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Flash Boys: Cracking the Money Code

Article  in  Quantitative Finance · February 2015

DOI: 10.1080/14697688.2015.1007472

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 Flash Boys. By Michael Lewis. W.W.
Norton, New York, 2014, 274 pp., ISBN
978-0-393-24466-3, $27.95
Reviewed by Philip Protter∗
January 10, 2015

High speed trading was controversial in financial circles before Michael

Lewis began writing this book. But now that he has, and it is a best seller,
it has reached the popular consciousness. It is worth describing a bit what
is high speed trading, and why it is so controversial.
High speed trading began in earnest when the SEC implemented the
“Regulation National Market System,” known as REG NMS, in 2007. Among
other things, this allowed for more competition among stock exchanges, and
led to the proliferation of stock exchanges within the US. Let us describe the
situation before the REG NMS. In essence, there were two types of market
orders: a “market order” and a “limit order.” Market orders are popular with
ordinary traders trading small amounts of stock, since the important thing is
to make the trade and one is not worried about large changes in price in the
small amount of time it takes to make a trade, between the time one places
the order and the time it is executed. For large institutional traders, such
as insurance companies, mutual funds, pension funds, university endowment
funds, charities, and sovereign wealth funds, typically large blocks of shares
were traded (usually broken up into small pieces), and the risk of moving the
price substantially with a large buy or sell oder (even when it is broken up
into smaller pieces) is larger, so limit orders were (and still are) preferred.
The large institutional traders provided liquidity to the market, by providing
∗
Statistics Department, Columbia University, New York, NY 10027; supported in part
by NSF grant DMS-1308483

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both demand and supply, depending on whether they were buying or selling,
enabling the small traders readily to find counter parties to their desired
trades. As such, they were able to earn liquidity profits at the (small) expense
of the ordinary traders. These liquidity profits greased the system, giving
profits both to the large institutional traders as well as to the exchanges,
which cleared the trades. (See for example [3] for a more detailed explanation
and mathematical analysis.)
This system changed dramatically after REG NMS, and this is explained
at length, in an entertaining style, in the book under review. The book
reads almost like a novel with too many characters, but by giving delightful
descriptions of individuals players in the financial markets, Michael Lewis
is able to rend fascinating a subject that might otherwise seem quite dry.
Before I read this book, I had often idly wondered why so many new stock
exchanges had suddenly burst onto the scene, changing the NYSE from a
dominant major player to a non dominant although still significant player.
At the time there was a bit of a scandal over the executive compensation of
Richard Grasso, the Chairman and Chief Executive of the NYSE, when it
was revealed that he received $140 million in 2003 and was forced to resign.
I realized there was serious money to be made in stock exchanges, and I
naı̈vely assumed that the mushrooming of new exchanges was motivated by
these profits. When I became aware of the “dark pools” established in the
major banks and investment houses, private exchanges that operated in secret
for their more important clients, I assumed this was a profits grab for part
of the money made by the exchanges, as well as an attempt to shield these
clients from the HFTs. But Michael Lewis gives a more sinister explanation
of these exchanges and also of the dark pools, and how they serve the ends
of the high frequency traders (hereafter, the HFTs), and the interests of the
investment banks, and do not at all serve the interests of the users of the
stock exchange, even not the big and important clients of the banks and
investment houses. This surprised me, but Lewis makes a convincing case.
The HFTs have computers which operate at enormously fast speeds, on
the order of 10−7 second. The NYSE has located its processing computers
not at its traditional headquarters in downtown NY, but in a small town
named Mahwah, in New Jersey. Mahwah is 27 miles from Wall Street. If
one were to place an order for a trade from Broad Street (the traditional
and still touristic site of the NYSE), and the trade instruction were to travel
with fiber optic cables in a straight line, at the speed of light, the delay
would be 0.000145 seconds. It is frightening to think about this, but it is

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much too slow for the HFTs. Their strategies, nicely explained in Lewis’
book, depend not only on extraordinary speed, but the most profits go to
the fastest trader. As a consequence, the HFTs “co-located” in the same
building that houses the NYSE processors, with carefully measured fiber
optic cable connections arranged so that no one co-locator has a shorter fiber
optic cable than any other. This reduces any speed advantage of any given
HFT either to better state of the art hardware, or to better (faster) software,
giving lucrative programming opportunities to talented programmers. The
question becomes: Why is speed so important?
It is hard to summarize a complicated situation, but in essence, Lewis
explains how the new exchanges have created a panoply of new types of
orders that are used only by the HFTs. These orders, for example an IOC
(immediate or cancel) order, coupled with the great speed of the HFTs, allows
the HFTs (or more properly their computers) to view the structure of the
limit oder book for a very small time into the future, and thus “know” (a
probabilistic knowing, not an actual knowing) the direction of the market in
selected stocks, infinitesimally into the future. This speed advantage and the
strategies Lewis explains, have allowed companies such as the high frequency
trading company Virtu Financial, to have a record of only one losing day
in 5 years of activity, as is documented in its IPO filing [5]. This has led
to accusations of wrong doing by the NY State Attorney General [1], and in
work with Younes Kchia of Goldman Sachs, we have mathematically modeled
this as, in effect, a type of insider trading [4].
The profits of the HFT industry are impressive. Billions of dollars are
made each year. Where does this money come from? It comes from the
institutional traders, including pension funds and mutual funds, who are
slow moving traders who trade in big blocks of stocks (often broken up in
algorithmic trading, which can be very fast, but not in comparison to the
HFTs), and essentially skims the cream off the liquidity profits the institu-
tional traders used to make. While critics of the book of Lewis, for example
Mathew Phillips [7], claim HFTs do not affect ordinary people (who are
market traders), he neglects to consider the impact of HFT activities on (for
example) the pension funds of ordinary people (or those of us ordinary people
who still have pension funds). It also increases costs to insurance companies,
for example, and inevitably these costs are passed on to its customers, in
large part ordinary people. Within academia, there is not agreement over
the value or harm of HFT activity, and one can consult (for example) the
research papers in [6] for an alternative view of how HFT traders provide liq-

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uidity to the market, considered to be a good thing.This is in direct conflict
with the message both of Lewis and [2, 3], where it is the institutional traders
taking positions in the market who provide liquidity to the market. They do
this by arriving with shares to sell or demand to buy, rather than the HFTs
who end the day with a net zero position in all stocks. The HFTs trade not to
take positions, or bring buy or sell orders to the market, but to profit in many
somewhat sinister ways, such as “slow market arbitrage,” one of the major
themes of the book of Lewis. In slow market arbitrage the HFTs use the
proliferation of exchanges and dark pools, coupled with their extraordinary
speed to, in essence, “front run” orders of the large, institutional players.
The book Flash Boys of Michael Lewis is a page turner that is fun to
read, where one roots for Brad Katsuyama and his heroic crusade; the book
ends with his success not yet certain, but seemingly with positive deriva-
tives. Lewis’ ability to describe people is superb: his description of 9/11 and
its effect on Zoran Perkov (an employee of Katsuyama) takes only 3 pages,
but ambushes the reader with its emotional power. An interesting feature is
that Lewis resists the cheap temptation to vilify market players, taking the
more abstract standpoint (and in my view, correct) that people are simply
doing what they must, given the system in its current incarnation. While
controversial the book nevertheless makes an important and I would argue
significant contribution to our ongoing attempts to understand the US (and
increasingly the world) financial system, and to make sense of its more es-
oteric but potentially catastrophic features, such as – yes – high frequency
trading.

References
[1] W. Alden, Barclays Faces New York Lawsuit Over Dark Pool and High-
Frequency Trading, The New York Times, June 25, 2014 3:28 pm.

[2] S. Arnuk and J. Saluzzi, Latency Arbitrage: The Real Power Behind
Predatory High Frequency Trading, A Themis Trading LLC Mini White
Paper, December 4, 2009.

[3] R. Jarrow and P. Protter, Liquidity suppliers ad high frequency trading,

SIAM J. Financial Mathematics, to appear.

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 [4] Y. Kchia and P. Protter, On Progressive Filtration Expansions with
a Process; Applications to Insider Trading, submitted for publication,
available at arXiv:1403.6323.

[5] M. Levine, Why Do High Frequency Traders Never Lose Any Money?
Bloomberg News, March 20, 2014 (13:34:28.813 GMT).

[6] M. O’Hara and M. Lopez de Prado, editors, High Frequency Trading,

Risk Books, 2013.

[7] M. Phillips, What Michael Lewis Gets Wrong About High-Frequency

Trading, Bloomberg/Business Week, April 1, 2014.

Statistics Department, Columbia University, New York, NY 10027

pep2117@columbia.edu

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