While HFT takes many forms, all of it is based on a couple of simple principles: First, powerful computers using algorithms can execute trades at lightning speed; and second, one can gain enough of an advantage over other investors through sheer proximity to the stock exchanges, even when one is dealing with communication speeds nearing the speed of light, to game the system.
The proprietary trading departments (prop trading) of the big Wall Street banks, the hedge funds, the bucket shops specializing in HFT, all do it. They all cheat by using HFT. As a result, HFT investors can take the risk out of investing and can report strings of profitable investing days running into the thousands, as many of them have. HFT investing acts, in essence, as a kind of tax on the world of finance, a tax extracted at the rate of a fraction of a penny at a time, repeated millions of times each day (this is the "high frequency" of high-frequency trading), money earned simply by gaming the system so the HFT player cannot lose.
Michael Lewis gives many examples of how it's done, but a systems analysis involves these key elements.
1. Under what is known as Regulation NMS, passed in 2007, a broker-dealer licensed by the Securities & Exchange Commission (SEC), when given an order to buy or sell stock by a customer, must search the available exchanges to find the NBBO, the national best buy or offer. In other words, the broker-dealer (a company like Paine Webber, when there used to be a Painer Webber and people would stop what they were doing, like stealing home, to listen to them) must seek to execute the order on the best terms available.
2. It is critical to understand that the world of stock exchanges in America has fragmented over the years into about 16 different and discrete exchanges, mostly located in New Jersey on the far side of the George Washington Bridge. The New York Stock Exchange that serves as a backdrop for the CNBC show, for example, is mainly a stage set. The actual trading is done by a computer server in a large room on the west side of the Hudson River. This is also the case for the other exchanges: stacks of electronic boxes in large, mostly empty rooms, scattered around New Jersey. There are no "trading pits" where buyers scream out orders to a guy in a colored jacket feverishly scribbling confirmation notes and thrusting them at the reaching hands. That's the old way. The new way is the silent flow of electrons through circuit boards, executing trades in microseconds, over and over, all day long.
3. The Flash Boys (well-financed Wall Street Banks and hedge funds) bribe the various exchanges (the NYSE, NASDAQ, Direct Edge, various others) to allow them to "co-locate" their electronic connections immediately adjacent to the stacks of computer boxes comprising the exchange. They pay a lot of money for the privilege. Thus, a communication from an HFT "trader" only has to travel a few feet on fiber optic cable to hit the exchange. This tiny advantage in speed makes all the difference. A trading floor on Wall Street might reach the exchange in 3 or 4 milliseconds (3 or 4 one-thousandths of a second). To get a sense of this duration, the blink of a human eye takes a little under 100 milliseconds to complete.
4. If, for example, a trader on the prop floor of the Royal Canadian Bank (RCB, where Michael Lewis's hero, Brad Katsuyama worked) receives an order to buy 1,000 shares of Procter & Gamble at a price not to exceed $80.05 (a limit order, as most purchasing is done), RCB submits the order on its "slow" 3 or 4 millisecond connection. Finding 1,000 shares of P&G for sale might involve a search among numerous exchanges, since SEC rules now allow multiple exchanges to sell the same stocks. The HFT trader exploits this environment by using its connections, which transmit data to the exchanges in microseconds (millionths of a second). The HFT trader "sees" the RCB limit order, then "front-runs" the order by instantaneously searching the exchanges for a buy at less than the limit order price of $80.05, completes that transaction, and then sells the P&G stock to the RCB trader. The HFT trader might make a penny a share or less, or ten bucks minus transaction costs, on the whole deal; but scaled up into a full day of trading, where such scams are repeated millions of times a day, it becomes real money. In effect, the HFT trader is an uninvited middleman standing between a seller and a buyer and taking from both.
This is but one form of differential "arbitrage" used by HFT algorithms. There are numerous others, limited only by the imagination of the mathematics Ph.D's and computer programmers who comprise the money-making wings of the big U.S. banks and hedge funds.
As noted, Michael Lewis tells the story from the vantage point of Brad Katsuyama, a Japanese-Canadian who worked for RCB, got fed up with HFT tactics, and started his own exchange, the Investor's Exchange (IEX), designed to foil HFT tactics. Whether it will work in the long run or not remains to be seen. It IS interesting that contemporaneous with the roll-out of the book, and the renewed focus on HFT brought by the book, the stock market has softened and headed south (even Attorney General Eric "Place" Holder has apparently been jostled out of his customary coma and now vows an "investigation" of a practice which has been the dominant force on Wall Street for five years). The largely illusory trading of HFT accounts for nearly SEVENTY percent of all investment activity on American stock exchanges, and the total volume of trades on the exchanges has doubled since about 2007, reflecting the "echo" transactions of the HFT players. It is a cash cow for the exchanges and for the scammers who run these investment games.
It might be difficult to overestimate the impact that a curtailment of HFT might have on the American economy generally. Our President, who never met a Fat Cat Banker he didn't like (and didn't shield from prosecution, such as the Great & Honorable Jon Corzine, formerly of MF Global), is either aware or has been told that he should be aware, that the old school method of investing, to buy stocks and hold them over time ("going long") has had its day, and that as with mortgage-backed securities and money printing by the Federal Reserve, financial scams comprise at least half of what appears to be purposeful economic activity in the United States. We might be left with only IPO issuances in social media stocks if this keeps up, and how many more hours do Americans really have left to waste on Facebook and Twitter?
Perhaps the wiser course is to cool out on the moralizing about HFT. Let Goldman Sachs, J.P. Morgan, Citadel, and the HFT shops in leafy Connecticut continue to game the system (which involves lots of foreign money, after all). Let them extract their toll of fractional pennies on every stock transaction. Let the rich get richer. They pay all the income taxes, after all, and always max out their FICA obligations. They provide the funding to the feds which allows all the vast hordes of Americans living on government assistance to keep their heads above water, to keep the SNAP cards topped off, to keep those S.S. checks coming, to receive those diabetes treatments as they wallow in their immense lipidinous carcasses in the trailer parks of Bullhead City. Noblesse oblige. What the rich are able to save from taxation they send offshore. That's okay too. It keeps "bankers" in the Cayman Islands in the market for late-model Benzes. It's all good. Let the Flash Boys have their fun. Brad Katsuyama, after all, was just a greedy bastard with a pang of conscience, or maybe a grudge against playahs who were scamming his trades. So he turned his IEX into his own money-making investment. He should have called it the BuzzKill Exchange, if you ask me. What's he going to do when the whole American investment edifice comes tumbling down around his ears, hmm? And what about Bullhead City?
Nice work, Michael Lewis. Good luck with your next book, when everybody's flat busted.
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