Let me tell you a story. Circa 2007, a Canadian US Stock market trader started out his day in a predictable manner. Grabbing a cuppa, he went to his desk punching in orders on behalf of his clients. This trade, however, didn’t turn out to be the way he expected, something felt amiss.
The hero of this story is Canadian Brad Katsuyama. Brad, a senior trader with the Royal Bank of Canada (RBC) who observed a series of organised and yet unpredictable fluctuations in the prices of the securities he wished to enter or exit. It seemed a “hand of God” was in play. He conceived – someone, somewhere knew what he wanted to buy before his order got fulfilled.
Who would have thought this very moment would give rise to a revolution that would send ripples across the financial markets?
Welcome to the world of High Frequency Traders (or HFTs as like to be referred to).
Michael Lewis (left) with Brad Katsuyama
Flash Boys- Cracking the Money Code by Mr. Michael Lewis (with blockbusters like Liar’s Poker and Boomerang) is an exciting and adventurous account detailing how the new world of financial markets – that controlled by computers and charting has been tuned to make the Wall Street live up to its reputation, that being an avenue where the rich intelligent exploiter fools the novice investor. It starts by breaking the old world notion about the traditional working of the stock markets – the one bombarded by uninterrupted telephone calls, and a stream of collar coded humans swarming the trading pits screaming at each other. All of them have been done away with sophisticated computers and algorithms.
The book goes on to familiarise the readers with HFTs. HFTs are basically traders who by spreading customised and refined networks gain an upper hand over mortal traders in terms of speed in executing orders.
From the time you press “Buy” in your online demat account to the time the order gets completed, your order faces numerous assaults, all of which is the work of these HFTs.
Imagine you wish to buy a thousand shares of Intel at the current market price. You switch on your screen and see a seller for 1000 shares of Intel at $10.00 apiece. As soon as you punch in the order to buy these shares, your order fails and in a flash the price jumps to $10.05 a share. Unsuspectingly, you may now bid $10.05 to get hold of them.
Here, in this simple transaction my friend, you have been scalped off by $0.05 a share.
Try computing this small figure on a base of hundreds of trillions of dollar and the amount you now stare at is no longer insignificant.
This scalping starting bleeding out the nameless- faceless investor community of $270 Mn dollars every single year.
Scalping done on large orders by high-frequency trading systems.
But what happened in the example above?
When you had honestly bid a price appearing at the screen, the order began its journey to the registered exchange. Here, at this exchange the HFTs, because of their ultrafast technologies and cables (costing in hundreds of millions) were able to trace and track your order faster than other market participants. HFTs noticing that an order is coming in to buy 1000 shares of Intel at $10.00 quickly bought the same quantity at the same price and then in turn offered it you at a marginally higher rate. Thus, making a sweet profit of half a percent (try annualising it and you might consider becoming a HFT yourself) on the transaction.
In fact, a simple rule of demand and supply was in play, wasn’t it?
The book carefully captures the in and out of the world of high frequency trading. With interviews of top banking analysts to testimonies of those laying the foundation of this new sphere, the text makes for a gripping account on how the pensioners/endowment funds/ and simple investors were being unknowingly forced to part with a couple of cents of every dollar they put in.
The book further goes on to tell the story on how Brad Katsuyama and other misfits set out to expose the rigged system, and his journey of starting IEX- the response to the wide spread wrong doings and opaqueness in transactions. IEX, by introducing a timed delay sought to ensure that the orders reached the HFTs and to the exchange at the same time, thus eliminating the arbitrage opportunity.
Intentional delays implemented by Katsuyama and his team
to ensure simultaneous order arrival.
Flash Boys is a story of taking on some of the richest and dirtiest people in business. It’s about changing an entire system. It’s about the importance of microseconds. And it’s about how corrupt the financial markets have become.
Michael Lewis with his use of words and humorous instinct will keep you hooked on to this one.
For more on HFTs, refer: http://en.wikipedia.org/wiki/High-frequency_trading
Views presented in the article are those of the author and not of ED.