Valuentum Exclusive Analysis for the Discerning Investor

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Flash Boys: A Wall Street Revolt
By Michael Lewis. W. W. Norton & Company, 2014. 274 p. ISBN 978-0-393-24466-3.

Michael Lewis’s (author of Liar’s Poker, The Big Short, and Moneyball) most recent work, Flash Boys: A Wall Street Revolt, has created quite a splash. The book itself focuses on what a millisecond means in the stock market. In light of high-frequency trading (HFT) and the loopholes in current government regulation, those milliseconds mean a lot. HFT firms have been able to take advantage of speed to know what trades are coming before they hit the market (or at least all of the markets as orders reach some exchanges faster than others). One of the central characters in the book, Brad Katsuyama, formerly of RBC and now the CEO of IEX Group, explores some of the inconsistencies he sees in what displays on his computer screen, versus what actually happens when he hits “buy.” This obsession to find the truth leads him to ultimately leave RBC and set up a new exchange, IEX, which is currently registered as an Alternative Trading System, not to exploit those milliseconds, but to bring equality back to the market.

According to Lewis’s research, it was actually an SEC regulation, Regulation National Market System or Reg NMS, that made this kind of front-running possible. This regulation “required brokers to find the best market prices for the investors they represented.” This in turn required brokers to buy up all the shares offered at one price before moving to another exchange and the additional routing to more exchanges opened up the door for high-frequency traders to pick up on large orders, allowing them to buy up shares more cheaply on the other exchanges before the original order came through. So, while Reg NMS was created to create equality, it actually created more inequality. Looking at the history of these regulations, however, Reg NMS was created to correct another loophole that appeared after previous regulations went into effect, and those regulations were meant to correct previous loopholes.

The issues revealed by Lewis’s work were not unknown. It seems that many in the industry, as well as those charged with oversight, including the FBI, SEC, and the New York Attorney General were aware of the role of high-frequency trading in the market and have already begun investigations. If the pattern alluded to in Flash Boys is any indication, one possible outcome is additional regulation to plug the loophole that has been exploited by HFT firms, and possibly some hefty fines.

Overall, this is another fine example of Lewis’s work. His narrative follows the story of a core group of people, making it easier to read and easier to understand. Even though there is some complexity in what happens behind the scenes in the markets, Lewis writes this book for the general reader, and it is thoroughly enjoyable.

Valuentum's Take

The book has sure made a splash in the markets during the past week, causing a delay in the marketing of Virtu Financial (VIRT) amid increasing controversy, an FBI investigation into whether high-frequency trading firms are actually engaged in insider trading or fraud, and modest fines paid by NYSE Euronext (NYX) to the SEC as a result of offering high-frequency traders stock-price data in advance of the general public. Other firms such as the Nasdaq OMX (NDAQ) and IntercontinentalExchange (ICE) have faced some rough sledding following the release of the book.

In any case, we don’t think high-frequency trading will go away anytime soon, nor do we think it has much impact on the efficacy of the Valuentum process. The odds are clearly not stacked against the individual investor, as many have done incredibly well since the bottom of the Financial Crisis. We think there is room for improvement in the regulation of the financial markets, but high-frequency trading is of little concern to the everyday investor and financial advisor. As long as the SEC and investigators work to prevent the potential of another Flash Crash, where the Dow lost 1,000 points and regained them in 20 minutes in May 2010, we’re not reading too much into Lewis’ latest topic.

Exchanges - Financial: CBOE, CME, ICE, NYX, NDAQ