It has already been promoted on 60 Minutes, but even without the boost Michael Lewis’s new book, Flash Boys: A Wall Street Revolt is guaranteed to be a best seller.
More importantly, it might very well make history.
Lewis is telling us that the stock market, the ultimate free market, is being rigged. He will show how an intrepid group of young people has been trying to restore fairness to the market.
Naturally, the story about how big banks and brokerages are using high-frequency trading to skim a miniscule profit off of every trade has attracted the attention of ambitious politicians.
It is almost inevitable that they will draw up new regulations and portray themselves as the champions of fairness. Unfortunately, unscrupulous traders seem always to be able to find a flaw in the regulations. They will exploit the flaw until they are caught.
Lewis does not tell how government bureaucrats cracked down on market skimming. He shows how people like Brad Katsuyama, Ronan Ryan and Rob Park are changing the system by introducing a trading platform that can eliminate the skim.
More importantly, for my purposes, Lewis emphasizes that markets can only work fairly when their participants behave ethically.
In the excerpt that the New York Times Magazine has published, Lewis emphasizes that when a young Canadian trader named Brad Katsuyama moved to Wall Street he was struck by how offensive the people were.
You may think, perhaps correctly, that the Occupy Wall Street crowd was especially offensive. You may believe that young radicals are extremely offensive. But, if you believe that college students are missing a couple of ethical behavior genes, you must accept that many of Wall Street’s high frequency traders are similarly deprived.
A free market is not a free-for-all. It is not a dog-eat-dog jungle where everyone is trying to rip off or to screw everyone else. Market participants are morally obligated to maintain market fairness. If they reduce it to the lowest common moral denominator—their personal greed-- it will fail.
Lewis explains what Katsuyama found when he moved from Canada to lower Manhattan in 2007:
It was his first immersive course in the American way of life, and he was instantly struck by how different it was from the Canadian version. “Everything was to excess,” he says. “I met more offensive people in a year than I had in my entire life. People lived beyond their means, and the way they did it was by going into debt. That’s what shocked me the most. Debt was a foreign concept in Canada. Debt was evil.”
Katsuyama should have known, and he certainly should know by now, that debt, public and private, is as American as cherry pie. If Americans were living beyond their means in 2007, afloat on a sea of debt, they have, of late, outdone themselves.
In fact, there’s so much debt that no one knows how to solve the problem except by creating more debt.
Katsuyama was working for the Royal Bank of Canada, a place where the culture was defined by, God help us, niceness. The concept defined the way RBC did business:
There was even an expression used to describe the culture: “RBC nice.” Although Katsuyama found the expression embarrassingly Canadian, he, too, was RBC nice. The best way to manage people, he thought, was to persuade them that you were good for their careers. He further believed that the only way to get people to believe that you were good for their careers was actually to be good for their careers.
Again, business involves ethics. It involves doing the best for clients. And you cannot be doing the best for your clients while you are messing with their trades and skimming money off the top to enrich yourself.
One might believe that real men do not want to be nice. They prefer to cultivate their capacity for ruthlessness. Don't nice guys finish second?
And yet, the concept of the gentleman derives from the concept of gentility. Not because it is trying to weaken men, but because no one becomes an adult without playing the game according to the rules. Niceness is about good sportsmanship, and good sportsmanship means respecting the game. If the game is not fair, then no one will respect the results.
The same applies to democratic nations. If everyone believes that both parties are playing fair, the results of elections, even the results of administrative fiat will be respect. If, however, everyone believes that politicians are in it for themselves, or worse, that they are imposing their ideology on an unwilling electorate, democracy will fail.
It is not easy to describe high-frequency trading. In truth, next to no one understands it. That’s why its adepts have been getting away with doing what they are doing… screwing not only the individual investor but many institutional clients.
Lewis makes an excellent effort to describe how the system works:
Broadly speaking, it appeared as if there were three activities that led to a vast amount of grotesquely unfair trading. The first they called electronic front-running — seeing an investor trying to do something in one place and racing ahead of him to the next (what had happened to Katsuyama when he traded at RBC). The second they called rebate arbitrage — using the new complexity to game the seizing of whatever legal kickbacks, called rebates within the industry, the exchange offered without actually providing the liquidity that the rebate was presumably meant to entice. The third, and probably by far the most widespread, they called slow-market arbitrage. This occurred when a high-frequency trader was able to see the price of a stock change on one exchange and pick off orders sitting on other exchanges before those exchanges were able to react. This happened all day, every day, and very likely generated more billions of dollars a year than the other strategies combined.
Since Lewis counts among those who explained the financial crisis of 2008, he is well qualified to explain the connection between the two kinds of market corruption:
The same system that once gave us subprime-mortgage collateralized debt obligations no investor could possibly truly understand now gave us stock-market trades involving fractions of a penny that occurred at unsafe speeds using order types that no investor could possibly truly understand.