Dumb Tourist: Michael Lewis “Flash Boys” Review

April 2, 2014
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flashboysI am (or sad to say, was) a huge Michael Lewis fan. Liar’s PokerThe 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?

LEWIS:  Yes.

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?

SCHATZKER:  Absolutely.

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:

Data charts showing narrower bid/ask spreads over time.

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.”

Cliff Asness / AQR on “High-Frequency Hyperbole.”

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.

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35 Responses to Dumb Tourist: Michael Lewis “Flash Boys” Review

  1. Tex Williams on April 2, 2014 at 11:16 pm

    Typical Jack Sparrow comprehensive, intelligent and perceptive piece. Thanks Jack.

  2. Michael ONeill on April 3, 2014 at 11:29 am

    Having spent over 40 years on the street, running a desk prior to Bunker Ramo and having been a big fan of you and Mike, I find your recent work to be lacking. I hope this is the bottom. The problem is not liquidity but the front running.

    • Jack Sparrow on April 3, 2014 at 7:17 pm

      Can appreciate your 40 years on the street, but the “front running” charge is itself wholly debatable. HFTs compete via combination of speed and legally obtained information. Front running implies an agency/principal problem, where a customer is being ripped off by an agent charged with fiduciary responsibility to that customer. That is not what is happening. As a commodity broker back in the day I was under no illusion that the floor trader executing my spread had a fiduciary duty to myself or my client – he was in business for himself, but his activity provided liquidity to the market nonetheless. HFT is the same way. HFTs are seeking to capture a piece of the bid/ask spread by moving quickly on the strength of legally obtained information. They use expensive infrastructure to do so because there is an internal arms race among HFT providers themselves. In so doing they narrow the average width of the bid/ask spread and, as a large body of empirical evidence suggests, lower trading costs on net, definitely for small players and quite possibly large ones too. Saying “it’s about front running” is assuming the debate in the first place. The charge of front running itself is a mischaracterization of what is happening and its net impacts. If I said “Have you stopped beating your wife” you would want to backtrack and remove the assumption in that statement or at least put it up for debate. So too the assumption in what “front running” is and whether it is accurate to say it occurs here.

      • Adam McCormick on April 4, 2014 at 3:17 pm

        This is actually a stronger argument than the one made in your article. The article falls into the false dilemma of “human traders” or HFTs, but there is a third option: to have the markets run the game directly (as the casino does). The argument is really that the HFTs compete and that allows the market to set the price of liquidity rather than the exchange. This has the effect of keeping the house honest.

        • Jack Sparrow on April 5, 2014 at 6:54 pm

          Well I could have expanded on the competitive aspects, but the review seemed long enough… it was naturally apparent to me that human floor traders and market makers keep each other in line (at the core) via direct competition, but you are correct, it probably should be explained to others who miss this point (and yell about HFTs anyway).

    • maxi on April 3, 2014 at 9:34 pm

      I was a nasdaq market maker for 10 yrs. During mid nineties thru early 2000. Your big spread gripe was a function of mandatory tier size that was imposed on myself and peers. Also as a mm we were required maintain a spread that was restricted depending on the price of the stock. “Prior to January 20, 1997, the NASD’s excess spread rule (the Rule or the Excess Spread Rule) provided that registered market makers in Nasdaq securities could not enter quotations that exceeded 125 percent of the average of the three narrowest market maker spreads in that issue, provided, however, that the maximum allowable spread could never be less than 1/4 of a point (125 Percent Rule). The Rule originally was designed to enhance the quality of the Nasdaq market by preventing firms from holding themselves out as market makers without having a meaningful quote in the system.” Fast forward to 2010 flash crash nyt report. “caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000.” hft mm’s claim and do have privilege since they claim to provide liquidity. OK if that were true then 13 years prior my $.01 quoted bid would be forced! By nasdaq terminal to be offered say @. $ .05 ? $0.50 ? Thereby I would force u to pay the beastly spread and I would short proctor and gamble to you @ $0.50. Trust me sir I’m only scratching the surface! Add automatic execution to you and every other client and you see myself and peers getting run over by the spread, why? Momentum! Yes, we took the other side of your trades, but we had too. Fading momentum was necessary when Dan dorfman opened his mouth, oh yes. Forget about raging bull, yahoo or whatever chat room the poor pick off Soes or day trader frequented. Anyway, do think that say a $50 stock that spreaded for $0.75 and required 500 shares to buy or sell on every quote. Do u think it would just lay there and an mm just flip buys and sells back and forth? Anyway, I should write a book, but nobody would read it..the truth is often un glamorous.

      • Jack Sparrow on April 4, 2014 at 1:14 pm

        You are the kind of guy I wish Michael Lewis had bothered to interview, to tell a more 360 degree version of the story (instead of creating a commercial for Katsuyama and IEX, which is also partly owned by Lewis’ buddy Jim Barkdsale).

  3. Josh on April 3, 2014 at 1:42 pm

    What service is provided by either guessing your intent and buying what you’re trying to buy before your order can make it to another exchange or by crossing your dark pool order with an order outside of a dark pool that should fill your order and pocketing the spread? There is no provision of liquidity. It is a useless activity in both cases and should not be compensated. Just because historically it was easier to rip off investors as a floor trader or bank doesn’t make either of these activities any more useful.

    • Jack Sparrow on April 3, 2014 at 7:12 pm

      Those who claim “front running” have not thought through the conceptual structure of how markets work. Orders are flowing in all the time. If an HFT tries to “front run” institutional A, they may well wind up filling the order of institutional B, who hits the execution button a millisecond later. Orders are flowing in constantly. The increased activity of HFTs serves a liquidity provision function by narrowing the average size of the bid/ask spread and putting someone on the other side of the trade. This is empirically visible through the narrowing of bid/ask spreads over time, the overwhelming tendency of institutionals to report that trading costs are going down, not up, and the fact that HFT revenues have decreased substantially over the past few years as a result of tighter competition. The infrastructure arms race is HFTs competing with each other as much as anything else, orders are constantly crossing and interacting, and available empirical evidence strongly suggests that HFTs are using 21st century technology to apply a competitive market making function. With, as Cliff Asness said, the vocal naysayers mostly the losers in the equation (and/or guys with books and dark pool solutions to sell).

  4. Royal Arse on April 3, 2014 at 2:57 pm


    The emphasis on liquidity provision and historical perspective on market making are vital to understanding why HFT operations aren’t pure evil.

    Not surprised Lewis would choose narrative over rigour since he’s an author and not an academic.

  5. David Ayer on April 3, 2014 at 4:02 pm

    Thanks, very informative.

    On Charlie Rose he was introduced as a former bond trader and he was explicitly dismissive of the importance of liquidity to traders. I wondered if he had ever really traded.

    I won’t go near a day trade with a dead tape or wide spread. I am glad we are almost done with humans as market makers.

    The world will be stunned at the liquidity consequences if transaction taxes are enacted.

    Do the big players have access to limit or stop limit orders and fill or kill? I have always wondered how they actually execute large trades.

    - David Ayer

    • Jack Sparrow on April 3, 2014 at 7:08 pm

      Big players have access to everything (in terms of order types, execution programs etc) – if you use a top tier prime brokerage they will give you a platform with its own execution algos. If you run a large enough pool of capital you can hire your own geeks to build and tweak these yourself. Algos to fight algos. The process is Darwinian in a way that makes sense. Smaller players have better liquidity through tighter spreads, larger players have to respond and react but hve the deep resources to do so in a way that makes for tighter spreads overall. Competition enhancing the efficiency of markets while the key important things stay the same.

  6. Mike Cautillo on April 3, 2014 at 9:11 pm


    Does this really matter except to a day trader?? Am I mistaken. I know the benefits of having more liquidity and tighter spreads is beneficial for all but besides this, a position or even a swing trader at times would not even notice this. I often worry about HFT creating an increasing volatile environment…thoughts??

    Thanks and great write up!!

    • Jack Sparrow on April 4, 2014 at 1:12 pm

      That’s one of the ironies, I’m not even sure it matters to daytraders in terms of being a bad thing, because empirical evidence suggests HFT has tightened bid/ask spreads, not narrowed them. The main way it matters, in my view, is in terms of political risk — ginning up false outrage and encouraging witch hunts and bad rules from Washington, while also muddying the waters of the debate. If there are things about HFT that should be fixed at the margins, they should be fixed — hyperbole about theft and rigging does nothing to help that. All in all, not a major thing… I was just really annoyed by the book and decided to crank out a quick review on it.

  7. Mark on April 3, 2014 at 9:12 pm

    Nice work.

  8. Sandip on April 5, 2014 at 4:40 am

    Pit traders and traders from 10/15 years ago bitch an moan about how the market has changed, how its so hard and not fair anymore.

    Blah, Blah blah…….their golden goose got cooked, and they were too arrogant or too stupid to change. Tough cookie!

    Get over it, and stop blaming everything and everyone. “Flash Boys” is toilet paper. Good on you guys to rip it as such.

    A “lowly” retail Futures Trader (that makes a living at this)

  9. Matt Hurd on April 6, 2014 at 7:26 am

    A good review. Thanks.

    I concur with much of what you say and here is my review after reading the book: My review of Flash Boys

  10. Adam S. on April 7, 2014 at 10:39 am

    Ok, I may be off base here but I think the crux of the issue has been missed here. As I understand it, the primary issue above all others comes down to the advantage that co-location provides to computerized traders over remote servers – not computerized trading or HFT itself – but the advantage location provides.

    The information sent to and from the exchange is all made “public” to everyone at t=0, as in the servers are now allowed to send that information, but due to the laws of physics it isn’t practically available to everyone at the same time.

    C is the maximum speed of information propagation in the universe – so the info is made “public” at time t=0 but doesn’t actually become public to you until at least t=d/c (distance/speed of light). Then when you release information to all “at the same time”, without factoring in this transmission limitation, you give an advantage to people willing to pay money to decrease their d term.

    Since we’re talking about hundreds of miles and microsecond trades this limit on how fast information can move is very relevant.

    In the case of the markets, companies can pay the exchanges to co-locate there servers (creating a smaller d term). Remembering that c is a hard limit on information propagation, this means that you can pay the exchange for the advantage of receiving market data before anyone else.

    Take this example – Imagine two different star systems observing a third star going nova. The first star system is 10 ly away from the event and the second star system is 5 ly away. We know that the star system 10 ly away will not receive any information about the event for at least 10 years (it’s impossible to get it sooner), but the star system 5 ly away will receive the information in only 5 years. The information was sent out to all of the star systems in the universe at the same time, but due to the non-instantaneous transmission of information some star systems will get the information before others. The information was “made public to everyone at the same time”… but because of this limit, it in fact wasn’t.

    Flip the problem on it’s head, imagine a universe where information could be transferred instantaneously, and in this universe exchanges implemented an artificial lag time that you could pay to have reduced. Would that be considered a level playing field?

    [The issue gets even worse if you have the money to co-locate at multiple exchanges and lease dedicated fiber between the locations. You will have a much much smaller d term, less and more predictable routing and ultimately an edge of milliseconds over all other traders that don't.]

    Ok, so information propagation has a speed limit and you can throw money at the exchanges and into infrastructure to give yourself an edge. Now, we’re at the real point of contention, is this fair? Should you be able to pay the exchange for advanced information?

    The gaming industry has had this issue for decades now.

    Think of an FPS (first person shooter), the server sends you my location, you line me up and fire on me but instead the server logs a miss and I killed you… why? because I’m on the LAN hosting the server, or I’m in the same city are the servers – giving me the information first. You processed the information faster than me (as soon as it was physically provided to you) and you acted faster than me, but by virtue of my location alone, I won.

    Well, game developers recognized that this was a huge problem to fairness ages ago and have come up with all sorts of ways to deal with Lag Compensation to level the playing field.

    That’s what all this boils down to, do you want to play on a server (market) with or without some form of lag compensation and is paying the game company (market) extra money for reduced lag times fair?

    HFT can still exist on lag compensated markets. There is no reason it couldn’t. Lag compensation would just remove the advantage provided by location relative to the market’s servers.

    • Jack Sparrow on April 7, 2014 at 3:07 pm

      How do we know what a level playing field even is? How do we know that speed is not a necessary function of market making, as it has always been in the past? How do we know that speed is not a self-defense mechanism, which in turn allows survival to fulfill the market making function in the first place?

      In the days of human traders, no one was faster than the floor. But the outside world had much more information than the floor. Consider this fascinating article from streetwise professor, which openly questions who is “predator” and who is “prey:”


      And as I wrote on an Amazon message board in reference to the above article:
      As [streetwise professor] points out, we can’t even be certain who is “predator” and who is “prey,” given that a meaningful volume of complaints (what few there are, as instis are strangely mum) may come from wielders of informed order flow now upset that they can’t tag non-informed market makers as effectively as they used to. HFTs may be getting raked over the coals for natural defense mechanisms, which would truly be ironic.

      What has become ever more clear, especially in the past few days of debate, is that HFT is an extremely nuanced topic. My overwhelming intuition, based on my fairly extensive experience with markets and 15+ years of ongoing participation in markets, is that the liquidity provision aspects of HFT are quite meaningful and quite substantial — as based on very strong empirical evidence and an experience-based strong intuitive sense of how important liquidity is to functioning markets, knowing full well that liquidity does not come free (ever tried to trade a thin market?) — coupled with the reality that, while economic impact beyond liquidity (or even in context of liquidity) can be debated, we are not truly talking about illegal activity here, only legitimate practices (for the most part) that many do not know how to properly interpret or put in context, and any attempt to say “the debate is about the illegal stuff only” is a bait and switch, a surreptitious attempt to take the broad brush out of Lewis’ hands and pretend he was being reasonable and non-hyperbolic in the first place. Which he was not.

      Which, again, leads to the frustration expressed in the review, and the dangers of hyperbolic “theft” and “rigged” charges inciting demagogues and resulting in political sledgehammer wielding…

      We have to be very careful in assuming the terms of debate. Lots of people are the opposite of careful – they want to get out pitchforks when they haven’t even properly defined the issue.

      • Adam S. on April 7, 2014 at 4:03 pm

        Again, pretend our universe allowed for the instantaneous transmission of information. Now imagine that exchanges decided to implement an artificial lag time for trades that you could pay to have reduced. Would that be considered a level playing field?

        This is exactly what we’re discussing here.

        • Adam S. on April 7, 2014 at 4:04 pm

          **not only a delay in trades, but a delay in the release of information as well.

          • Jack Sparrow on April 7, 2014 at 11:49 pm

            No it wouldn’t be a level playing field, necessarily, because informed order flow has an edge over market makers. The balance of strengths and weaknesses is opaque, not obvious, making it hard (if not impossible) to even define what a “level playing field” actually is. If you make all fighters the same speed by slowing down the fast ones, you may be conferring extra advantage to the inherently stronger ones, or to the ones who cheat in ways not involving speed. The point is that you can’t make casual assumptions about impacts to an ecosystem, or what is best for, or ethical in regards to, that ecosystem, without fully understanding checks and balances of niche strategy interaction and how things work, which includes hard to predict outcomes that appear as spontaneous emergent properties, some quite beneficial. If someone asserts that niche participant group “A” has an unfair advantage over group “B”, but in reality that supposed unfair advantage is actually an evolved survival mechanism that allows the beneficial participation of “A” where it otherwise would not exist, then by making things “level” in theory one might simply drive “A” out of existence and cause a degraded or even collapsed ecosystem, with net results worse than before. Thought experiments built on assumptions can be red herrings or excessive complications if important aspects of the hidden core assumption set are not unpacked first.

            Or, to put it more succinctly: Shit’s complicated.

            • Adam S. on April 8, 2014 at 2:39 pm

              1) This is not an “evolved survival mechanism” this is exploitation of a physical limitation in our universe that was never addressed when designing the exchange’s servers. This is paying the exchange for advanced information, plain and simple. Minimum propagation time is T = d/c, it’s a law of nature. This is not some abstract thought experiment, that lag is real and you can pay money to exchanges to have it reduced.

              2) If you’ve got the money for better algos or faster servers or the ability to make better predictions you are still going to be the fastest “fighter”. You’ll see the info same as everyone else, at the same time as them, and if you pull the trigger first, then you’re still the fastest. We are only talking about removing this lag advantage due to distance. It -is- paying for advanced information. Which has already been established to be “unfair”.

              3) Again, no one is being “slowed down” this should be a matter of correcting for non-instantaneous information transmission (buying advanced information).

              4) Yes “shit’s complicated” but that is not a valid counter argument as it could be used as an argument against any regulation or change to any complex system. Perhaps we shouldn’t enact any new regulations?

              This isn’t as complex an issue as you’re making it. You can pay for the privilege of receiving market information before anyone else. The servers weren’t designed correctly. That’s what the argument is about. Because the systems were never designed with this physical limitation in mind you can pay for advanced information… and well, that’s already been established to be wrong.

              • Jack Sparrow on April 8, 2014 at 2:42 pm

                I think we are talking past each other completely. HFTs have speed in the same manner the old market makers had speed. In a sense, trading on the floor is comparable to co-location or what have you. That speed allows fulfillment of a function: liquidity provision.

                I’m thinking we just need to go our separate ways on this. I do not agree with your characterization of the situation or the potential impacts of what you propose. We don’t have enough common ground to debate the narrower points you are trying to put forth, and I don’t much feel like backing up and expanding the debate again in dramatic fashion.

              • Adam S. on April 8, 2014 at 2:53 pm

                “HFTs have speed in the same manner the old market makers had speed. ”


                “In a sense, trading on the floor is comparable to co-location or what have you.”

                Yes and No, trading on the floor is the same as algorithmic trading / hft/ whatever name you want to give it, but co-location is having your servers in the same room or on the same fiber as the exchange servers (it’s a server location).

                If I pay the exchange to co-locate my HFT servers and you don’t pay to co-locate your HFT servers I have a huge advantage over you due to the fact that I will get information milliseconds before you. I can see it and act on it before you even see it (depending on your server location).

                We have lots of common ground I just think we’re failing to communicate on the technical aspects.

              • Jack Sparrow on April 8, 2014 at 4:29 pm

                You don’t have a “huge advantage” if I have better information than you, or if I trade in a completely different way. Our relationship might even be symbiotic in that case — think birds that pick food from a crocodile’s teeth, thus serving as the croc’s dentist — unless I try to blunt or buffer your niche strategy. I understand the technical aspects of what you are saying. My point is that the necessary context of debate is far larger.

  11. Steve Previs on April 8, 2014 at 8:01 am

    Hi Jack:
    Like some of the other posters here I have been executing client orders for close to 37 years. So, I have seen and felt firsthand the evolution of the marketplace. The event that compressed spreads and lowered commission rates was one thing and one thing only…….Decimalization. The switch from fractions to decimals took place in August/September 2000. HFT shops didn’t start to appear until around 2005, just about the time that BATS Exchange was founded. As spreads narrowed from 1/8 ( .125 cents ) to 1 cent, commission rates plunged commensurately, especially on the institutional side. Since HFT wasn’t around then how can HFT proponents and defenders claim HFT compressed spreads and lowered commissions? As far as HFT providing liquidity I think you proved that to be another falsehood by citing the information from the Tabb Group. If HFT revenues have declined from $7.2 billion in 2009 to $1.3 billion in 2014 wouldn’t the supposed liquidity they provide ( volume ) also have declined by 82%? And, if they are not being compensated for providing liquidity, exactly what service are they providing? I can’t think of another industry that has suffered an 82% drop in revenues and has managed to survive. However, maybe HFT is different. Or, the data from the Tabb Group is completely erroneous. Meanwhile, defenders of HFT don’t explain exactly how the algorithms function. It might be worthwhile, in the interest of transparency, if one of the technologists or code writers explained exactly what problems the algos are solving. The results may be fascinating. Finally, I find it quite interesting that more than a few HFT shops ( GETCO, VIRTU, Citadel ) among others, all started in the commodity/futures space and not in the equities space. Hmmm, maybe something to do with the technology that replaced the pit traders? There are many more points that I could make to dispute your well written attempt to defend HFT. But I’ll leave it for another time. Because in the fullness of time, I believe we will see HFT for what it is……a group of some very clever techies, who have gamed the rules congress and the regulators put in place, for their own benefit, much to the detriment of millions of other investors. Karma?

    • Jack Sparrow on April 8, 2014 at 12:55 pm

      Hi Steve,

      There is unambiguous empirical evidence that bid/ask spreads have narrowed, particularly in the past five years or so. Meanwhile, unless the Tabb group is lying about having surveyed thousands of institutionals, their experience of net lower trading costs would seem unambiguous as well.

      While I respect your intuition based on your ample experience, my instinct is to question everyone’s intuition, including my own, and work more from evidence and nuanced discussion. Some have wondered why I would decide to defend HFT out of nowhere. The answer is not because I have some special affinity for HFT, but because my spidey sense took great affront at the way a false narrative was rammed through by Lewis (with the attendant dangerous political side effects).

      If we have learned anything through the study of behavioral science, the excellent work of Kahneman and Tversky, and so on, it is that gut feel cannot always be trusted, and that in certain cases there are cognitive illusions that “system 1″ (to use Kahneman’s term) will fall prey to even when system 2 is appraised of them. The HFT debate fascinates me in part because it is so clearly an issue that appears simple on the surface, yet is deeply complex underneath. As such I lean towards nuance and subtlety, plus the most significant pieces of available evidence — which center around institutional behavior and activity, plus the observed results for the small investor — while naturally being wary of internal impulse toward self-righteousness, including within myself. It is as much a telling and fascinating philosophical test of how complex issues are handled, as it is a pure finance question. Thus far we are collectively acting like gorillas eating spaghetti with boxing gloves.

  12. isomorphismes on April 9, 2014 at 3:40 am

    Hi, this is probably my favourite review of Flash Boys – so thank you! – but I have a favour to ask as well as a compliment to give.

    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.

    Would you mind explaining a bit more of the history here, or providing some references where I could find it?

    Many thanks.

    • Jack Sparrow on April 9, 2014 at 12:13 pm

      Check out “The Futures” by Emily Lambert or “The Poker Face of Wall Street” by Aaron Brown…

  13. isomorphismes on April 9, 2014 at 4:06 am

    Nice how you worked in Lewis’ dig at Düsseldorf from his subprime book.

  14. isomorphismes on April 9, 2014 at 4:59 am

    I have logged thousands of hours in casino poker rooms (trusty laptop at hand)

    To calculate probabilities?

    • Jack Sparrow on April 9, 2014 at 12:17 pm

      No, because I do market research in between hands. There are so many long stretches of inactivity, it’s a decisive advantage having the ability to work at the table. It also enhances image wonderfully. If I haven’t played a hand in 30 minutes, to an opponent it might appear as if I haven’t played for hours (bc of recency bias). Then, when I see a clear opportunity to steal a large pot, they write me off as a tight player with a strong hand and fold. Layers within layers. If I couldn’t access electronic devices, I wouldn’t play.

  15. soullfire on May 10, 2014 at 5:47 pm

    Nice write up and good counterpoints made in support of HFT. In thinking about the issue, I think HFT’s are dangerous, but they are being vilified for the wrong point of “front-running”.

    As you’ve stated, since they have legally acquired access and the ability to co-locate their servers at the main hub, there’s nothing sinister about having a time advantage and their profit margin is limited because they have to operate withing the boundaries of what the sanctioned market makers/specialists are setting the spread at.

    The actual problem is these HFT entities have become the defacto market-makers without the associated responsibilities that go with it.

    Specialists are required to have an active spread of the products they are offering during the entire time the market is open. Not so with HFT’s.

    As a result, HFT’s provide the market with much liquidity when times are good, but if things start getting rocky, they can turn off their machines and walk away, and with that goes all that extra liquidity at a time when it would be needed the most.

    Therefore the liquidity HFT’s provides is a false sense of security to market readings making the system appear more robust than it actually is.

    So rather than issue a transaction tax, a more effective regulation could be that they are required to keep their machines on throughout the day like sanctioned market makers for a certain percentage of their overall trading volume. That would add an additional measure of risk to HFTs which would help regulate and smooth out market liquidity in general.

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