Flash Boys: A Good Story, Not a Regulatory Plan
Michael Lewis deserves credit for making a topic as arcane as equity market structure the stuff of water cooler conversations. His book, Flash Boys: A Wall Street Revolt, released last week after a much-watched 60 Minutes teaser interview, is written for a Main Street audience.
Lewis offers us an inspiring story, but government regulators and prosecutors should not rely on his book to guide their efforts. Lewis was under no obligation to analyze objectively high-frequency trading's costs and benefits, and he doesn't do so. Instead, Lewis allows a colorful cast of characters, who use more profanity than technical jargon, to introduce the reader to the world of super-fast electronic stock trading. Although set against the backdrop of today's incomprehensibly speedy markets, his story is a classic tale of entrepreneurialism. Protagonist Brad Katsuyama comes to Wall Street from Canada, discovers that it is broken, figures out why, and sets out to fix it. Katsuyama's motive is an irresistible desire to set things right and a belief that he is the only man who can do it. He surrounds himself with an adorably eclectic group of brilliant sidekicks who share his passion for remaking Wall Street. Together they develop a new high-frequency-proof market and convince investors and even Goldman Sachs to give it a try.
Speaking of Goldman Sachs, the most interesting part of the book is Lewis' dissection of the government's case against former Goldman employee Sergey Aleynikov for his alleged theft of proprietary Goldman code. Lewis convenes a "jury" of experts to consider the evidence against Aleynikov, and the government's attempts to portray Aleynikov's actions as nefarious end up looking very weak. The Aleynikov story is a detour that is based on a prior Lewis Vanity Fair article and has more to do with potential prosecutorial abuses than abusive trading. But it is a warning to government prosecutors hot on the trail of high-frequency traders to be careful before entering Wall Street's competitive squabbles.
Readers would do well to pair Lewis' book with Scott Patterson's Dark Pools: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market, which does a better job of putting high-frequency trading in historical perspective. It tells the story of another set of entrepreneurs--the founders of Island, an electronic trading venue--who used their computer genius and tirelessness to take on the Wall Street of the 1990s. In those days, telephone-wielding market makers collaborated to fix prices and sought to ensure that the industry's self-regulator busied itself with their competitors. Patterson's book, while critical of high-frequency trading, makes it clear that retail investors get a much better deal on Wall Street now than they did two decades ago.
By contrast, the crux of Flash Boys--a message that has garnered many headlines--is that the current market is rigged in a way that harms investors. Suggesting that retail investors are suffering at the hands of profit-crazed high-frequency traders misrepresents the markets and the problems in them. Yes, high-frequency traders are going to great lengths to outrun and "outalgo" one another, but their constant buying and selling helps to ensure that retail investors are able to buy and sell stock whenever they want at remarkably low cost. There is certainly room for greater transparency and less fragility in the equities markets, but focusing on purported harm to retail investors will misdirect reform efforts. In fact, as Lewis points out, Regulation NMS--undertaken in the name of retail investors--is part of the problem in today's equity markets.
Flash Boys already has government officials scrambling to show they are on top of high-frequency trading. On the heels of the book's release, Eric Holder announced that the Justice Department is investigating high-frequency trading. New York Attorney General Schneiderman wrote an op-ed highlighting his efforts to protect "regular investors." Rather than allowing the release of a book to define their focus, government officials--particularly those at the SEC--should look carefully and holistically at our equity and fixed income markets in order to identify regulatory changes that would facilitate market innovations like the one featured in Flash Boys. In making any rule changes, the SEC has to undertake the economic analysis that Lewis did not attempt in his book and that the SEC has not conducted particularly well in the past.
