March 28, 2021
'Flash Boys': Swimming In The Dark Pools With The Sharks
…there were times when the gap between the high-frequency traders’ view of the market and that of ordinary investors could be twenty-five milliseconds, or twice the time it now took to travel from New York to Chicago and back again.‘Flash Boys’, by Michael Lewis, pg. 98
In 2005 the SEC passed the Regulation National Market System, or Reg NMS, which required brokers to find the best market prices for the investors they represented. The SEC also created the National Best Bid and Offer (NBBO) regulation, which forced brokers to buy the cheapest available shares on behalf of their investors. This meant that if an investor wanted to buy 100 shares of Microsoft, and the cheapest 10 shares available could be found on the BATS exchange, for example, the broker would first have to buy those 10 shares from BATS before fulfilling the remainder of the share purchase on other exchanges where prices might be a bit higher per share. These SEC rules essentially laid the ground work for algorithmic (algo) high-frequency traders (HFTs) to spend comparably small sums of money to buy shares of stocks and list them for relatively cheap prices on the BATS exchange so they could detect when someone was placing large stock orders. This in turn allows the algo HFTs to front-run the orders by using their extreme transaction speed as a comparative advantage to purchase shares at lower prices and offer them at a higher price to buyers needing to fulfill the remainder of their bulk stock purchase.
According to my understanding of ‘Flash Boys,’ this is the complicated process of the algo HFTs for front-running stock purchase and sell orders to make big money from individual and institutional investors alike. Transaction speed is the name of the game.
‘Flash Boys’ paints a disturbing picture of a wide variety of exchanges on which stock transactions can take place, none of which appear to be particular transparent about what actually takes place on the exchange. In fact, it is even standard practice for banks and financial firms to create even more secretive exchanges called ‘dark pools’, which reveal even less about the transactions happening within them.
Add to this the fact that information the average person has on the near-real-time price of a given stock is not as timely as it can or should be. The stock prices we all see streaming on online services and on cable TV, like on CNBC, all come from the Securities Information Process (SIP). The 13 stock exchanges pipe prices into the SIP so that it can know what shares are outstanding and can calculate the NBBO value per share. The problem, however, is that it takes milliseconds to get data from all of the exchanges and millisconds more to calculate NBBO values. These milliseconds provide valuable time for the HFTs to update their own internal, better maintained and faster SIP with more real-time prices of the market values and prices.
In February of 2013, researches at the University of California at Berkeley showed that the SIP prices of Apple stock and the price seen by traders with faster channels of market information differed 55,000 times in a single day. Meaning, HFTs had around 55,000 opportunities per day to exploit incomplete and inaccurate investor awareness of the market and to profit off of this lack of real-time stock price awareness.
The Computer Is The Network
I miss Sun Microsystems. Such a great company and slogan: ‘The Computer Is The Network.’ This reality becomes truer every day as networks continue to change the world around us, including the world of online stock trading.
Up until 2007, buying and selling stocks still required a human-in-the-loop. I recall in my reading of ‘Snowball’, about the life of Warren Buffett that painted a picture of his younger years having to manage pices of paper stock managed by his Uncle’s firm purchased through brokers over landline phones. In 2007, machines started replacing human brokers and since then an arms race of sorts has begun to see who could get the closest and fastest network pipe to the various Wall Street exchanges, like DJIA, NASDAQ and NYSE, for this purpose.
In fact, ‘Flash Boys’ interweaves the story of Dan Spivey and his creation of ‘Spread Networks’, which attempted to build a fiber optic network (as straight as possible) from Chicago all the way to a data center in Cartaret, New Jersey expressly for the purpose of being able to perform stock transactions on both the Chicago Mercantile and Wall Street exchanges at almost the same time (with round-trip transactions occurring in 16 milliseconds or less). This would allow users of his network to exploit stock price disparities between the two geographically disparate exchanges for potentially large profits.
Spivey almost succeeded in his business quest, but was summarily put out of business by a competing firm who built a faster line-of-site microwave network across the same route. The highly entertaining movie, ‘The Hummingbird Project’, is about Spivey and ‘Spread Networks’.
Ok, So What?
After reading ‘Flash Boys’ it seems like a foregone conclusion that the US Stock Market is a yet another rigged system where the house always wins. HFTs are virtually guaranteed to make money as long as there are buyers and sellers of equities on the exchanges. And as Michael Lewis points out in ‘Flash Boys’, at the end of the day, the HFTs hold no stocks of their own, as that (apparently) would be too risky.
And by the way, you know all that stuff we’ve been reading lately about people buying ‘Game Stop’ stock on the Robinhood platform claiming to be ‘sticking it’ to Wall Street? Whatever. HFTs are the brokers for all transactions conducted on the Robinhood platform.
In terms of building wealth, it seems as if the US Stock Market cannot be avoided (especially considering things like trying to reduce your taxable income by contributing to a 401k, for example). I am still not clear, however, if HFTs are front-running corporate 401k fund purchases as well, but I suspect they are. I suspect HFTs front-run most transactions that take place on the stock market.
‘Flash Boys’ gave me a much deeper insight into the inner workings of Wall Street, and for that I am glad I picked it up.
podcast leadership learning catalyst change organizational learning high frequency trading hft dark pools djia nasdaq wall street manhattan new jersey chicago flash boys michael lewis IEX brad katsuyama goldman sachs citadel dan spivey chicago mercantile exchange sergey aleynikov