but who slavered at the thought of becoming wealthy beyond the wildest dreams of any human. The crash, the failure of several large investment firms, and the general aftermath brought a degree of sanity to one aspect of this technological transformation of the financial markets, namely to the idea of ‘derivatives’ and ‘sub-prime’ loans and mortgages. But there were other innovations that were made at this time that continue to be in use, misuse and abuse. And as information and communication technology advances, more and more such tools continue to be made, enabling rapacious, amoral and barely legal predators (a word which occurs frequently in ‘Flash Boys’) in the financial markets to continue to prey upon the unsuspecting ordinary investor – the pension funds, the insurance companies, the charitable trusts and, of course, the retail investor.
Financial markets – stock exchanges; bond, derivatives and currency markets; futures markets – these have always been the archetypical and essential components of a capitalist system. They have however never been paragons of virtue or shining examples of the good in human societies. Consider, for example, the savage characterisation to which they are subjected in many of Charles Dickens’ works. (Dickens does not talk about any actual stock market – he does deal at length with capitalist strategies to raise money for risky, and mostly fraudulent, enterprises.) ‘Flash boys’ describes in some detail one more way by which crooked traders use advanced technology to cheat ordinary investors.
In my understanding, a stock market exists to channelize money from hundreds of sources, each of which may be a small amount, but which in the aggregate adds up to the large sum required to undertake a large, and presumably socially useful enterprise. (It is another point altogether whether any such large enterprise - dams, factories, even bridges - can actually be characterized as socially useful in the long run to humanity and to life on earth.) In return, the contributors of the small sums are promised proportional shares of the benefits, i.e. the profits. Done well (in all senses - economic, ethical, social), and as indeed it has been many times, the result of this process is often of greater value to society than just the profits (or capital gains) generated for the shareholders. For example the benefits accruing to everyone from the activities of a company like Larsen and Tubro is probably greater than that represented by just profits and gains to the shareholders of the company. Done honestly but badly, as it is happening more and more, the stock market process may generate gains for the shareholders, but not necessarily for all of society – Pepsi and Coke are prime examples of this type of enterprise. Done dishonestly, the stock market benefits the cheats, not the investors, and certainly not the general public.
The fact that a stock exchange is required for this purpose, i.e. to channelize small sums and build a large amount, makes it a truism that such an institution adds value to society, and obviously, the people associated with the institution will have to be paid for generating this value. Thus stockbrokers and investment banks make money, as does the exchange itself, and all the people who run it. In an ideal world, of course, no such middlemen would be needed, and the large number of small people with small amounts of money would join together, automatically, to set up large enterprises. Ants do it, and so do bees, but humans are autonomous, and its hard to get them to act together. Attempts have been made and are made still to get everyone to do the same thing – Nazi Germany, Soviet Russia, Maoist China, maybe even modern-day China – but these attempts have either ended in failure or are objectionable on other, non-economic grounds. So stock exchanges, if run honestly for the purpose stated above, are a common good.
But not all that happens in the exchange, in the financial market, and not all that the traders and the brokers and the bankers do, is good. Far from it. Among the more pernicious activities we have insider trading, artificial bull runs, synthetic bear runs, artificially created market sentiment, and so on, none of which can be considered, without argument, as good for society, or sound reasons for the existence of the stock exchange. All the same, the brokers and the traders and the bankers make money, huge amounts of it from such activities. And a lot of it is legal, even though the nature of their ‘services’ is very hard to understand, and their true value even more difficult to estimate. [It needs to be pointed out that ‘legal’ is not necessarily ‘ethical’ or ‘moral’. Consider, for example the following passage that occurs in the book, describing a perfectly legal, and according to the author, a morally and ethically sound set of events. ‘After a big buyer enters the market and drives up the prices of Brent crude oil, for example, it’s healthy and good (!) when speculators jump in and drive up the price of North Texas crude, too. It’s healthy and good (!) when traders see the relationship between the price of crude oil and the price of oil company stocks, and drive these stocks higher. It’s even healthy and good (!) when some clever trader divines a necessary relationship between the share prices of Chevron and Exxon, and responds when it gets out of whack’ (the ironical exclamations are mine). I really can’t see anything ‘healthy’ or ‘good’ in the situations described. All of them appear to me to be gambling, which may not be morally bad, but belongs in casinos, and is not what a market that exists for the good of society as a whole should be doing.] The long term consequences for society of a lot of what the traders and the brokers do are bad, bad even for capitalism. Society, through various institutions such as the Government, or the courts, or the Press, sees the ill effects and tries to prevent them by changing the laws and maybe bringing in additional regulations. But, as pointed out in the book, every change in the laws brings in a fresh set of loopholes, ready for exploitation by the traders and their ‘running dogs’. According to ‘Flash Boys’, precisely one such set of regulations, and the consequent loopholes, is responsible for nurturing the bizzare phenomena of High Frequency Trading.
According to the book, the US Government mandated that all buying and selling of stock should be carried out electronically, thus offering the retail investor direct control of his transactions. Well, it didn’t do any such thing. High frequency trading is only one of the ways in which this particular regulation allows amoral traders to forcibly come in between the buyer and the seller of shares, and make billions of dollars while adding zero (actually negative) value to the basic economic processes underlying those transactions. Here’s a brief summary of how HFT works (as I understood from the book).
First, we have to know that there is not just one market where we can buy or sell shares, but many. (As we shall see, more is better for the HFT companies.) Think of a seller who sits at a computer at home (or office) and makes a bid to sell X shares of some company at a price between Y and Y+dY (dY is a small amount compared to Y). He (most of the people doing this are white males) sends his request to markets A, B, C and D. Now let’s assume there a buyer who wants to buy at price between Y+dY and Y+2dY. For simplicity of explanation, let’s further assume that the buyer is only in market D. Now this is where advanced technology comes in. Because of the difference in location of the markets, the time it takes for the sell request to travel from the seller to market D is a few milliseconds more than it takes to go to market A. A HFT company has invested in buying superfast connections between the markets A and D – connections which are exclusive to it. These lines (OFC, sometimes line-of-sight microwave, and, more recently, line-of-sight laser, connected by the fastest switches and routers available) are only a few tens of microseconds faster than those of the ordinary investor (the ‘buyer’ and the ‘seller’ mentioned above), but these unbelievably small fractions of time are enough. The HFT company sees the sell request on market A the instant it gets there, rushes around the markets a few tens of microseconds before the request itself can get around, sees the buy request on market D, and now it knows the existence of the two complementary requests before they can match up in a normal way. The company buys from the seller at price Y and sells to the buyer at price Y+2DY, and makes a profit of 2DY for doing nothing of value to anyone. The seller has lost DY, and so has the buyer. For, left to themselves, the sale would have gone through at the mid range of Y+DY. This high frequency chicanery is apparently legal.
This is just the simplest of the possibilities. Michael Lewis describes several others, and hints at still others, even more complicated. We have ‘dark pools’ and complicated varieties of buy and sell orders and ‘co-location’ of computer hardware, and other jargon, all of which tries to hide the fact that the most sophisticated financial market in the world is now so far removed from the simple high-minded purpose I described in the beginning, that nobody understands just what it does that allows it to claim that it deserves the tons of money it is making. It is highly doubtful if a casino would be allowed to operate in such an opaque manner. Note that the high frequency trading, or in fact even the simple one-on-one trade between the buyer and seller, I described in the previous paragraph is impossible with human intervention. Computer programs talk to other computer programs, do all the deals at blinding speeds counted in microseconds and maybe even nanoseconds. The stock exchange is now just an ecosystem of computer programs (or algorithms) talking to each other, and reacting to each other. Sudden and inexplicable crashes therefore can (and do) come about by the unmeant creation of feedback loops. The lack of clarity is precisely the opportunity for a brilliant but unscrupulous technical wizard to make money, unethically, but just within the law.
Lewis is generally down on the HFT companies. He is careful not to mention any particular company as illegal or even unethical. But his disapproval of them, in general, comes through. The book has heroes, in particular a group of idealistic (or so he says) young techies who get together and set up their own exchange, IEX, which they claim is fair to everybody, and offers the HFT companies no particular advantage. He also mentions Goldman Sachs with some approval. The book is an illuminating and interesting read. But Lewis is not the best of writers for one such as me who is reading about all of this for the first time, and who has, apparently, a constitutional disinclination to spend too much time and effort in trying to understand all the machinations. His language is sometime unnecessarily profane – though he claims to be just quoting his protagonists and his heroes. He makes several important points about technology and the markets. One of them is that the world is no longer 'flat', at least not for online trading. The closer you are to the stock exchange - which is now just a huge computer - the better. Even a few tens of meters will make a difference.
Lewis does not deviate too far from the mainstream capitalist line, but the book makes it clear there is no such thing as a free market, so beloved of all those on the ideological right who misquote Adam Smith.