Book Review: Flash Boys by Michael Lewis – A Journey Through Wall Street and High Frequency Trading

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It’s been a couple of months now that I have been eager to write this review. Flash Boys is definitely the most entertaining book I have read this year in its genre. This piece of literature has already spurred a lot of controversy in the media since its release earlier this year, mainly because of the frequent use of the word ‘rigged’ to describe markets today, since the explosion of high-frequency trading. But this isn’t the only reason why I believe everybody should read Flash Boys, whether you work in finance or not.

Flash Boys is a story about the consequences of the hyper-computerization of trading, or in simpler terms, how machines have taken over humans on what is commonly known as Wall Street. It’s a story about how practices like high-frequency trading (HFT) have completely distorted the way and the reason why people transact stocks, bonds or commodities (the original objective being to make the economy more liquid and accessible to the whole).

The context: How financial markets work today

In order to grasp the depth of this book, it’s important to have an accurate understanding of the way financial markets work today. Still today, a lot of people envision trading in its traditional form, as shown in 80s movies: A guy from an investment firm, who wants to buy 500,000 stocks from ABC Inc, calls a broker stationed at the New York Stock Exchange to place his order. The order is then picked by another exchange broker representing a seller at the other end of the line. This visual is very intuitive for most people.

However today, not only did phone calls got replaced with computers, internet and automated orders (removing the need for traders and brokers to interact), but physical exchanges as we know them are no more the places where transactions take place. Buy and sell orders are all originated by computer algorithms within investment banks and trading firms, and sent to the data centers of various exchanges (NYSE, Nasdaq, BATS, etc) where the orders are processed and executed at the speed of light. So today, to buy 500,000 shares of ABC Inc, a trader can either click on a button, or program his computer to automatically trade at some time in the future, in response to the possible occurrence of a market scenario.

The impact of technology in today’s markets

It’s important to understand that since the wide adoption of the Internet and the evolution of powerful computers, this increasingly automated market has completely changed the way people transact since the 80s. Sure enough, for individual investors like you and I, technology made trading faster, cheaper and more accessible, but for most investment banks and trading firms, it also enhanced the opportunity to make huge money by exploiting small and rapid market fluctuations through market making and speculative practices. Long gone are the days when, the sole objective to buy or sell a company’s stock was to help them raise capital or to make profit from stock appreciation (an appreciation happening over time and reflecting the underlying company’s real value).

It’s it in this context that, for most actors, the need for exponential speed comes into place. For example, if at a particular point in time, for some reason, everyone wants to buy or sell stocks from Coca-Cola, then the traders who will make the biggest profit are the ones acting the earliest and the fastest. Therefore a one or two-millisecond advantage becomes crucial. Flash Boys perfectly explains why banks and HFT firms would pay millions to get that advantage over their competitors, and how they would do it.

How High-Frequency Trading Works

The narrative of the book is told through the experience of Brad Katsuyama, a trader from the Royal Bank of Canada, who was trying to solve a simple problem: Understanding why every time he pressed on the order button from his computer screen to buy say 500,000 shares of ABC Inc at $10.05 each , the price of the share would increase to say $10.09 few milliseconds before his trade got executed. This would systematically result in him losing large potential revenues (for example $20,000 in the case of this single ABC Inc trade). With Brad’s team making thousands of large trades per day, RBC, like several other investment banks and funds, was thus losing millions every month.

Through Brad’s breathtaking investigation, Lewis broke down for us how HFT firms are able to front-run traders’ orders before their arrival at the exchange, by leveraging their speed advantage. In the example of ABC Inc, they were able to see Brad’s 500,000 buy order, and buy the shares before him from various parties, before selling them back to him at a higher price. RBC’s loss had become HFT firms’ profit, and that is how these new market intermediaries had been generating billions of dollars in trading activities for years, without adding any value in the economy.

In order to front-run trades from financial institutions, HFT firms needed to be aware of the trades being ordered before they reached their destination (the stock exchange servers). For that purpose, they would create electronic exchanges and compensate traders who sent orders to those exchanges (chargebacks), or pay more established institutions like NYSE, Nasdaq and large investment banks, to have access to their trade orders in real-time. Then to ensure HFT’s orders arrived at the exchange before anybody else, they would:

  • Hire or acquire telecommunication companies to build the shortest and straightest fibre cable path from their data center to the exchanges’ data center.
  • Build their data center close to the exchange, or even install their servers as close as possible to the destination servers in the same room. This is called collocation.

Flash Boys Review: My personal take

Through Brad’s story and a dozen of other extraordinarily colourful characters that I invite you to discover, Flash Boys is the story of how curiosity, passion and obsession has led a few to understand how the market really works, the failure of American regulation and its impact on small investors and the financial system as a whole. The entrepreneurial journey of Brad Katsuyama and its partners, once they decide to start their own exchange (IEX), is described by Lewis in a thrilling, intriguing, funny, touching and memorable writing style.

It’s not just a book about well-paid computer geeks tired of generating insane bonuses for Wall Street traders. It’s about the lack of fairness that questions the very existence of financial markets and the way they have evolved today. The increasing number of intermediaries that now stand between a buyer and a seller of a stock, the multiple regulatory loopholes and the financial motivations of those intermediaries are all factors that have:

  • Reduced the public’s confidence in financial institutions;
  • Brought more volatility in already shaky markets;
  • Injected excessive liquidity in an economy already stimulated by the overwhelming creation of artificial money for the 1%, instead of a sustainable growth backed by the production of tangible goods and services benefiting the whole.

I hope you’ll enjoy this book as much as I did!

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