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Michael Lewis: Flash Boys

Michael Lewis is a contemporary of mine (no joke didn't know him but he did his MA in Economics at the LSE at the same time I did).  Granted he did much better than I, and is a man of conviction.  ML started in Salomon Brother's bond sales desk in the early 1980s -- Although the world believes that Salomon was a investment bank (it was in some small scale) where it dominated was in the bond market.  In fact, long after ML left the bank it was convicted of cornering the US gov't short term bond market -- it takes some massively large brass balls to try that (even in the 1980s).  Salomon Brothers was the biggest bond house on Wall Street.

Anyway, ML wrote his first book:  Liar's Poker that was a cautionary tail as to what banks actually did -- the amazing thing (and it shows the level of depravity of young bankers) was that future bankers used the book as a "how to get into banking manual".  ML wrote a number of other great books (Blind Side, Money Ball, The New new thing) and some less good books (the Big Short: story was great book was too long).

Anyway, last night Amazon started selling ML's new book:  Flash Boys that talks about the High Frequency Traders (HFT for short), something that started about a decade ago (early for some but not in the institutionalize way you have today).  What the HFT guys need is fast computers (algorithm ) high speed bandwidth and cheap execution cost.

I've not read the book yet, but HFT do two things; first they trade ahead of the market -- as is explained in the 60 minute clip they are able to execute a trade ahead of the rest of Wall Street.  The second thing (which I guess he talks about in the book) is price discovery.  Price discovery is very important it tells you where the demand/supply curve really is.  HFTs do that by flooding the exchange with orders -- and removing these order almost instantaneously -- but slow enough to trigger actions by the "regular" market participants (which generates a "failed trade"), this way the HFT discover at what price institutional money start to sell stock and at what price options will trigger  activity (buying/selling/exercising).  Having that information allows you to "game" the market.  Knowing how the price will affect the market behaviour is a huge structural advantage -- in fact the HFT don't care about the price they just know the present a few seconds ahead of everyone else, and they know what the market will do when the price changes!

You know the problem is serious when Fidelity, Goldman and a bunch of massive hedge funds (multi billion) are concerned about the problem -- the attractiveness of ML's book is that it puts it all in perspective. BTW the real question is why do exchange allow HFT traders to operate -- the reason is revenues: HFT account for about 50% of all exchange revenues -- a source of revenues that did not exist a few years ago.

Finally, how much are we talking about?  Well imagine one HFT spent $300 million in optic cable to shave 3/5 milliseconds from its trading.  That's a lot of money for such a small time advantage.

The other attractive aspect of the of the book is that it shows the solution to the problem... which was the creation of a exchange that stops the HFT from functioning, the method is very interesting, but HFT are really really smart and have huge incentives to find a solution.  One thing for sure is that the HFT's form of "legal" frontrunning may become more difficult execute.  Don't know what they are going to do about price discovery.

Anyway, interesting stuff

Note:  BTW this is not saving the market for the little guy -- there is no little guy, the issue here is that the markets are rigged by some of the institutional participants (like the LIBOR scandal of last year).  This is not about Every Man Trader; its the Big Boys who are complaining; hence the Shadenfreude



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