Mark Baum:
[In] a few years people are going to be doing what they always do when the economy tanks: they will be blaming immigrants and poor people.
(The Big Short, 2015)
Charlie Munger [Vice-chairman, Berkshire Hathaway]:
[High frequency trading is] the functional equivalent of letting a lot of rats into a granary [— it does] the rest of the civilization no good at all.
(Investors Conference, 2014)
Michael Lewis:
Financial intermediation is a tax on capital …
[It’s] the toll paid by both the people who have it and the people who put it to productive use.
[It is, in effect, a private Tobin tax.]
(Flash Boys, 2014, p 109)
Fair Trading Versus Free Riding
In 2014, [one] money manager bought and sold roughly $80 billion in US stocks.
The teachers and firefighters and other middle-class investors whose pensions it managed were collectively paying a tax of roughly $240 million a year for the benefit of interacting with high-frequency traders in unfair markets. …
The big banks and the exchanges have a clear responsibility to protect investors — to handle investor stock-market orders in the best possible way, and to create a fair marketplace.
Instead, they’ve been paid to compromise investors’ interests while pretending to guard those interests. …
[There] is now a minority [of Wall Street dissidents] trying to fix the [system:]
- their new stock market [IEX] is flourishing;
- their company is profitable;
- Goldman Sachs remains their biggest single source of volume; [and]
- they still seem to be on their way to changing the world.
(Flash Boys: One Year Later, Vanity Fair, March 2015, emphasis added)
Michael Lewis (1960)
- Flash Boys, Big Ideas, ABC Radio National, 14 May 2015.
- Flash Boys, Allen Lane, 2014.
From 2006 to 2008, high-frequency traders’ share of total US stock market trading doubled, from 26% to 52% — and it has never fallen below 50% since then.
(p 108)
[Since 2007,] more than two hundred SEC staffers [have] left their government jobs to work for high-frequency trading [HFT] firms or [for] the firms that lobbied Washington on their behalf. …
For instance, in June 2010, the associate director of the SEC’s Division of Trading and Markets, Elizabeth King … quit the SEC to work for Getco.
The SEC, like the public stock exchanges, [was a stakeholder] in the future revenues of high-frequency traders.
(p 106)
In early 2013, one of the largest high-frequency traders, Virtu Financial, publicly boasted that in five and a half years of trading it had experienced just one day when it hadn’t made money, and that the loss was caused by “human error.”
In 2008, Dave Cummings, the CEO of a high-frequency trading firm called Tradebot, told university students that his firm had gone four years without a single day of trading losses.
This sort of performance is possible only if you have a [massive] informational advantage. …
(p 109)
[HFT is] not just as an unnecessary middleman but … a middleman [incentivized] to make the market as volatile [and fragmented] as possible.
(p 110)
The more sites at which the same stocks changed hands, the more opportunities [there are] to front-run investors from one site to another.
[Increasing the number of exchanges and distances between them serves] to maximize the difference between the speed of [HFTs] private view of the market and the view afforded the wider public market.
The more time [they had to] sit with some investor’s stock market order, the greater the chance that the price might move in the interim.
[The challenge was] to slow down the public’s information [and / or] to speed up [their] own. …
The easiest way for [a HFT] to extract the information it needed to front-run other investors was to trade with them.
At times it was possible to extract the necessary information without having to commit to a trade.
That’s what the “flash order” scandal had been about: high-frequency traders [paying the stock] exchanges to [preview] other people’s orders [before the rest of the market] without any obligation to trade against them.
(p 111)
That initial market contact between any investor and [a HFT] was like the bait in a trap — a loss leader.
For [the HFT] the goal was to spend as little as possible to acquire the necessary information — to make those initial trades, the bait, as small as possible. …
{A front-runner sells you a hundred shares [ie the market minimum] of some stock to discover that you are a buyer and then turns around and buys everything else in sight, causing the stock to pop higher (or the opposite, if you happen to be a seller).}
Since the mid-2000s,- the average trade size in the US stock market had plummeted,
- the markets had fragmented, and
- the gap in time between the public view of the markets and the view of high-frequency traders had widened. …
(p 112)
Their frustration with the public stock exchanges had led the big Wall Street banks to create private exchanges: dark pools.
By the middle of 2011, roughly 30% of all stock market trades occurred off the public exchanges, most of them in dark pools.
[Dark pools were offered to investors as places to trade safe from predators, however the banks then sold access to the pools to those same predators.]
(p 113)
At the very top of the food chain were a [group of around 25] white guys in their forties [— a cadre of] highly trained scientists and technicians … pulled onto Wall Street by the big banks [from the fields of physics, engineering, computing and mathematics.]
(p 121)
[In 2007,] Goldman’s bond trading department was aiding and abetting a global financial crisis, most infamously by helping the Greek government to rig its books and disguise its debt, and by designing subprime mortgage securities to fail, so that they might make money by betting against them. …
The thirteen public stock exchanges in New Jersey were all trading the same stocks.
Within a few years there would be more than forty dark pools, two of them owned by Goldman Sachs, also trading the same stocks.
(p 134)
Essentially, the more places there were to trade stocks, the greater the opportunity there was for high-frequency traders to interpose themselves between buyers on one exchange and sellers on another. …
[The windfall from such financial intermediation was] between $10 billion and $22 billion a year …
[In 2008, one HFT guy was] paid $75 million in cash [and two of his work colleagues were head-hunted by a competing firm with] guarantees of $20 million a year each.
(p 135)
A lot of the moneymaking strategies were of the winner-take-all variety. …
Goldman Sachs often used complexity to advantage.
The firm [manufactured] complex subprime mortgage securities that others did not understand … and then [exploited] the ignorance they [themselves] had introduced into the marketplace.
(p 136)
[To] assuage the concerns of their customers that the [publicly available Securities Information Processor] was too slow and offered them a dated view of the market, a few banks promised to create a faster data stream — but nothing they created for customers’ orders was as fast as what they created for themselves.
(p 138)
Day after volatile day in September 2008, Goldman’s supposedly brilliant traders were losing tens of millions of dollars. …Sergey Aleynikov:
Goldman hunted in the same jungle as the small HFT [shops,] but it could never be as quick or as nimble as those firms:
They thought they controlled the market, but it was an illusion.
Everyone would come into work and were blown away by the fact that they couldn’t control anything at all. …
Finance is a gambling game for people who enjoy gambling. …
No big Wall Street bank could.
The only advantage a big bank enjoyed was its special relationship to the prey: its customers.
(p 140)
By late 2011 … more than two-thirds of Nasdaq’s revenues derived … from high-frequency trading firms. …
[The] high-frequency traders were preying on investors, and that the exchanges and brokers were being paid to help them to do it.
(pp 163-4)
The trouble with … all of the public and private exchanges … was that they were fantastically gameable, and had been gamed: first by clever guys in small shops and then by prop traders at the big Wall Street banks.
(p 165)
The maker-taker system of fees and kickbacks used by all of the exchanges was simply a method for paying the big Wall Street banks to screw the investors whose interests they were meant to guard.
The rebates were the bait in the high-frequency traders’ flash traps.
The moving parts of the traps were [the new] order types.
(pp 168-9)
[These] were designed to create an edge for HFT at the expense of investors.
Their purpose was to hardwire into the exchange’s brain the interests of high-frequency traders — at the expense of everyone who wasn’t a high-frequency trader.
And the high-frequency traders wanted to obtain information, as cheaply and risklessly as possible, about the behavior and intentions of stock market investors.
That is why, though they made only half of all trades in the US stock market, they submitted more than 99% of the orders:
[This is because the purpose of the orders was not primarily to trade — ie to facilitate the flow of capital from sellers to buyers — but to gain market advantage over] ordinary investors. …
[As the IEX design team] worked through the order types, they created a taxonomy of predatory behavior in the stock market.
(p 171)
[There] were three activities that led to a vast amount of grotesquely unfair trading.- The first they called “electronic front-running” — seeing an investor trying to do something in one place and racing him to the next. …
- The second they called “rebate arbitrage” — using the new complexity to game the seizing of whatever kickbacks the exchange offered without actually providing the liquidity that the kickback was presumably meant to entice.
- The third, and probably by far the most widespread, they called “slow market arbitrage.”
This occurred when a high-frequency trader was able to see the price of a stock change on one exchange, and pick off orders sitting on other exchanges, before the exchanges were able to react.
Say, for instance, the market for P&G shares is 80–80.01, and buyers and sellers sit on both sides on all of the exchanges.
A big seller comes in on the NYSE and knocks the price down to 79.98–79.99.
High-frequency traders buy on NYSE at $79.99 and sell on all the other exchanges at $80, before the market officially changes.
This happened all day, every day, and generated more billions of dollars a year than the other strategies combined.
[To maximize profit high-frequency] traders sought to trade as often as possible with ordinary investors, who had slower connections. …
[The] nine big Wall Street banks that controlled 70% of all stock market orders …
All of them tended to send the orders first to their own dark pools before routing them out to the wider market.
Inside the dark pool, the bank could trade against the orders themselves; or they could sell special access to the dark pool to high-frequency traders. …
If the bank was unable to execute a stock market order in its own dark pool, the bank directed that order first to the exchange that paid the biggest kickback for it — when the kickback was simply the bait for some flash trap [set by a HFT operating on the open market.]
(p 182)
It wasn’t just that the high-frequency traders were demanding changes to the market [trading system] that would benefit only them:
The mere act of changing the system increased the risks to everyone who depended on it.
(p 199)
In March 2013, the Commodity Futures Trading Commission … ended its nascent program to give outside researchers access to market data after one of those researchers … used the data to study the tactics of high-frequency traders.
The commission shut down the research after lawyers for the Chicago Mercantile Exchange wrote the regulators a letter arguing that the data … belonged to the high-frequency traders [and, therefore,] sharing it was illegal.
[The offending research had] showed how HFT firms were able to predict price moves by using small loss-making stock market orders to glean information from other investors.
They then used that information to place much bigger orders, the gains from which more than compensated for the losses.
(pp 207-8)
Before IEX launched, Brad [Katsuyama] had rebuffed an overture from Intercontinental Exchange (known as ICE), the new owners of the New York Stock Exchange, to buy IEX for hundreds of millions of dollars — and walked away from the chance to get rich quick. …
(p 213)
[IEX’s basic strategy was] to open as a private stock market and convert to a public exchange once their trading volume justified incurring the millions of dollars in regulatory fees they would have to pay.
Although technically a dark pool, IEX had done something no Wall Street dark pool had ever done:
It had published its rules. …
(p 211)
There are now forty-five markets.
On forty-four of them no one has any idea how they trade.
(p 212)
Nine weeks after IEX launched, it was already pretty clear that the banks were not following their customers’ instructions to send their orders to the new exchange.
(p 214)
[HFTs] traded in the market the way card counters in a casino played blackjack:
They played only when they had an edge.
That’s why they were able to trade for five years without losing money on a single day.
A big Wall Street bank really had only one advantage in an ever-faster financial market: first shot at its own customers’ stock market trades.
So long as the customers remained inside the dark pool, and in the dark, the bank might profit at their expense.
But even here the bank would never do the job as … thoroughly as a really good HFT.
[It was, therefore,] hard to resist the pressure to hand the prey over to the more [efficient predator and then join the feast after the kill.]
[Unfortunately, in this so-called dark pool arbitrage, it was the HFT who] captured about 85% of the gains, leaving the bank with just 15%.
[Also, if] the markets collapsed, or if another flash crash occurred, [it was not] the high-frequency traders [who would] take 85% of the blame, or bear 85% of the costs of the inevitable lawsuits [— it would be the banks who were left with] the lion’s share of the blame and the costs.
[Ironically, the] relationship of the big Wall Street banks to the high-frequency traders [mirrored] the relationship of the entire society to the big Wall Street banks.
When things went well, the HFT guys took most of the gains …
[When] things went badly, the HFT guys vanished and the banks took the losses.
(p 263-4)
The more money to be made gaming the financial markets, the more people would decide they were put on earth to game the financial markets — and create romantic narratives to explain to themselves why a life spent gaming the financial markets is a purposeful life. …
Once very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system up further, or to remain silent as they watch it being screwed up by others. …
There was simply too much more easy money to be made by elites if the system worked badly than if it worked well.
(p 266)
