Lessons from the “Flash Boys”
With the publication of Michael Lewis’ 2014 book, “Flash Boys: Cracking the Money Code,” the notion that high frequency traders were utilizing speed to take advantage of regular investors was first made public. In this narrative, former RBC electronic traders Brad Katsuyama and Ronan Ryan had an epiphany when they realized that the market has become more electronic, allowing a new type of “predator” to enter the market quickly and overtake slower, more established institutions. With its introduction, the significance of speed in trading was emphasized, and attention to how it may be used to exploit the untrained average investor intensified.
Flash Boys relates the tale of latency arbitrage and market manipulation, starting with the establishment of Spread Networks, a business that, in an effort to sell speed to HFTs and Wall Street banks, spent $300 million laying an ultra-low latency fiber optic cable between Chicago and New Jersey. HFTs and proprietary traders have been accused of exploiting unaware traditional institutional, and retail investors through high-speed connections, either through co-locations or access to augmented proprietary data feeds. These traders are said to have used information gathered on the public markets at a quicker rate or through access to banks’ private dark pools. In 2011, over 30% of all stock market deals, mostly in dark pools, were off the market, according to the book.
Katsuyama and Ryan’s accusations that the market was systematically manipulated were based on Reg NMS in the US. Reg National Market System (NMS) was implemented by the Securities and Exchanges Commission (SEC) in the United States in 2007 as a result of front-running accusations made against participants in 2004. The broker is required to find the investor’s best price in the National Best Bid and Offer (NBBO), which means the broker must first purchase whatever much of that stock is offered at the best price. Exchanges developed Securities Information Processors (SIPs), which are consolidated data feeds that include all bid/ask quotes from every trading venue, to gather the picture of the NBBO. However, the IEX founders contended the system offered lacunae to those firms that were willing to develop improved SIPs closer to the exchange’s systems to harvest the information more quickly.
The publication of the novel has had a considerable and long-lasting impact on some participants’ choice of trading strategies, as well as encouraged regulators to pay closer attention to various practises, such as payment for order flow, in an effort to protect regular investors. The novel was the first window into the shadowy underhanded operations of the market.
At a major US asset manager, “the novel’s publication was a cultural milestone, especially at a time when electronic trading was becoming widely accepted as a tool for efficiency, and there was an acknowledgement that this was ‘good technology’ and would enable the industry to scale even more rapidly,” says one buy-sider.
“The ‘Flash Meltdown’ a few years earlier introduced improved risk controls, better procedures, and better management of the electronic operations, which had been adopted in a limited way by the major asset managers. The ‘Flash Crash’ lasted about 30 minutes and was a sudden stock market crash. Similar to the recent run on $LUNA [a price collapse of the digital asset at the beginning of June that resulted in $500 billion in losses in the broader crypto market], the incident highlighted potential industry weaknesses like the development of negative feedback loops due to the flimsy interconnectivity of fragmented markets and venues that had emerged as a result of the introduction of Reg NMS in the mid-2000s,” they go on to say.
“I was amazed at how little individuals knew about what was going on with their orders and how they interacted with proprietary trading activity run by huge banks, and the book did at least drive people to ask more questions and understand more about what was going on in a complex marketplace.”
Based on the claims made in the book, several court suits were quickly initiated, including SEC inquiries into the private dark pools of both Barclays and Credit Suisse. But in the end, it was the exchanges’ fault for enabling the alleged behavior to occur. Five lawsuits were filed against the alleged trading venues in 2014, just one month after the book hit the market. These lawsuits subsequently merged into a single action.
The exchanges, including Nasdaq, the New York Stock Exchange, and BATS Global Markets, now a division of Cboe, were accused of creating a trading environment that favored high frequency traders (HFTs) and disadvantaged other investors in the case, now known as the Flash Boys Case, which institutional investors brought forward. These advantageous trading conditions included National Best Bid and Offer (NBBO) and complex order types, which were all offered for a fee, as well as co-location services, which allowed businesses to place their servers close to the exchange’s servers, superior data feeds, which allowed participants to quickly and accurately visualize the market, and superior data feeds.
These latency-focused solutions were created to increase the speed at which businesses could access crucial information and enter and exit orders on venues, giving them the advantage over other investors and allowing them to profit from the brief window of time when they had access to information that the rest of the market did not.
2015 saw the dismissal of the action on the grounds that the self-regulatory status of the exchanges shielded them from claims of private damages. But in 2017, it made a comeback when it was discovered that they didn’t actually possess this immunity. It was rejected when the seven exchanges requested to have it overturned once more in 2019. Only in March 2022, eight years after the exchange’s acts, did the Federal Court come to the conclusion that the institutional investors could not demonstrate that they had been harmed by such actions, adding that Dave Lauer’s expert witness testimony was not a valid approach.
The issue was that the institutional investors genuinely lacked any evidence of harm. Even though there have been a few isolated fines, I wouldn’t argue there is systemic evidence that the markets are “rigged.” Electronification was designed to allow people to trade from anywhere and bring the buy-side and sell-side on an equal footing. It was theoretically possible to be as competitive as anyone without actually being on the floor of the New York Stock Exchange. According to Bloomberg Intelligence’s head of market structure research, Larry Tabb, the laws of physics and the issue of speed are problems with that idea.
“An exchange’s primary function is price discovery; therefore, it is more concerned with offering the tightest pricing they are able to than it is with volume. Since the SEC pays exchanges for market data in two different ways—first, based on the number of shares they execute, and second, based on the aggressiveness of the bids and offers on their market—they are also interested in the transaction flow. While I don’t believe collusion worsens the markets for institutional investors, there are incentives in the exchange infrastructure to try to offer a fast, tight, efficient market. They will receive a larger rebate if the price is tighter compared to whether the price is lower or wider.
One HFT explains that co-location and proprietary products are available to all institutions and are approved by the SEC. Do your algos link to proprietary data feeds? – is typically one of the first things the buy-side asks brokers when connecting to exchanges, they claim. “The same thing is available to everyone.”
Some market observers assert that a group of proactive legal firms seeking to persuade players to participate in potentially profitable litigation, rather than institutional investors who felt wronged, were primarily responsible for the court case over the publication of Flash Boys.
Earlier this month, the SEC demanded $187 million from retail broker Charles Schwab to resolve allegations that it had misled consumers of its robo-advisors about fees. The SEC determined that Schwab failed to inform customers that the firm was allocating funds “in a manner that its own internal studies demonstrated would be less beneficial for their clients under most market situations” from 2015 to 2018.
“If you looked at Bloomberg, you would see that new law firms were springing up, seeking to represent elite plaintiffs in situations similar to what had occurred with Schwab. The Flash Boys case is the same; plaintiffs are sought after by law firms. The HFT claims that it is a peculiarly American and especially irritating issue.
Expanding the area
Even though the legal action was largely unsuccessful, the novel’s publication was successful in spurring change in the sector. By bringing the Flash Boys’ events to the attention of the larger market, investors demanded more transparency, and there were more trading options available. It was more important to give vultures and hyenas fewer opportunities to kill, as Lewis so poignantly stated, than it was to remove them from the food chain.
US-based Investors Exchange (IEX), which was co-founded in 2013 by Flash Boys actors Katsuyama and Ryan, is one of the fresh venues that have recently entered the market. The couple hoped to promote a market that would make it easier for high-frequency and conventional institutions to coexist more peacefully in light of what they believed they had uncovered. The exchange has added what is known as a “discretionary limit order,” or D-Limit order, in addition to different speed bump methods. An investor may purchase or sell a security using a limit order at a stated or higher price. When the market is ready to move, IEX’s order anticipates it and then pushes limit orders near the bottom of the orderbook—typically those belonging to the buy-side—out of the way, so they won’t be run over.
According to a market source, “things like the D-limit order are looking at how to slow trade down as well as to see whether venues can safeguard limit orders that are already present on the exchange.” To their credit, the general idea of the majority of exchanges is to maximize liquidity because if you don’t trade, you don’t get paid, you don’t get to receive tape money, and you don’t get to enjoy all the advantages of market data. In this case, they are actually entering an order type that instructs the system to transfer the order out of trade when the flag is raised.
The D-limit order does, however, have certain issues of its own. It has drawn criticism from some who contend that it simply provides IEX members with a delay and disadvantages non-IEX members in the market.
Tabb continues, “If IEX were on an equal basis with everyone else who could look at the order book and move, then it wouldn’t be that problematic.” The issue is that shifting those D-limit orders does not pass over the speed hump for IEX clients, giving them an advantage of 350 microseconds over everyone else.
The independent Members Exchange (MEMX), which entered the market in October 2020 to boost competition, enhance transparency, and cut costs, has considerably eclipsed IEX’s market share, reaching 3% for the first time in August 2019. MEMX joined the market in January with a 0.1% market share and only increased to 3% by April of this year. IEX opted not to comment.
“That brings up the previous point regarding speed and market judgment. Fast and affordable MEMX. In addition, they offer a substantial rebate, explains Tabb. “Because MEMX is fast and has a big rebate, that means they pay people to trade there, and because they pay you to trade there, you can quote more aggressively because they’re fast.
The Aquis Exchange was also introduced in 2013, and it adheres to the same idea as IEX by forbidding HFTs from crossing the spread in order to prevent them from adopting specific trading tactics on the exchange. Instead, they are limited to using a particular post-only order type by the exchange.
“We don’t oppose high-frequency trading, but there are some tactics that we think proprietary trading companies use to alter the composition of the liquidity pool. Many customers expect immediate gratification, and if your market doesn’t include HFT and prop traders, it will take longer to fill your order. Alasdair Haynes, chief executive of Aquis, agrees. “You don’t have competition if someone constantly wins. There ought to be various markets available, in our opinion, both those that cater to everyone and those that are focused on long-term investors. They may coexist.”
Events that occurred after the novel’s publication probably prompted European regulators to take more restrictive action against broker crossing networks (BCNs), which were abandoned as part of Mifid II in 2018, and to encourage more volume toward agency matching venues and periodic auctions.
Order flow compensation
The controversial practice of paying for order flow (PFOF), whereby retail brokers direct their customers’ flow to banks and market makers in exchange for payment, was another activity that received attention as a result of the publication of Flash Boys. Firms not only have the option to direct this flow where it may be more advantageous for them (according to the US exchange rebate system, some venues pay you to provide or take liquidity), but they also have access to the order-specific data that may be used to make trades in the larger market.
Due to the pandemic, the GameStop incident, the meme stock explosion, and the expansion of the US retail industry, PFOF has drawn the attention of authorities. As a result of this heightened attention, PFOF has been targeted by the regulators. SEC chair Gary Gensler recently issued a warning that PFOF constituted conflicts of interest and skewed routing decisions. He added that it might push brokers to promote the gamification of the markets, as seen with GameStop, in an effort to boost trading volumes.
Traders receive reimbursements from exchanges. According to Gensler, high-volume traders gain more from these agreements, and individual investors don’t immediately profit from the rebates. Exchange rebates may create a similar conflict of interest when client limit orders are routed, just as payment for order flow does with marketable retail orders.
Citadel Securities spent $2.6 billion on order flow payments in 2020 and 2021, according to 606 reports compiled by the SEC. Susquehanna (G1X global execution brokers), who spent $1.5 billion, and Virtu, who spent $654 million within the same period, were the next highest spenders.