High-frequency trading: when milliseconds mean millions

Asked to imagine what a Wall Street share-dealing room looks like and the layman will describe a testosterone-fuelled bear pit crammed full of alpha males in brightly coloured jackets, frantically shouting out bid and offer prices.

He couldn’t be more wrong. Technological advances mean that stocks are now traded digitally on computer servers in often anonymous – but heavily guarded – buildings, generally miles away from the historic epicentres of finance, meaning the brash men in sharp suits depicted in films such as the The Wolf of Wall Street have been dethroned as the kings of finance.
Computer programmers have taken their crown thanks to the code they churn out, which is able to execute trades thousands of times faster than any human.
This new world is described by bestselling author Michael Lewis in Flash Boys: Cracking the Money Code, his new book that exposes Wall Street’s latest method to make money off ignorant investors – and the financial firms’ need for speed to make massive profits at almost zero risk.

Lewis, whose previous books include Liar’s Poker and The Big Short, gets inside the world of high-frequency traders (HFTs) who install ultra-fast fibre-optic data connections between their systems and modern stock exchanges, giving them a minuscule speed advantage over rival traders. This advantage, while just milliseconds (thousandths of a second), allows HFTs to see other buyers’ orders before they are executed.

At the most basic level, they use this time advantage to buy the stock before the first deal has been processed and sell it on to the original purchaser at a slightly higher price, a process known as “front-running”.

And, says Lewis, they are willing to go to extraordinary lengths to gain this speed advantage – including laying the shortest, and therefore straightest, possible fibre-optic cable between the Chicago exchange the New York exchange based in New Jersey, a distance of 827 miles.

“It needed its burrow to be straight, maybe the most insistently straight path ever dug into the earth. It needed to connect a data centre on the South Side of Chicago to a stock exchange in northern New Jersey. Above all, apparently, it had to be secret,” Mr Lewis said.

“The construction crews were as bewildered as anyone. The line didn’t connect anyone. Its sole purpose, as far as they could see, was to be as straight as possible, even if that meant they had to rocksaw through a mountain rather than take an obvious route around it.”

What was previously thought of as fast – before 2007 – just wouldn’t cut it for HFTs. What was fast then was the fastest a human could go. Now there was no man in the loop.

“The response of many of them suggested that their entire commercial existence depended on being faster than the rest of the stock market,” writes Lewis revealing that some of them “would sell their grandmothers for a microsecond [a millionth of a second]”.

No wonder that Spread Networks, the company building the fibre-optic connection, proudly boasted: “Round-trip travel time from Chicago to New Jersey has been cut to 13 milliseconds.”

And HFTs were willing to pay through the nose to use it, with the first 200 to sign up forking out $2.8bn between them.

But while they were taking advantage of the new technology, others were losing out. Lewis relates how Brad Katsuyama, a New York-based trader, realised the market “knew” how he was about to trade before he mades a deal as HFTs stepped in and used their speed to take advantage of his share orders.

“[Brad] had always been able to look at his screens and see the stock market. Now the market as it appeared on his screens was an illusion,” writes Lewis. “It was as if someone knew what he was trying to do and was reacting to his desire to sell before he had fully expressed it.”

Frustrated and mystified by share prices moving against him, Katsuyama investigated and discovered how HFTs – and even highly respected major banks – were trying every method they could to get their systems to be the fastest into the exchange, including “co-locating” their servers inside stock exchange buildings to minimise the distance their own digital instructions had to travel to outpace rivals.

This was all attempted to be done under competitors’ noses: one HFT secured a spot a few feet nearer to an exchange computer that had previously been occupied by machines owned by Toys ‘R’ Us. It insisted the toy shop’s logos were left on the “cage” surrounding the computers for fear its rivals would realise it had gained an advantage measured in just inches.

“[He] described what he’d witnessed in exchanges: the frantic competition for nanoseconds, the ware for space within exchanges… ‘What he said told me we had to care about microseconds and nanoseconds’.

“The US stock market was now a class system, rooted in speed, of haves and have-nots. The haves paid for nanoseconds; the have-nots had no idea a nanosecond had value.

“The have enjoyed a perfect view of the market; the have-nots never saw the market at all.

“What had once been the world’s most public, most democratic, financial market had become, in spirit, something like a private viewing of a stolen work of art.”

Lewis relates how Katsuyama realised that he could not have been the first to discover how to take advantage of speed to look into the future, making it a riskless operation. However, unlike those who had gone before, Katsuyama was the rarest of breeds on Wall Street – a truly honest person, and one who was unwilling to perpetuate an unfair system just because it meant he could gain personally.

He left his job and multi-million-dollar salary to launch IEX, a new exchange that negated the speed advantages HFTs enjoyed and made all who traded on it equal.

However, his attempts to raise the capital he needed to start it met with resistance from Wall Street.

“Eight of 10 pitch meetings began with some version of the same question: ‘Why are you attacking a system that has made you rich and will make you even richer if you just go along with it?’” writes Lewis, adding that Katsuyama soon learned to get round this concern by telling potential investors he was “long-term greedy”.

Katsuyama decided that HFTs weren’t pernicious, says Lewis – they added liquidity to markets – and it wasn’t necessary to eliminate them completely, just remove their advantages. So he joined with others to design a system to accommodate this. He would examine the share trading logs to see just how much value HFTs added to the system.

“Once IEX opened, they would be able to see how much of what HFT did was useful for business,” writes Lewis. However, the US public seemed to have already made up its mind on their value. HFTs were widely blamed for the May 2010 “flash crash” that saw US markets plunge nearly 10pc in minutes, only to recover these losses shortly after. Prior to this event, 67pc of US households owned shares, by the end of the next year this had fallen to 52pc. And in August 2012, HFT group Knight Capital’s flash trading systems went berserk, causing $440m of losses that resulted in the company later being sold at a knock-down price.

Concerns over whether IEX would be a success weighed on Katsuyama’s mind once he launched – and he was right to be concerned. HFTs and banks feared the new exchange could kill a billion-dollar revenue stream for them and so tried to sabotage it.

However, in the end IEX was given the support it needed from the most unlikely of places – Goldman Sachs.

The investment bank, infamously described in Rolling Stone magazine as the “great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money”, saw the value in IEX, and directed its trading orders to the exchange, giving it the volume it needed to survive in a crowded market.

Lewis explains how the new structure of the US markets had robbed investment banks such as Goldman of their traditional role as an intermediary, with HFTs now making 85pc of the gains in its own internal markets, leaving the bank with just 15pc. However, when things went wrong, or markets collapsed, HFTs tactics, such as front-running, meant they made no losses, while banks were left to suffer.

“Goldman had figured all this out – probably before the other big Wall Street banks to judge by its treatment of IEX,” writes Lewis. “They truly believed that the market at the heart of the world’s largest economy had grown too complex and was likely to face some catastrophic failure. But they were also trying to put an end to a game they could never win – or control.”

By directing orders to IEX, they started a process, says Lewis, that “would take billions from Wall Street and return it to investors. It would also create fairness.”