This is a classic Michael Lewis book. It reads quickly. The topic is fascinating. The content is extremely insightful as the true technicalities of High Frequency Trading are either not covered or not understood even by the investment related media.
Michael Lewis book follows three intertwined narratives.
First, he opens the black box on what is high frequency trading (HFT). How it works, how it extracts rent profits from investors in the stock markets. There are currently over 50 stock market exchanges: 13 are public, and the rest are dark pools. The more market exchanges there are, the more arbitrage and front running opportunities there are for high frequency traders (HFTs) to exploit.
Second, it narrates the history of the Investors Exchange (IEX) founded by a righteous quant type bunch who decided to start a stock market exchange that would eliminate all the HFT rent seeking strategies so to deliver a fairer market price to institutional investors trading on their platform.
And, third it follows the strange life and career of the Russian computer programmer Sergey Aleynikov. He worked for two years for Goldman Sachs from 2007 to 2009 to render their computer trading systems faster and more competitive within the high speed world of HFT. He left Goldman Sachs with his computer codes that Goldman Sachs deemed proprietary. Goldman Sachs had him arrested by the FBI in 2009, and ever since he has been either engaged in trials prosecuted by Goldman Sachs or in jail.
This third narrative also covers the ambiguous and evolving engagement of Goldman Sachs in HFT. At first, it attempts to become an engaged competitive high frequency trader itself. And, that is when it hired Aleynikov to improve its trading computers’ speed. Later, it will realize that chasing the HFTs in a speed competition is a losing proposition. And, it will become the only major Wall Street investment bank to fully support the Investors Exchange (IEX) to counter and neutralize the nefarious impact of HFTs.
Going back to the first narrative, High Frequency Trading extracts rent profits from institutional investors (and their retail investors) in three ways.
The first way is by beating the investor to the stock market gateway and quickly buying and reselling the stock to the investor at a small profit. They call it “electronic front-running.” To do that, you need to be fast. That is where the nano second trading speed comes in. The “co-location” of the HFTs servers next to the ones of the exchanges plays a major role by reducing the electronic distance travelled and maximizing trading speed.
The second way is by exploiting a complex system of kickback and rebates on trades implemented by the various exchanges themselves. They call it “rebate arbitrage.”
The third way appears similar to electronic front-running, except that the HFTs exploit minute price discrepancies between the various exchanges before the exchanges themselves have had a chance of correcting those. They call it “slow market arbitrage”. Apparently, of the three rent seeking strategies this is the most lucrative one for the HFTs.
The above strategies are implemented within a market universe that is alien to individual investors and most institutional investors. This market universe has interesting characteristics. Its foundational one is an unfathomable stock trading speed measured in the 1/10000 of a second. Such speed relies on extra fast fiber optic networks and computer servers located extremely closely to the servers of the stock exchange themselves. Another characteristic is the HFTs purchasing customer order flows from the Wall Street brokerage houses. The latter now make more money from selling those customer order flows to HFTs than from trading itself. In essence, Wall Street sells proprietary customer order information to the HFTs, so the HFTs can front run these same customers (their stock orders). And, somehow SEC laws have still not caught up to this apparent infraction of the integrity of the stock markets. That’s even though the mentioned HFTs rent seeking strategies are at least a decade old.
So, next time when you think your brokerage house is acting in your best interest, think again. It is acting in the best interest of the HFTs and itself by making money on selling your order information to the HFTs. And, we are talking millions if not billions of dollars in total annual revenues for the Wall Street brokerage houses.
Going back to the second narrative, to correct for all those markets flaws exploited by the HFTs, Brad Katsuyama, a former trader at Royal Bank of Canada, will create a “fair” exchange: the Investors Exchange (IEX) in 2012. This exchange takes specific infrastructure measures to entirely eliminate all the exploitative advantages of HFTs including: 1) ensuring market pricing data arrives at external points of presence simultaneously; 2) slightly delaying market pricing data to all customers (no co-location, HFTs servers are not allowed proximate to the IEX servers); and 3) IEX refuses to pay for order flow and does not offer related trade rebates of any kind. The majority of Wall Street banks and HFTs will do everything possible to kill this emerging “clean” exchange in its infancy. This is because they collectively extract yearly rent-profit in the $billions on the back of retail and institutional investors. However, as mentioned one of the main player will break rank as Goldman Sachs ultimately decides to support IEX by routing a good portion of its trades to IEX. Goldman Sachs understands that what IEX is doing to restoring integrity in the equity markets is critical. And, as a result IEX survives. Nevertheless, it is not entirely encouraging when evaluating how much impact IEX has in restoring the integrity of the US equities markets since it captures less than 3% of its volume to this day. In other words, over 97% of such market trading volume still is done under the exploitative rent-seeking system abused by the HFTs (electronic front running, etc.) and the other Wall Street banks (making more money from selling their customer order flows than actual trading).
The third narrative about Sergey Aleynikov and Goldman Sachs evolving position regarding HFT is very interesting because of its ambiguity. Aleynikov used mainly open source software to develop his codes to improve Goldman Sachs computer speed. When he accepts an offer to join Teza Technologies (who offered to triple his compensation from $400k to $1.2 million), he decides to copy and take his computer code on a USB drive. At such point, Goldman Sachs aggressively pursues him (gets him arrested by the FBI, tried, and jailed). At the time, Goldman Sachs considered the mentioned computer codes to be proprietary and critical to its competitive position within the HFT environment.
Michael Lewis will engage with many industry insiders (HFTs, computer programmers, etc.) and solicit their opinion on whether Aleynikov was truly guilty of stealing proprietary company codes or not. Almost unanimously this crowd of insiders advance that Aleynikov was innocent. And, that his practice of copying his own open source based codes when he moved to another employer is absolutely standard within the computer programming community. Aleynikov also indicated that he had no use for Goldman’s proprietary codes as they were very cumbersome catered to Goldman’s antiquated legacy computer systems. When Michael Lewis talked to outsiders like institutional investors, they were far less lenient. And, they typically considered that Aleynikov was clearly guilty of stealing proprietary codes.
As indicated, Goldman Sachs at first vigorously pursues Aleynikov in order to protect its position in terms of trading speed within the world of HFT. Much later, when it decides to give up on the speed competition and decides to do just the opposite by supporting IEX, Goldman Sachs does not pursue Aleynikov as adamantly anymore. But, by then the legal system takes a life of its own. As a result, some of the related lawsuits are still going on to this day. Aleynikov is nearly bankrupt and has an online legal defense fund to raise money to mount his defense and reclaim his innocence.
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Reviewed in the United States on June 6, 2020
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