High-frequency trading could be as perplexing to the average reader as quantum physics is to a five-year-old, but Michael Lewis does an excellent job of explaining this phenomena through the story of one young professional trader, Brad Katsuyama, in Flash Boys Cracking the Money Code.
A star-trader with the Royal Bank of Canada, Katsuyama, having been posted to Wall Street in New York, discovered that high-frequency trading could and did give traders an edge, and Katsuyama realised that this was, essentially, unfair to investors.
High-frequency traders, simply by developing ever-faster means of communicating with stock markets, were able to ‘front-run’ investors – essentially
becoming intermediaries for no other purpose than to extract a profit.
Katsuyama was outraged, and determined to mount a crusade against this practice. He came to the conclusion that the only way to do so would be to establish a new stock market, which he did, that would present an even field to regular investors and the high-frequency traders alike.
This new market would ensure that the ‘regular’ investor would not be gouged – and the large funds that looked after the savings and pensions for the thousands, sometimes millions of working people would no longer fall hapless victims to predatory ‘flash boys’.
Just why this story, taking place thousands of miles away in the US should be of interest to African investors is that in this day and age, all international markets are inextricably joined together, interlinked in ways that perhaps did not seem possible as little as a decade ago.
There is another reason too that this story is so important for Africa. For as African economies grow, the rationale for developing equity and treasury markets becomes ever more apparent. The problem arises when the model for these new African markets is taken from overseas – making them also susceptible to the same kinds of manipulation that are described by Lewis.
As Lewis goes on to explain, high-frequency traders (or ‘Scalpers Inc’ in his parlance) “apart from taking some large sum of money out of the market, and without taking any risk or adding anything of use to that market, had other, less intended, consequences.
“Scalpers Inc inserted itself into the middle of the stock market not just as an unnecessary middleman but as a middleman with incentives to introduce dysfunction into the stock market.”
That dysfunction, Lewis goes on to explain, resulted in volatility, a volatility that served the interests of high-frequency traders but few others.
Because volatility meant that the high-frequency traders might buy a tranche of shares (or counters), hold them for a few microseconds – knowing that even with a fall in the price of the share within that split second, they would still be able to sell for a tiny profit as just the volatility of the market would, almost inevitably, result in a rise in the price.
“Another incentive of Scalpers Inc,” Lewis writes, “is to fragment the marketplace. The more sites at which the same stocks changed hands, the more opportunities to front run investors from one site to another.
“The bosses of Scalpers Inc would thus encourage new exchanges to open, and would also encourage them to place themselves at some distance from each other.” In fact, today there are more than 13 public stock exchanges in the US.
The real nature of the high-frequency traders is essentially automated trading. The designers of the systems write the software and computer codes that generate the algorithms. These algorithms then comb information on stock trades on the look out for anomalies.
Those discrepancies are buying or selling trading opportunities, but only if the computers can react quickly enough to place the orders before their competitors do. And to achieve that speed, the high-frequency traders go to extraordinary lengths.
While in the old days, “before, say 2007,” Lewis explains, “the speed with which a trader could execute had human limits, [and] human beings worked on the floors of the exchanges, and if you wanted to buy or sell anything you had to pass through them.
“The exchanges by 2007 were simply stacks of computers in data centres. The speed with which trades occurred on them was no longer constrained by people. The only constraint was how fast an electronic signal could travel between Chicago and New Jersey – or, more precisely, between the data centre in Chicago that housed the Chicago Mercantile Exchange and a data centre besides the Nasdaq stock exchange in Carteret, New Jersey.”