Wall Street
Credit: mjpyro

Flash Boys is Michael Lewis’ latest book on exposing the abuses on Wall Street and the secret trading activities and tactics used by large trading firms and the infrastructure providers.

The basic premise of the book is that the market is rigged for insiders in the know that have invested hundreds of millions of dollars in fiber optic infrastructure to gain an edge on all stock orders that go to the various exchanges in the United States.[2]

These individual firms can also use this information to make an educated guess on what kind of trading strategies are being used instantly in the market, then adjust accordingly.

As with is book, "The Big Short", the book is told from the point of view of a small group of individuals led by a former trader named Brad Katsyama, that separately figure out what is going on and come together to do something about it or alert investors as to what is really happening behind the scenes.[2]

The “flash boys” as Lewis calls them, leave their high paying salaries and band together to create their own exchange (the IEX Exchange) which eliminates the advantage of the high frequency traders with unique solutions and software to even the playing field.

To understand the advantage the high frequency traders are getting, think of it in terms of placing an order on Amazon. What if you wanted to buy an item of limited quantity (stock shares are issued in a finite quantity) and you placed that item in your shopping cart, however, before you could hit submit to place the order, another entity was peaking in on all Amazon orders, saw your desire to buy that item and bought up the existing supply. Then, without your knowledge, turns around and sells it to you, with the complicity of Amazon, at a higher price than what they just paid.

Although the analogy is not perfect, that in a nutshell is the advantage of high frequency trading.  Understand, we are not talking about a lot of money per trade, really just a few cents, but because of the volume involved, it leads to billions in profits. That is why these high frequency traders are willing to spend hundreds of millions of dollars on new fiber optic networks directly to exchanges, or rent tiny amounts of space for huge sums of money each month on top of buildings to place antennae for better line of sight.

The book will leave you with the same thought over and over again. How is this possible? How can this be legal? Lewis refers to it in the book as “legal front running” where milliseconds are worth fortunes if manipulated correctly.

Criticisms of Flash Boys

The books does not really touch on something called proprietary feeds that the exchanges sell to anyone as opposed to using public feeds. Proprietary feeds provide more detailed trading activity allowing anyone who pays to have access a glimpse into the size and direction of the marketFlash Boys, A Wall Street Revolt: A Review of the Latest Book from Michael Lewis for any particular stock. And this is all legal according to the SEC rules. In fact, the exchanges such as NASDAQ and the New York Stock Exchange are complicit in the high frequency trading advantage because they not only allow proprietary feeds, but they rent out on-site server space to anyone willing to pay for it, and that is not likely to change without government intervention. 80% of their revenue comes from high frequency trading related activity. Basically the exchanges are selling advantages to anyone at your expense.

Another criticism of this book is that none of the stock exchanges were contacted for the 60 Minutes piece or are included in the book itself to defend themselves against some of the most serious claims. After all, Lewis is practically indicating them as co-conspirators guilty of rigging the market, so you would think they would be allowed to offer a rebuttal. However, I personally do not care to hear from them because I already know what they would say. How? Well, they have been on networks like CNBC for years defending the practice, and this is the first insider book to actually present it from another point of view from people in the know.

Flash Boys
Amazon Price: $27.95 $7.07 Buy Now
(price as of Jun 29, 2016)

Potential Solutions to High Frequency Trading

The fear of many market experts regarding high frequency trading is not that pennies are being made on trades, but that it creates an instability in the market that is going to cause a serious issue one day similar to the so-called Flash Crash that occurred on May 10, 2010.

What should be done about high-frequency trading?

As in The Big Short, Lewis simply presents the issue and how it all came to be without offering many solutions. He mentions the creation of the new IEX exchange that sends all outgoing messages through what they call a “speed box”, which is 60 miles of fiber optic cable wrapped in a coil, so they arrive at all exchanges at the same time giving no advantage to anyone.

However, Lewis does touch on two options in the book and in interviews promoting the book.

Bring back Rule 10a-1(a)(1) – “The Uptick Rule”

Rule 10a-1(a)(1) states that a listed security may be sold short (A) at a price above the price at which the immediately preceding sale was effected (plus tick), or (B) at the last sale price if it is higher than the last different price (zero-plus tick). Short sales were not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions.[1]

The uptick rule was removed in 2007 after being in place since 1938.

Give Regulators Better Software to Detect Abuse

The SEC recently unveiled the MIDAS system to look for manipulative trading behavior. Sound vague enough? However, a much more robust tool called Consolidated Audit Trail would give regulators access to every quote and trade by every customer, but it is not scheduled to go online until 2015. But what kind of abuse are we actually talking about here? Again, everything discussed in this book is legal.

Go Back to Factions

Lewis does not talk about one idea which I believe would eliminate a lot of the micro-trading. Toward the end of the 90s, the exchanges decided to get rid of offering stock prices in fractions and instead went to decimals. Before that, you had to buy stocks in 1/8s, such as 20 1/8 or 20 1/4. Simply going back to fractions would eliminate some of this penny pinching by theses traders.

The Big Short: Inside the Doomsday Machine
Amazon Price: $27.95 $5.64 Buy Now
(price as of Jun 29, 2016)

Final Thoughts

If you saw the Michael Lewis piece on 60 Minutes the other night, it is true, the game is rigged. I have been trading stocks for almost 20 years and all of us are really at a severe disadvantage. Lewis focuses on high frequency trading in this new book, however that is just a drop in the bucket.

All of those people that work on Wall Street and the surrounding areas in New York City share insider information and only a fraction are ever caught. And it doesn't even have to be obvious passing of information. It can simply be that one firm gets wind of another buying or selling a large order of stock like Apple, then the herd moves together thinking (knowing) the other has insider information one way or the other allowing them to get in on gains or cut losses before any of us ever know what hit us. The Regulatory agencies are incompetent or indifferent, many of them just biding their time until one of the large firms offers them a job.

So while none of this makes you want to go out and open a brokerage account right away, there is still money to be made if you wait it out. By that I mean, do not stay invested in the market all of the time.  I am speaking specifically in regards to owning individual stocks, not mutual funds or employer 401k accounts. Buy and hold is dead and you have to be nimble, so wait for the next mini crash or when it seems like all growth is gone and the world is doomed (it happens about once a year), then go in and buy at the lows.

The game will continue and they (the people in the know) will work together to run those stocks back up to make their money back. You just have to be smart enough to see the signs to know when to get out.