“Flash Boys”

Michael Lewis’s new book Flash Boys: A Wall Street Revolt is both fascinating and entertaining, but as a trader, I also find the issues raised in the book to be deeply disturbing. Here are a few of the most troubling assertions from Flash Boys.  First, most exchanges are owned and operated by public companies that are catering to high-frequency traders (HFT) in an attempt to maximize short-term revenues.  Second, HFTs have a speed advantage in both seeing and executing market orders.  Finally, HFTs are using their speed advantage to front-run our orders.

 Flash Boys: A Wall Street Revolt

Here are a few select quotes from Flash Boys that you will find unsettling:

“Someone out there was using the fact that stock market orders arrived at different times at different exchanges to front-run orders from one market to another.”

“The sequential cost-effective order will go first to BATS and buy the 100 shares — and cause the other 100,000 shares to vanish into the paws of high-frequency traders.”

“By complying with Reg NMS, he now understood, the smart order routers simply marched investors into various traps laid for them by high-frequency traders.”

“The high-frequency traders wanted to obtain information, as cheaply and risklessly as possible, about the behavior and intentions of stock market investors. That is why, though they made only half of all trades in the U.S. stock market, they submitted more than 99 percent of the orders: Their orders were a tool for divining information about ordinary investors.”

“The banks took different approaches to milking the value of their customers’ orders. All of them tended to send the orders first to their own dark pools before routing them out to the wider markets.  Inside the dark pool, the bank could trade against the order themselves; or they could sell special access to the dark pool to high-frequency traders.  Either way, the value of the customers’ orders was monetized — by the big Wall Street bank, for the big Wall Street Bank.”

Solution

There are a few guys with white hats in Flash Boys as well.  Lewis chronicles the story of the founders of IEX, a new type of exchange created by buy-side investors to provide a fair marketplace.  In theory, IEX should eliminate the advantages of flash traders and enhance our ability to buy and sell at market prices, thereby reducing slippage.  Below is some additional background information from the IEX website:

“IEX is unique in that it is a registered ATS owned by a consortium of investors: mutual funds, hedge funds, family offices, and individuals. However, IEX will only have brokers as Subscribers, recognizing their integral role in the investment process.

IEX will focus on investor protection and performance by creating a market that aims to maximize shares traded at the best available price, decreases information leakage, eliminates informational disadvantages and persistent inefficiencies, and promotes an opportunity for natural interest to interact without unnecessary intermediation. IEX is dedicated to offering fair access to a balanced marketplace, and delivering a defined and objective experience in support of just and equitable principles of trade.

In operating the ATS, IEX will conduct itself strictly in an Agency capacity, and will not have a proprietary business, or an agency business other than the ATS. IEX has no broker affiliates. All Subscribers will have equal access to the ATS and its features and functions.”

After reading Flash Boys, I was troubled enough by Lewis’s claims that I checked with my broker (Interactive Brokers) to see if they allowed trades to be routed to IEX.  I was pleasantly surprised that IB had already established a relationship with IEX.  I have designated IEX for all of my recent stock and ETF orders and the fills have been excellent.

I would encourage you to do your own research on this issue and conduct your own due diligence on IEX, but the system that has existed for many years does not offer a level playing field for all market participants and the existing incentive structure will make it very difficult for brokers and Wall Street banks to act in the best interest of individual traders and investors.  I am not affiliated with IEX in any way (other than as a paying customer) and neither is Trading Insights, LLC.

Other Recommended Books by Michael Lewis

 The Big Short: Inside the Doomsday Machine

Liar’s Poker: Rising Through the Wreckage on Wall Street

Moneyball: The Art of Winning an Unfair Game

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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2 Responses to “Flash Boys”

  1. QUSMA says:

    It should be noted that you should never, ever, ever, ever route a non-marketable order to IEX because their book does not use time-price priority and is designed to screw over the retail investor.

    • I learn something new every day editing Trader Edge. As QUSMA pointed out, IEX does not use the standard time-price priority when matching their trades. However, their “broker preference” only applies to crossing trades for the same broker, when the broker takes both sides of the same trade simultaneously. This type of trade would normally be crossed within the broker’s own dark pool, which is why IEX processes these trades for the broker at no cost. Given that these crossing trades account for only 2-3% of trading volume, it is not clear how this would adversely affect the retail trader – especially given the potential advantages of preventing HFT abuses on IEX.

      Brian Johnson

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