Most people, if they think of financial markets at all, probably have a metal image taken from movies like "Trading Places" or "Wall Street," in which traders shout orders across a trading floor littered with trading slips. But it's been a good many years since that was the case. Today, trading exchanges are computer programs that match up buy and sell orders between traders at blinding speed. That system has led to unprecedented speed and liquidity in markets, and, Michael Lewis claims, a rigged system, in which a few large players skim profits off every trade made. The story is fascinating, even if Lewis' conclusions may be debatable.
The story begins when a trader at the Royal Bank of Canada noticed that his bids weren't being accepted at his trading terminal. He'd put in a buy order for 10,000 Intel at $22- and the order would disappear. It was if he were being scooped on all his orders. At first he thought it was some sort of technical glitch, but his investigation proved to be something very different. He was being scooped by companies who had found a way to get ahead of every order in the market.
Here's how it worked. In the old days, there were two main US exchanges, the NYSE and the AMEX. Today, there are thirteen electronic exchanges, and when a trader issues a buy or sell order, a computer goes to each in turn, looking for the best deal. This is done blindingly fast in human terms, taking only a few thousandths of a second to execute a trade. But computers work in billionth or trillionths of a second. Someone with a very fast computer and very fast communications networks can look at that first trade at an exchange, and rush ahead to the other exchanges and put in their own orders.
Going back to that first example, the trader puts in his buy order for Intel at $22 at exchange #1. Someone listening in- and that's perfectly legal, since all trades are public- rushes ahead to exchanges 2 through 13 and buys Intel at a fraction below $22, and then sells it to you at $22. More specifically, they look at all the trades coming in and undercut them at both the buy and sell end, making a few fractions of a cent on the dollar, but doing it trillions of times a day.
Competition between these high speed trading firms is fierce. They pay huge premiums to put their servers cooer to the exchanges, saving nanoseconds or pico seconds of time, and connect their trading computers to each other via dedicated fiber and microwave networks. The result is a what amounts to a transaction tax on every trade through these exchanges that adds up to many billions of dollars a year. And it affects every stock buyer and seller, not just the individual. Banks, mutual funds, pension funds, arbitrage funds, and other sophisticated traders were shocked when Brad Katsuyama, the Bank of Canada trader, brought this story to them. Some had suspected that they were the victims of inside traders scooping them, but none expected that it was as big an operation as it turned out to be.
Every thriller needs a hero, and the hero of Lewis' book is Katsayuma, who, with a group of other Wall Street pros, created a computer system designed to defeat the high-frequency trader by synchronizing orders with all the exchanges, preventing the high frequency traders from using information from one to get an advantage at other. This led to the creation of a new exchange, initially called Investors Exchange but changed to IEX when the founders realized that their domain name, investorsexchange.com, was too easily read as "investor sex change." IEX acts as a broker for other brokers, synchronizing orders to protect members from what they call "predatory trading," and they have been very successful at getting major banks and hedge funds to sign up.
Reading this book, you get the idea that Lewis thinks that high frequency trading is on the whole a bad thing, and one that should be in some way outlawed. But there's a positive side to this sort of trading, too. It does increase liquidity in the marketplace, it increases the velocity of money, and (somme argue) by trading small fractions of a cent it improves the likelihood of every offer finding someone to accept it. Clever people will always find ways to exploit any sort of arbitrage system, and clever people like Katsayuma and his partners will find ways to counter them. Indeed, the story of IEX is a perfect example of a market solution to a market problem.
