I am (or sad to say, was) a huge Michael Lewis fan. Liar’s Poker, The Blind Side and The Big Short are all classics. I love most of what Lewis writes for Vanity Fair — his long-form pieces on Iceland, Ireland, Greece and Germany for example. I ordered Flash Boys as soon as it came available on Amazon.
With that said, Flash Boys is terrible. It is not just a major whiff, but a travesty. And it really ticked me off.
To state up front, I have no hidden allegiance to high frequency trading (HFT). I have never worked for an HFT outfit, never consulted for one or invested in one. I do not go out drinking with HFT buddies. In fact, if anything, I am one of the “dumb tourists” Lewis talked about in a Bloomberg interview (more on that to come). Our firm, Mercenary Trader, is focused on long / short trading with a global macro overlay. Our preferred holding time is weeks to months — if a trade lasts less than 24 hours, something went wrong. So there is no industry bias here. I get no benefit from panning this book. I do so because the book made me angry.
Lewis, however, did have a major incentive to over-hype the story, as he all but admitted. I fully agree with Cliff Asness of AQR Capital, who wrote in a Wall Street op ed: “Making mountains out of molehills sells more books than a study of molehills.” That is more or less what happened here. Lewis wanted to sell a lot of books. He wanted to capture “lightning in a bottle” (to use his own phrase). He captured irresponsible hyperbole instead.
In Flash Boys, Lewis’ immense talent as a writer works against him. He is a master of storycraft — of telling a complex story through the lens of key players. But when the actual story is distorted or skewed, the talent covers up for empty artifice. It’s like watching a world class musician putting shine on a set of truly lame tricks — or, as they say in the advertising business, “buffing a turd.” The extra polish somehow makes it worse.
The key thing that made me mad — there is more than one thing — is the way a huge, huge aspect of the story is left out. Flash Boys is deliberately set up to suggest a “perfect world gone bad” scenario: As if, prior to the advent of HFT, markets existed in a 1950s “Leave it to Beaver” state where nobody ever got bad fills and liquidity was provided by a fairy godmother who never skimmed. It is hard to express how blatantly irresponsible, how downright dumb and deceptive, it is to try and talk about HFT without talking about what HFT replaced.
In the very beginning of the book, Lewis gives hand-waving mention to the old floor trading “dinosaurs” now all but extinct. He gives just enough print space to point out their extinction, then moves on. This is absolutely ridiculous. Why, pray tell, did floor traders and market makers play a key role in the function of markets for multiple centuries? Because floor traders provide liquidity. Liquidity provision is a service, and it has a cost. A discussion of what HFT replaced — with examination of new systems, old systems, and continuity between the two, with attendant pluses and minuses — should have been a third of the book if not half. Yet for Lewis it barely rates a paragraph.
Reminiscences of a Stock Operator, published in 1923, is the fictionalized version of Jesse Livermore’s true story. A key point in the story is when Livermore (aka Larry Livingston) goes from trading in the “bucket shops” to actually trading real equities on the exchanges, by way of the ticker tape. In this book, more than 90 years old now, Livermore talks about how his “bucket shop” trading style had to adjust because instant fills were not available in the real world. He talked of a “lag” in the tape that forced him to adjust his style. Sound familiar? Liquidity has always been an issue. The more size you want to move, the more of an issue it becomes. There has always been a need for middlemen to provide it, and friction / incentive issues in doing so, ever since the fabled meeting under the Buttonwood tree.
In the late 1980s, the Justice department busted 46 traders and brokers in the Chicago trading pits. The stealing had gotten so bad, the FBI came onto the trading floor. At the turn of the 21st century, the stealing was still bad. I was an international commodity broker as my first job out of school circa 1998. We had lots of hedge clients, and did a lot of business with futures giant Refco (who later imploded in a fireball of corruption). I remember countless screaming conversations with scuzzy floor clerks in the pits, trying to get restitution on a horrible fill (which usually never came).
Then, at the same time, there used to be an old saying, “Have your daughter marry the son of an NYSE specialist.” Because, of course, being an NYSE specialist was a huge privilege, passed down among family members, allowing the guy who held it to make buckets of money without a lot of brains. That money came from, you guessed it, privileged access to order flow. This system persisted for ages, however, because the specialist actually provided a service. There were costs, but they were perceived as worth it.
And then, too, you have the many billions the big investment houses (Goldman, Morgan etc) used to make on market-making activities. Lewis described this activity in Liar’s Poker, ironically enough. Client order flow passing through a bank is like a bag of popcorn, or maybe a big chocolate cake. You reach in and grab some of the popcorn, or nick some frosting off the side. Bid ask spreads used to be huge, with most investors at the mercy of whoever was working them.
My point in recalling the above is simple, and it is a point so massive that Lewis should be straight-up ashamed for not addressing it. First, floor traders and market makers have always had “privileges” — since time immemorial — in exchange for providing liquidity. Second, floor traders and market makers of old used to flat out steal, a lot. Third, even when doing an honest job, those floor traders and market makers (especially within i-bank desks) took a lot bigger spread, on balance, than the HFT guys take.
There is a much better book on HFT than Flash Boys. It is called Dark Pools and was written in 2012. You can read my review of it. In that review I further cited yet another book review I had written, The Predictors by Thomas Bass, in the mid-2000s. In my review of The Predictors I said that electronic traders would be “the new market makers.” I said that in 2005. And that is exactly what has come to pass nearly a decade later.
If you imagine that HFT came out of nowhere and started stealing at the speed of light, then okay, it is outrageous. If you imagine that HFT is a “tax” on markets that some jerks just decided to impose for zero economic give-back, then okay that is outrageous too. But if you understand that liquidity provision is a benefit, and that 21st century technology can allow for liquidity provision at a lower cost than the old system, you start to understand that all this talk about market “rigging” is a bunch of red herring garbage.
In some ways the markets are “rigged” — insert tired soundbite for why all small investors should buy index funds here — but in far more important ways the charge is nonsense as applied to HFT. It is uninformed hand-waving at its worst. Markets need liquidity to function well. Liquidity is a benefit. This is the whole reason commodity speculation was sanctioned in the first place, so that actual hedgers had someone to trade with in offsetting the risks of daily commerce. Liquidity providers will extract a very small edge for themselves in providing it — if there were no payment, what would be incentive to do the job? They may find ways to do hinky stuff around the edges, but that is why liquidity provision technologies need to be regulated. Nobody ever said the entire Chicago floor trading system was “legalized theft” (even though it felt that way to us commodity brokers sometimes!). It was recognized that the essential service provided was a necessary good. It’s the same with HFT.
Flash Boys reveals itself as a tempest in a teapot on pages 52 and 64. (I speak here of the hardcover edition from Amazon.) When Lewis is forced to use real numbers, the frivolity of his case is revealed.
On page 52, there is talk of an HFT “tax” that amounts to $160 million per day on $225 billion worth of volume. That is significantly less than one-tenth of one percent. Now, if the HFT guys were skimming while providing zero value, then you could argue they are, y’know, taking a nickel out of every hundred dollar bill that Wall Street transacts. But they are not skimming to zero value impact, they are providing a service. They are in the LIQUIDITY PROVISION business. So all this yelling about thievery and markets being rigged is not only blown way, way out of proportion, it is potentially 100% BS because the new system may well cost less, on net, than the old liquidity providers (floor traders and market makers). The market is “rigged” because six cents out of every hundred bucks goes to guys doing a better job than the old floor traders and market makers, more than a few of whom were crooked enough to steal the dimes off a dead man’s eyes? Give me a freaking break, dude.
Then on page 64, there is open admission as to not knowing how much profit the HFT guys are making — but oooh, they must be making a lot, because one of the book’s heroes billed them $80 million over the course of three years for setting up computers and whatnot. Oooh, they paid out all that skrizzle and to just one guy, so the thieves must be thieving big time right? Never mind that the published revenues of existing HFT firms are MULTIPLES SMALLER than what the big bad i-banks used to make in their equity trading departments. Never mind that the billions banked by Goldman and Morgan on market making have been turned to notably lesser amounts by Getco, Virtu and the like. Just focus on the raw numbers and go “ooh” and “aah” like one of those idiot German bankers Lewis made so much fun of as the patsies of the subprime crisis.
This is a blatant case of mathematical sleight-of-hand. The whole damn book is hyperbolic sleight-of-hand. A number like $80 million might impress someone in a vacuum. But your favorite grocery store may have bought $80 million worth of hummus to sell this past fiscal year. What does it mean? Nothing. Wall Street is a huge business. Providing liquidity will be, fractionally, a large business in absolute size, with massive costs. What we do know is that the new HFT guys are significantly LESS profitable than the old i-bank equity trading departments used to be, which strongly implies they are providing a service at a lower cost, that used to be provided at a higher cost. Hey, what do you know, that is how technology is supposed to work.
Oh, and by the way, HFT is actually better for the “little guy.” The average investor now gets better fills than he could before, on balance. Various sources of credible origin have pointed this out. And even large institutional firms (again note Asness, who has no skin in the HFT game either) say the same thing. So who does Lewis shed a tear in his beer for exactly?
But oh, I’m not done. The reason this review is called “Dumb Tourist” is because Lewis himself used that obnoxious phrase in a Bloomberg interview (after going on 60 minutes and saying the market is “rigged”). Here is the direct quote, as Lewis speaks to Stephanie Ruhle and Eric Schatzker of Bloomberg News:
LEWIS: Let me give you an analogy and I think is a very close analogy to the way the stock market is structured. It’s a casino analogy. So I have a casino and I want to start a poker game in the casino, so I get three card sharks and I tell them, go sit there and start the game. Make it look like a good game’s going on. There are no 4s, 9s, there are no queens in the deck. Only you will know that. And we will pay some tour group operators to bring like a bunch of dumb tourists in to pay with you. They won’t know. You’ll –
RUHLE: Hold on, a bunch of dumb tourists? So is David Einhorn is a dumb tourist?
RUHLE: Come on now.
LEWIS: In this analogy. Hold on. In this analogy, every investor — David Einhorn did not know; he did not understand. He understood that whenever he tried to do something in the market, the market moved like someone knew what he was up to. In the same way that big pension fund managers and mutual fund managers saw when they tried to execute big orders, oh my god, it’s like someone knows I want to buy before I buy. But he didn’t know why. He didn’t know – he didn’t understand that high-frequency traders were putting machines in exchanges to be closer to the exchange so that they could get price information in two milliseconds before him. And so on and so forth.
Let me — can I finish my analogy?
LEWIS: So of course the tourists get fleeced all the time in the poker games, because they don’t know the deck is rigged. The poker players pay the casino a cut of what they make. The casinos, operators, pay the tour group – the tour group company money to bring in the tourists.
So in this case, casino’s the exchange, the poker players are the high-frequency traders, and the tour group operators are the banks and the brokers that handle the stock market orders. And I think the analogy is pretty close. So is that rigged? Is that a rigged game? I think it is a rigged game.
Now, as it so happens, yours truly (the one writing this review) is a seasoned high stakes poker player. As I write this review in my home office, I can literally see the Bellagio from my high rise window. I have logged thousands of hours in casino poker rooms (trusty laptop at hand). I have sat down next to billionaires and degenerates and everything in between, and won and lost $10,000 pots on too many occasions to count. And I can tell you that the casino poker analogy is perfect — but not in the way Lewis thinks. It shows perfectly why HFT is not a big deal… and why Lewis himself is the “dumb tourist” in this whole discussion.
Let me explain, briefly, why Lewis’ analogy is so apt — but in a way that skewers him rather than making his point.
The casino is by far the best venue for high stakes cash games. You don’t play high stakes in someone’s house — unless you know the host very well and he has amazing security — because there is far, far too much money on the table. In the regular 10-20 game at Bellagio, stacks of $50,000 or more are not uncommon. You want to take a stack of high society into someone’s house that might get robbed? Not to mention the challenge of getting these games together — something a great room also provides. The Bellagio has been the top high stakes room in Vegas for years and years because they know how to get the players in. (Wealthy businessmen, we love you!)
Economic point being, the casino provides a SERVICE in terms of 1) providing a secure place for games of this size, 2) attracting the players and running the games, and 3) keeping the games running smoothly via skilled dealers and floor personnel.
This service is vital to high stakes poker players. The casino CHARGES for that service (duh) but their relative costs are very, very small. In a 10-20 blind No Limit cash game, you will pay a flat 30 minute rate — typically six or seven bucks, known as the “rake” — and you will tip the dealer when you win a pot, known as “tokes.” The average sized pot in a high stakes cash game can easily be $1,000. Against that average cost, your rake and tokes will run three or four bucks. That is less than one half of one percent. Sound familiar?
Similarly, HFT is a form of liquidity provision — that activity is a SERVICE — that has replaced an older, less efficient, more expensive form of liquidity provision (floor traders and market makers). Lewis is running around saying “The game is rigged!” But all he really discovered, as the casino analogy shows, is the more modern-day equivalent for how liquidity is provided. And is six cents out of every hundred bucks a horrible price to pay? Considering many players large and small are reporting better liquidity than before? Umm, no.
What about Katsuyama then, and his new exchange in which big institutionals can match orders with each other? The poker analogy applies here too. Let us say a group of high stakes players say “We don’t need the security of the casino, and we can get our own dealer. We will play at big Jim’s house and save that 0.05%.” That is certainly an option these players have. And if they can pull it off, why not. The key thing here is large players deciding they can create their own liquidity — their own demand — as such to forego the public option. Nothing wrong with that at all. It is part of the natural evolution of Wall Street services. But again, is the rake-and-tokes system of the casino, or the liquidity provision of HFT, “theft” as a core function? No, not at all. Katsuyama is simply providing an alternative, betting he can draw the necessary liquidity to make it work, in the same manner mother nature and mother free market provide systemic “alternatives” all the time. In yelling “Wah wah rigged!” Katsuyama is getting lots of free PR, and Lewis is being irresponsible in making him out as a hero.
Now let me share two more reasons this book made me angry — angry enough to hammer out this lengthy review while having better things to do with an hour of my time.
First, Lewis didn’t have to do this. He didn’t have to push so hard for another “big score” that he created a fake issue and used his formidable talents to spin a BS story. He could have just said “I’m Michael Freaking Lewis,” and sat back and made a million a year or whatever writing stories that weren’t “big scoops,” but remained insightful and true to point. He was already big enough that he could have kept his integrity and kept doing great things. He didn’t have to sell out like this.
But the even deeper reason this book made me angry is because Lewis has given new firepower to the self-righteous idiot Luddites who like to kill flies with sledgehammers. I was more disgusted and frightened by the comments attached to various articles on the HFT issue than anything else. All these people who probably don’t know the first thing about trading saying “Oh yeah, it’s obvious HFT is a blatant scam, it’s obvious the American capitalist system is a blatant rip-off,” on and on. The only thing that is “obvious” is that the average commentator is an opinionated fool who feels far too strongly about far too many things he doesn’t know the first thing about, and Lewis played right into that like the worst huckster.
Worst of all, the HFT debate seems to have given new lung power to cries for a “transaction tax” on all trades. I can’t count how many times I have heard cries of “transaction tax!” since Flash Boys came out. The people proposing a transaction tax are the worst kind of meddlers. They are in the same camp as the debt doomers who argued that the system should have been allowed to get blown up because their gut told them it was a good thing. Do you remember the Tea Party candidate who actually argued that defaulting on America’s debt would improve our fiscal standing in the world?
America has a real problem with excitable idiots and demagogue politicians happy to exploit that excitement, with very bad things the net result. (Government shutdown and near debt default anyone?) And by creating a hyperbolic issue where one should not exist, Lewis has given ammunition to those hyper “fixers” and muddied the waters of what could have been a more logical and fair debate.
In a more reasonable world, Lewis could have taken another year or two before rolling out this book. In addition to interviewing his “hero,” Katsuyama, he could have interviewed a bunch of floor traders and market makers. He could have investigated the long history of liquidity provision, balancing out its pluses and minuses. He could have examined the transition from floor trader to black box as a form of 21st century change. He could have compared the profit spreads of HFT firms to the old i-bank divisions. He could have concluded that yes, HFT has some “wild west” about it, and there is some unsavory stuff going on, but we need to recognize that a core value function is being provided here, and that the industry needs to be cleaned up and polished, not written off as “rigged!”
The book should have been longer anyway. Not because “long” is intrinsically better, but because it feels rushed in a sloppy way. This was not a true effort to explore an interesting and important story (the rise of HFT) from multiple angles, as past Lewis books have been. This was more a flat-out bromance between an author looking for his next big hit and a Canadian entrepreneur who had all the quirky hallmarks of “hero” that Lewis picked up like a bloodhound on the scent. And he manages to insult real investors and traders in the process by calling us “dumb tourists” to boot. So lame.
ADDENDUM: This review generated a lengthy comment stream on the MT Amazon review page. Additional evidence, for the perusal of those unconvinced:
Equity Trading in the 21st century: An update. “Despite many complaints in the national media, various measures of market quality indicate that U.S. markets continue to be very healthy. Trade transaction cost estimates have stayed low and market depth and execution speeds remain high.”
Via Tabbforum: “TABB Group estimates that US equity HFT revenues have declined from approximately $7.2 billion in 2009 to about $1.3 billion in 2014. Looking at recent public data, the profitability of HFT firms in the US equities market has declined, just as the number of players has decreased… If the exchanges, brokers and HFTs are not reaping the rewards, then where is this leakage going? This money is going back to investors in the form of better and cheaper executions, as few if any institutional investors we have interviewed – and we have interviewed thousands – have ever expressed that their equity implementation costs have increased, meaning … trading just becomes cheaper and cheaper. That cost comes from somewhere: market makers, speculators, brokers and exchanges.”
Also via Tabbforum: “We hear frequently that on an aggregate basis there is significant displayed volume, but when approached, it disappears. The reason why this occurs is twofold: first, since there are 13 exchanges and more than 40 dark pools, liquidity providers and investor algorithms spread orders across exchanges and often oversize them, to ensure that no matter which venue you arrive at there is the ability to get executed. So that large aggregated volume really doesn’t exist. It is being represented multiple times. Second, if a large order does arrive in the market and outstrips supply, then the price should adjust given the increase in demand.”
Scott Locklin on why Flash Boys is basically a paid endorsement for the establishment.
Streetwise Professor on why the endorsement of a Dark Pool is ironic.
More Streetwise Professor: Pinging – Who is the Predator, and Who is the Prey?
And the DOJ investigation, by the way, is evidence of possible need to clean up questionable practices around the margins — as stated in the review, and IF bad apple practices even exist in bulk (as they might just be misinterpreted legitimate activities) — and NOT justification for indicting an entire industry as “legalized theft” and “rigged.” We should be shocked, shocked — NOT — that government agencies hungry for funding and enhanced relevance in the Washington power structure would exploit a publicity bomb all but thrown into their laps.
So yeah, Flash Boys is full of it…
ADDENDUM II: Well what do you know – via NYT: ‘Flash Boys’ Fuels More Calls For a Tax on Trading. Here come the fly-killing sledgehammers, just as expected.