Exposing the dark side of trading places: Flash Boys by Michael Lewis
Review: The proliferation of new stock exchanges has given rise to high-frequency trading, so-called because the average length of time that “investors” hold on to their shares is 11 seconds
Dan Aykroyd and Eddie Murphy in ‘Trading Places’. Their characters’ antics would be an anachronism today. Photograph: Paramount
This is another story about well-intentioned regulation going awry. It is also an example of something that lots of people are concerned about: the rise of the robots. We are often told that new technologies are on the way that will displace huge numbers of jobs. Technology may have replaced only manual workers in the past, but we will now see plenty of skills becoming obsolete. Flash Boys suggests the robots are already here.
The story begins with cables being straightened and new ones being laid, drilling through mountains and under roads, always with the imperative of being shortened and carrying data as quickly as possible.
Initially, technology is deployed to automate a trading activity that is centuries old: cash-futures arbitrage.
When I started in financial markets, cash-futures trading was done by guys (almost always men) wielding nothing more than an ability to do lightning-fast mental arithmetic.
A futures market is where we buy or sell promises to deliver commodities, equities, bonds and almost any other asset some time in the future. The cash markets are about trading today. There is a simple formula that aligns the two markets.
Sometimes the price of a futures contract slips slightly out of line with the prices in the cash markets. The prosaic reasons for this are usually to be found in human behaviour and the physical separation of where these trading activities take place.
In the US, historically, the futures markets have typically been in Chicago and the cash markets have been in Lower Manhattan. Quick traders spot the pricing anomalies and “arbitrage” them away: they buy one and sell the other until prices come back into line, making a guaranteed profit. At least, that is what they used to do.
Today, this activity – and most trading – is no longer conducted by smart young men. It is done machine to machine. The image of buying and selling we have of people in bright jackets yelling at each other is almost totally wrong. The Dan Ackroyd and Eddie Murphy movie Trading Places could not be made today: it would be a complete anachronism.
Shenanigans in the markets
Machine-driven cash-futures trading is simply a logical development; there is nothing sinister to worry about, unless you are one of the young men made unemployed (and there are lots of those). Flash Boys goes on from this story into something far more murky, focused almost entirely on shenanigans in the cash markets.
Essentially, there used to be two stock markets in the US: the Nasdaq and the New York Stock Exchange. Microsoft shares, like any other company stock, were traded exclusively on just one of these exchanges.
Now there are lots of exchanges, shares can be traded on any of them and they are almost always fully automated. In the good old days we could see (either on our screens or via a telephone call) where prices were trading. Investors had transparency about what was going on.
The central characters in Flash Boys became suspicious only a few years ago that transparency was not what it seemed. As did many other investors. Suspicions grew that the prices we could see were not “real”.