Tuesday, April 1, 2014

On A 'Rigged' Wall Street, Milliseconds Make All The Difference

(from wbur.org

"The stock market is rigged," Michael Lewis tells Fresh Air's Terry Gross. "It's rigged for the benefit for really a handful of insiders. It's rigged to ... maximize the take of Wall Street, of banks, the exchanges and the high-frequency traders at the expense of ordinary investors."

Lewis is the author of several books about the world of finance, including Liar's Poker and The Big Short. His new book Flash Boys is about the form of computerized transactions known as high-frequency trading, in which the fastest computers with the highest connection speeds get the information first, and make the trade before anyone else can. A millisecond — even a nanosecond — can make all the difference between how much money is made or lost on any transaction.

You'd be surprised to hear what investment banks do to get that nanosecond edge, and how they often use it in ways Lewis describes as predatory. The victims range from some investment houses to individual investors. Lewis says high-frequency trades can end up hurting the returns on your retirement accounts. The FBI, Wall Street regulators and New York's attorney general are investigating high-frequency trading, and whether it has created an uneven playing field.

"There's a decline of trust in the marketplace because it's not as trustworthy," Lewis says. "And if it's not as trustworthy then the whole economy suffers. Trust is the grease that keeps the system working."

What it does is it neatly divides the market into predator and prey. It creates this relationship between people who are there to actually invest in companies and these artificial middlemen who have been unnecessarily inserted in-between buyers and sellers of stock.

On high-frequency trading and how milliseconds matter

If I get price changes before everybody else, if I know a stock price is going up or going down before you do, I can act on it. If you're coming in to buy shares in Procter & Gamble and you think the price is 80 ... and I'm sitting there as a high-frequency trader and I know that the price of Procter & Gamble is actually lower — it's gone down [to] 79 — I can buy it [at] 79 and sell it to you at 80. So it's a bit like knowing the result of the horse race before it's run. ... The time advantage of a high-frequency trader is so small, it's literally a millisecond. It takes 100 milliseconds to blink your eye, so it's a fraction of a blink of an eye, but that for a computer is plenty of time.

On how Brad Katsuyama — who worked in New York for the Royal Bank of Canada — discovered the system was rigged

He has 25 traders working for him, he deals in hundreds of millions of dollars of shares every day, he takes risk in the market — and it's in early 2008 he senses something's wrong. What he senses is, when he looks at his trading screens ... his screens will tell him say, that there are 10,000 shares of Microsoft offered at $30 a share if he wanted to buy them.

And normally, up to this point in his life, if he hit his button and said "buy" he'd get the shares for $30 a share, but all of a sudden, when he hits the button on his computer terminal, the shares disappear. It's like someone knows he's trying to buy Microsoft and the price of Microsoft goes up before he can get it. He doesn't understand why this is happening and that's the beginning of the story.

On what was going on

What turns out is happening is he's sitting physically in lower Manhattan when he makes his trades. When he pushes the "buy" button, the signal from his computer travels up the fiber optics along the west-side highway of Manhattan and through the Lincoln Tunnel. On the other side of the Lincoln Tunnel is one of the 13 stock exchanges, called the BATS Exchange founded by high-frequency traders.

They're sitting there, and they get the signal that he wants to buy first. ... They can see what he wants to do. They discern his desire to buy Microsoft and they have faster connections to the 12 other exchanges that are scattered across New Jersey and they race him to the other exchanges, buy all the Microsoft in front of him, and sell it back to him at a higher price.

He was physically being raced by high-frequency traders who had faster and more direct fiber optic lines from the first exchange to all the other exchanges, but it takes him literally 18 months to figure this out and he has to assemble people who have been essentially in New Jersey laying fiber optic cable to figure out how all this works.

What it does is it neatly divides the market into predator and prey. It creates this relationship between people who are there to actually invest in companies and these artificial middlemen who have been unnecessarily inserted in between buyers and sellers of stock.

On how even insiders don't understand the market

There is this perception that Wall Street insiders understand how Wall Street works — and it's false. It's especially false right now. Here you have this young man, this kid [Katsuyama] at the Royal Bank of Canada who's engaged in this kind of science experiment in the market. He figures out at least one angle the predators are taking and he goes and talks to not just ordinary investors ... the biggest investors, the smartest investors in the world and their jaws are on the floor. ... Even these people have no idea what's going on in the market and are being educated by this Canadian who has basically just arrived on the scene and has decided to make understanding [this] his business.

On attempts to level the playing field

The solution to the problem, [Katsuyama and his team] thought, was, "Well, let's create an actual fair stock exchange. Let's take on the responsibility of essentially restoring trust to the stock market, of creating an environment where every dollar stands the same chance." And who would've thought this would be such a radical act? But it is.

They design an exchange on which high-frequency traders can operate, but they don't have any speed advantage anymore. They make everybody essentially the same speed on this exchange. ... The problem once they create this exchange is they have to persuade brokers and banks to send stock market orders onto it, and that's the war that they create when they do this. The banks and the brokers are also paid a cut of what the high-frequency traders are taking out of investors' orders, so they don't want to send their orders on this fair exchange because there's less money to be made.

On Katsuyama and his team who started IEX, which aims to be a more equitable exchange

They're all people who are making — in some cases several million dollars a year — in very safe jobs, and they were successful, beloved by their firms, etc., etc. There are two things about them that are striking: One is it's amazing how many of them are immigrants ... they're Canadian, they're Irish, they're Chinese, they're Russian. I don't know what that means, but they came to this country and they had some view about the way the system worked. They were disturbed by what they found and they wanted to make the system work the way they imagined it. The other thing is, they're all one way or another people who are living their lives as they want to look back on them, rather than thinking about the next quarter's bonus. They were kicked into that state of mind by various events in their lives. There's a peculiar moral quality about all of them that I found just really interesting.