Deceit in milliseconds

Deceit in milliseconds

2014-07-20 09:58

Flash Boys: A Wall Street Revolt By Michael Lewis

WHAT if what you think is happening is not happening? What if the difference will adversely affect your pension fund, or your investments?

Author Micheal Lewis’s latest book is an investigation of high frequency trading in the United States, the major economy in the world, and one affecting almost everyone, almost everywhere.

First, some clarification. Most people’s impression of a stock exchange is of people shouting at each other about buying or selling orders from clients. That is a lingering impression of a stock exchange that no longer exists in the developed world.

Today, the shouting of orders has been replaced by computers. These show the “bid” and “ask” prices and the “spread”.

If you were trading in your 2001 Toyota Corolla, the “bid” is the price the second-hand car dealer would be willing to pay you for the old car. If you went to the same second-hand car dealer to buy the same 2001 Toyota Corolla, the dealer would sell it to you for significantly more. That is the “ask” price. The "spread" is the difference between the two: probably in the order of thousands of rand.

“High Frequency Trading” or HFT, does not refer to the volume of shares being traded, but rather to the speed at which the information about bids and asks are transmitted to the exchange that handles the transactions. The purpose of the exchange is to ensure that buyers and sellers can find each other easily. The intermediaries and stockbrokers facilitate the trades and are expected to get the best deals for their clients. They advise on where the market is going, on the quality of the equities being traded. They also recommend deals to clients.

The book shows that what people think is happening on the stock markets is not happening. The book is not the ranting of a conspiracy theorist. Michael Lewis is a respected journalist and author of a number of best-selling books of Wall Street. The facts he describes are currently under investigation by the regulatory authorities, the SEC, and the New York Attorney General.

The book centres on a Royal Bank of Canada trader, Brad Katsuyama’s observation that the bids and asks he was responding to on his computer seemed to be fluid. It was there, but when you hit the “Go!” button, it changed. If this fluidity happened irregularly, it could have been a coincidence; someone else had given an instruction to buy or sell just seconds before yours, and his instruction was executed first. Now you would have to buy or sell at a higher or lower price.

When Katsuyama notices that this is not an occasional occurrence, but happening with regularity, he begins investigating why this is so.

What he uncovers is how HFT works. HFTs transmit data in milliseconds; that is a thousandth of a second. (Blink now…  A millisecond is far faster than that!)

At speeds of milliseconds, deceit is possible in ways that are unimaginable. Prices can be manipulated by cents, so I am always selling at a bit more than I intended, or buying at a bit more than I intended. Cents on a trade may not sound like much but if you consider that each day about $225bn are traded on the US stock markets, that amounts to more than $160m every day that could be skimmed off by whoever controls the process.

Stock markets are currently driven more directly by machines and less by human beings. The problem is that most of the people do not know how the machines work. They are simply too complex.

The data on the screens of the professional traders and the ticker tape running across the bottom of the CNBC screen are now an illusion. Through HFT and advanced algorithms, markets are being manipulated. According to the information uncovered by the author, the people driving the process are technology experts, the engineers, IT experts, mathematicians and the like. Most of whom probably don't even understand the consequences of their work because they are far from the actual trade.

Markets work efficiently when they are transparent. However, transparency can affect markets in ways that may be unwanted. If a pension fund wanted to purchase a huge amount of shares in a major company at a particular price, the knowledge that someone was looking for the shares in those quantities would push the share price up.

To avoid a price movement, big brokerages established “Dark Pools”, a type of private exchange that would match the buyers and sellers without this being widely known. The brokers are also not required to reveal what happens inside the Dark Pools. In addition, there are nearly sixty other exchanges where one can purchase listed stock.

Sophisticated high-frequency traders gain access to trading information before it is sent out widely to other traders. For a fee, the exchange will ‘flash’ information about buy and sell orders for just a few fractions of a second before the public can see it. In that time significant amounts of money can be lost or made.

Combine the lack of transparency with the ability to manipulate the price of the shares, and you have a more dangerous situation. Unknown agents make money out of people who trusted others with their money by manipulating the share price.
With access to incredible speeds, the US stock market is rigged, out of control and out of sight.

In many ways, the book reads more like fiction than non-fiction. If you invested in the local stock market, this book offers another reason to be glad you live in South Africa.

Readability      Light -+--- Serious
Insights           High +---- Low
Practical          High +---- Low

- Fin24

*Ian Mann of Gateways consults internationally on leadership and strategy and is the author of Strategy that Works. Views expressed are his own.

  • Ike Jakson - 2014-07-20 10:29

    “With access to incredible speeds, the US stock Market is rigged, out of control and out of sight.” So is the JSE, Ian. I have had reason to follow my own things live lately and sat here amazed at the numbers from openers Friday to closing time. A few shares including one I have an interest in were running up and down faster than the eye can follow. Your Article is spot on. The “big boys” was at it with other peoples’ money; the entire thing is rigged. You may not though I hope you are, in there yourself to actually see it. I want to make a prediction. Amplats is being used and may ultimately survive; neighbour Implats is being set up to go under.

      Isac Molema - 2014-07-20 13:49

      hi ike your prediction is incredible.I thought Implats had a lower cost structure since they operate a cheaper extraction facilty up in Zimbabwe.

      Ike Jakson - 2014-07-20 14:46

      Thanks Molema. I was going to place another viewpoint on my angle and you reminded me to do it. It is difficult to forecast the final outcome and it may be the other way round in my prediction between AMS and IMP; one thing is sure: that the share price movements have not been in tandem since the strike began and “ended.” You must watch it live on the JSE to evaluate the growing incongruence.

  • Ike Jakson - 2014-07-20 14:49

    Calling … Calling …. Please come in Ian Mann

  • Lionel De Frontignac - 2014-07-21 06:23

    Actually the US economy is nothing more than a gargantuan Ponzi scheme. They sell debt to allegedly make money, then print money and call it "quantative easing"; the system is bound to implode

      Ike Jakson - 2014-07-21 07:56

      Same here, Lionel.

  • Ike Jakson - 2014-07-21 09:22

    Now I expect that it will be denied but the JSE was closed down at opening time this morning and at the time you see on this comment it was still down. I wonder why?

  • Vuyo Ntsinde - 2014-07-21 09:30

    Auctions are rigged too. Whether you use a manual or computerised system, there will always be crooks who manipulate it.

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