Flash Boys
Michael Lewis
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.
No comments:
Post a Comment