Flash Boys: A Wall Street Revolt - by Michael Lewis

Over the past decade, the financial markets have changed too rapidly for our mental picture of them to remain true to life.

"When something becomes obvious to you," he said, "you immediately think surely someone else is doing this."

Dark pools were another rogue spawn of the new financial marketplace. Private stock exchanges, run by the big brokers, they were not required to reveal to the public what happened inside them. They reported any trade they executed, but they did so with sufficient delay that it was impossible to know exactly what was happening in the broader market at the moment the trade occurred. Their internal rules were a mystery, and only the broker who ran a dark pool knew for sure whose buy and sell orders were allowed inside. The amazing idea the big Wall Street banks had sold to big investors was that transparency was their enemy.

Someone out there was using the fact that stock market orders arrived at different times at different exchanges to front-run orders from one market to another. Brad knew that he was being front-run--that some other trader was, in effect, noticing his demand for stock on one exchange and buying it on others in anticipation of selling it to him at a higher price.

The U.S. stock market was now a class system, rooted in speed, of haves and have-nots. The haves paid for nanoseconds; the have-nots had no idea that a nanosecond had value. The haves enjoyed a perfect view of the market; the have-nots never saw the market at all. What had once been the world's most public, most democratic, financial market had become, in spirit, something more like a private viewing of a stolen work of art.

Financial intermediation is a tax on capital; it's the toll paid by both the people who have it and the people who put it to productive use. Reduce the tax and the rest of the economy benefits. Technology should have led to a reduction in this tax; the ability of investors to find each other without the help of some human broker might have eliminated the tax altogether. Instead this new beast rose up in the middle of the market and the tax increased--by billions of dollars.

Why would anyone pay for access to the customers' orders inside a Wall Street bank's dark pool? The straight answer was that a customer's stock market order, inside a dark pool, was fat and juicy prey. The order was typically large, and its movements were especially predictable: Each Wall Street bank had its own detectable pattern for handling orders. The order was also slow, because of the time it was forced to spend inside the dark pool before accessing the wider market.

An order hidden inside a dark pool wasn't very well hidden. Any decent high-frequency trader who had paid for a special connection to the pool would ping the pool with tiny buy and sell orders in every listed stock, searching for activity. Once they'd discovered the buyer of Microsoft, they'd simply wait for the moment when Microsoft ticked lower on the public exchanges and sell it to the pension fund in the dark pool at the stale, higher "best" price. It was riskless, larcenous, and legal--made so by Reg NMS. The way Brad had described it, it was as if only one gambler were permitted to know the scores of last week's NFL games, with no one else aware of his knowledge. He places bets in the casino on every game and waits for other gamblers to take the other side of those bets. There's no guarantee that anyone will do so; but if they do, he's certain to win.

What everyone noticedabout Don Bollerman--even if they didn't quite put it this way--was how badly he wanted not to be surprised by his own life. To eliminate the possibility of surprise required not that Don's life be especially unsurprising but that he control his feelings about whatever surprise it produced.

He refused to feel morally outraged or self-righteous about any of it. "I would ask the question, ‘On the savannah, are the hyenas and the vultures the bad guys?' " he said. "We have a boom in carcasses on the savannah. So what? It's not their fault. The opportunity is there." To Don's way of thinking, you were never going to change human nature--though you might alter the environment in which it expressed itself.

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 him to the next. (What had happened to Brad, when he traded at RBC.) The second they called "rebate arbitrage"--using the new complexity to game the seizing of whatever kickbacks the exchange offered without actually providing the liquidity that the kickback 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 the exchanges were able to react.

It's worth performing a cost-benefit analysis of this infrastructure, from the point of view of the economy it is meant to serve. The benefit: Stock market prices adjust to new information a few milliseconds faster than they otherwise might. The costs make for a longer list. One obvious cost is the instability introduced into the system when its primary goal is no longer stability but speed. Another is the incalculable billions collected by financial intermediaries. That money is a tax on investment, paid for by the economy; and the more that productive enterprise must pay for capital, the less productive enterprise there will be. Another cost, harder to measure, was the influence all this money exerted, not just on the political process but on people's decisions about what to do with their lives. The more money to be made gaming the financial markets, the more people would decide they were put on earth to game the financial markets--and create romantic narratives to explain to themselves why a life spent gaming the financial markets is a purposeful life. And then there is maybe the greatest cost of all: Once very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system up further, or to remain silent as they watch it being screwed up by others. The cost, in the end, is a tangled-up financial system.