Why Michael Lewis got it wrong.
May 2, 2014
“There is systematic corruption in the market. A rigging, a rigging in the market. And it’s the provision to high frequency traders of information that ordinary investors do not have [which is at the core of this form of corruption]”.
This is, in a nutshell, the central claim of Michael Lewis’ new book, Flash Boys. Built around the almost heroic journey of Royal Bank of Canada’s Brad Katsuyama to understand how the interconnected American stock market works, Lewis’ story is now a centerpiece of the debate on HFT. In the smallish world of finance and technology, it is definitively the talk of the town.
As much as it has been praised (particularly by detractors of high frequency trading), Lewis’ book has also become the subject of intense, acerbic and at times quite emotional critiques. There is, indeed, something both provocative and awkward in Lewis’ account. Perhaps it is its frankness. Perhaps it is the heroic narrative of moral entrepreneurship upon which his story is predicated. Perhaps such awkwardness simply derives from factual inconsistencies in Lewis’ account. Is Lewis right, I wonder? Is the stock market rigged, as he argues in Flash Boys and countless interviews thereafter?
Custom indicates that, in addressing these questions, I should be as terse as possible, that I should offer something close to a standard, balanced, boilerplate analysis stating something of the sort: “Lewis got some bits of the story right, others less so.” But let me be provocative and offer an answer that, like Spread Networks’ cable, is a bit more direct: Michael Lewis is wrong, and there are important reasons why his being wrong matters to the social studies of finance.
As far as I can tell, there are three elements of Lewis’ story that misrepresent HFT, markets, and more importantly the problems facing contemporary finance.
The first element is factual. The basic structural setup of Lewis’ book is of a story of ignorance, discovery and moral transformation. In the spring of 2006, Brad Katsuyama observed that the US market was “behaving oddly,” when “suddenly” RBC’s recently purchased electronic trading system didn’t work as he expected it to: “when he pushed a button to complete a trade, the offers would vanish,” writes Lewis. As Katsuyama sought to understand his impossibility to complete trades, he contacted others in the industry, including “big-time hedge funds” that were facing similar difficulties. As Lewis insists, no one knew what was going on. Neither Katsuyama, nor his developers, nor the heads of sophisticated hedge funds understood what had changed in the market. They were ignorant of the transformed structure of the system in which they operated. It was only after working with telecommunications expert Ron Ryan that Katsuyama realized that physical distance mattered once again in finance; he now understood why his orders weren’t being filled (and came to see, in the process, that the market was ‘rigged’ by exchanges in cahoots with high frequency traders).
Note that, central to this narrative, is the claim that no one understood the microstructure of American financial markets in early 2007. This is what separates Lewis’ story from a story of negligence. Indeed, in a number of interviews, Katsuyama is presented as he who singlehandedly discovered the terrible secret of American finance. However, this claim of wholesale ignorance seems to contradict my experience and, quite probably, that of many others both within and outwith the industry.
I can think, in particular, of one of the early field experiences that informed my research on the history of the London Stock Exchange. In summer 2007, I was invited to attend a trade conference in London on the future of stock exchanges. At the time, I was a PhD student at the University of Edinburgh; the event mattered because it provided me with access to a key gatekeeper of the UK’s finance and technology community who would become a central informant of my doctoral project. Remember that, at the time, my head was in the past, in how markets changed in 1980s Britain—everything else was archived for the future. One aspect of the meeting, however, was especially salient and caught my attention immediately: more than half of the conference dealt with latency, network configurations, co-location, and competition in global finance. Indeed, a memorable handout provided to conference participants was a copy of a Financial Times article that earlier in the year had hailed the arrival of millisecond trading. For most in the room, the types of questions that Katsuyama was trying to answer were perfectly intelligible. There was, in this sense, no ignorance.
The conference was in London so, naturally, one could imagine that news of a change in market microstructures, and discussions about latency, order types and speed, took some time to reach the US. I am being ironic, of course: among conference participants were Benn Steil, a renowned financial expert and since 1999 member of the Council on Foreign Relations, and Mary Shapiro, then head of the Securities and Exchange Commission. Indeed, the claim that in 2007 no one knew what was going on in American finance seems woefully incorrect: at least one major (and relatively accessible: I was there) conference dealt with the topic. Perhaps there is an agnatological argument to be made, but the point is that, if the FT and SEC knew about millisecond trading and the re-configured structure of global finance, then it was probably old news to the market. Perhaps rather than being shocked at how some firms were moving markets towards faster speeds, we should be a bit more concerned by what seems to have been a grievous lack of information about market structure within investment banks and hedge funds. Then again, the shortsightedness of incumbents tends to be a classical feature of technical change (and, in a different manifestation, had global consequences a few months after the London conference).
But Flash Boys is also erred in its epistemology. Beyond Katsuyama’s story, Lewis pursues the broader argument that key to the problems of the American stock market is the fact that innovation resulted in an unnecessarily complex and opaque system that creates opportunities for catastrophe and malfeasance. Complexity, for Lewis, is dangerous and widespread.
Complexity has long been a scapegoat when dealing with the regulation of technological systems: to say that something is ‘complex’ removes it rhetorically from the domain of what is knowable and casts doubt on our collective ability of control. For Lewis, the hallmark of the market’s complexity is his observation that, in today’s America, when investors submit their orders they know not where they go. Such lack of knowledge permits, for Lewis, the type of front-running-like practices that, as he argues, are derivatives of a rigged market architecture.
What Lewis perhaps forgets is that, in many ways, the architectures of financial markets are far more domesticated, transparent and tractable than those of ostensibly more commonplace and less controversial technological systems. Like the proprietary systems in finance, the internet is also a tangle of cables, routers, intermediaries, semiformal agreements, standards and regulations. Yet unlike the systems deployed in financial markets, and as one telling article notes, something as simple as determining what affects a customer’s broadband speed is largely an impossible task. If anything, developments such as Spread Network’s direct communication between Chicago and New York reduce, rather than increase, complexity: the users of such systems will be better able to manage and know how the system behaves since they will rely on one, rather than a multiplicity of service providers (though at a hefty cost).
The source of this rhetoric of complexity in Lewis’ account may well have two origins. The first, which is admittedly very hypothetical, is the fact that there may too much Liar’s Poker in Flash Boys: when Lewis invokes the image of investors not knowing where their orders went, he invokes, too, a materialistic conception of order flow in markets. There was indeed a time when physical objects would ‘flow’ in financial centers: tickets on the trading floor, and certificates in clearinghouses and banks. Thirty years of automation later, it would be naïve to think of markets as flows of concrete material packages. Markets today are all about data and information and stock exchanges are closer to IT providers than members clubs. And for these markets, for these spaces of transaction, the traditional metaphor of a specialist on the trading floor no longer holds valid. Think, rather, of computers, algorithms and network topologies.
A second source of this rhetoric may be a deeper, more historically entrenched cultural division within the financial sector. Despite the rise of technology in financial markets, Lewis seems to hint at a conflict between traders and technologists, manifested in the absence of a sort of interactional technological expertise (to paraphrase Harry Collins and Robert Evans) within the more traditional, trading-minded managerial spheres of banks and investment funds. Take the example of Brad Katsuyama. He was not a quant in any way, nor was he trained in computer science or telecommunications engineering. Rather, he followed a very ‘traditional’ career trajectory within Wall Street, having risen through the trading room and into managerial ranks. This is why, perhaps, technology seemed so unintelligible to both him and most of the financial characters in Lewis’ book: their origins were in trading, not engineering. “Thank God,” said a ‘big investor’ when Katsuyama explained market structure to him, “finally there is someone who knows something about high-frequency trading who isn’t an Area 51 guy”. (Back in the 1980s, technologists were ‘those back office people.’ They’ve been upgraded: now they work for Area 51.) Indeed, maybe Brad Katsuyama’s success itself was built on this difference and on an acquired ability to translate between two cultures.
Finally, Flash Boys falls short in history. To say that markets are rigged is almost a claim of conspiracy: actors (in this case, high frequency traders and stock exchanges) colluded to create a system advantageous to them. Yet the recent history of American financial infrastructures would suggest that the origins of today’s market architecture are temporally and institutionally more distributed than what Lewis suggests. Much of the rise of algorithmic and high frequency trading, for instance, traces back to decisions taken in the 1960s and 1970s by US Congress to establish a National Market System and to innovations associated to a new-found technoliberalism in 1990s American finance. Ironically, the same type of moral imperatives that motivate Lewis’ book framed such decisions, namely, that powerful intermediaries (i.e. the NYSE) maintained an opaque and expensive marketplace that was an uneven playing field for ‘ordinary investors’. In one way or another, the quest for equality and fairness led to the forms interconnection and fragmentation upon which HFT grew. Responsibility is distributed, as much upon some putatively opportunistic actors in the present as on the failure of the (weak) American state and its regulator to act in the past.
So why does this matter, particularly to social studies of finance?
At one level, Flash Boys highlights the fact that there remains much scope for researching market change in recent years. There are, for instance, open and exciting questions on the organizational cultures, historical trajectories and overall epistemologies imbricated in market evolution: What are the consequences of automation to knowability? Have market ontologies changed? What type of creatures are contemporary financial markets, and why does this matter? And given that technologies always fail, what does this mean for the future of finance and regulation? Indeed, one of the key contributions of SSF may well be to provide intelligent answers to the type of questions posed by Lewis and the characters in his book: there is clear scope for SSF to be part of a stronger form of public sociology, scrutinizing the mechanisms of markets and their public controversies (as evidenced, for instance, in Daniel and Yuval’s work on the NYSE).
At another level, Lewis’ story reminds us of the importance of dealing with morality in markets. Lewis’ is a moral tale, one in which the questionable practices of some actors (HFTs) are contrasted with the virtuous principles of his story’s hero. This is, perhaps, where most of the awkwardness in Lewis’ tale lies, that is, in having told the story through a dualistic moral narrative of the virtuous and the immoral. What we know as sociologists, however, is that markets are always and ever moral projects: what matters is understanding the dynamics and consequences of the struggles of authority and power played on moral grounds. In effect, the controversy surrounding Flash Boys may not only have unveiled diverging interests within the market: its public reception may, indeed, be more productively seen as reflecting moralized disputes in evaluating the legitimacy of finance in contemporary societies.
More critically, however, is being careful to not transform the debate on HFT into a form of escapism, which I feel is what Lewis has done. Yes: the architecture of American financial markets may well need reconsidering. Yes: equality of access is and will always be an issue. And, yes: Spread Network’s cable seems like the folly of baroque innovation. But let us not forget that this set of practices, which are structurally important in providing liquidity, represents a mere £2 billion in global revenues per year, according to most meaningful estimates. This is the magnitude of HFT, of the tax it levies on trading in what are probably the cheapest and most efficient financial markets in history. In 2014 alone, the bonuses in Barclays—a large, yet single bank—amounted to £2.4 billion. And in 2013, the NY Times reported, disappointingly, that Wall Street bonuses were down to $91.44 billion from a previous high $92.49 billion. Surely, high frequency trading is the least of our collective problems.