Name: Flash Boys
Rating: 4 (202 reviews)
Author: Michael Lewis

What’s in it for me? Learn how the US stock market turned into a rigged game of speed.

What happens when you invest in the stock market? There was a time when the answer was relatively straightforward. You’d talk to a broker who would put out an order, and maybe it would involve some traders yelling numbers on the floor of the New York Stock Exchange.

Those days are over. Now it’s all done electronically, through a system of servers, codes, and algorithms. The New York Stock Exchange, which used to be the primary trading ground, is just one of dozens of public and private stock exchanges. By reducing the human element, electronic trading was supposed to make trading safer and more efficient. But as we’ll see in this very short Blink, it opened the door to predators all too eager to exploit the investors who are the lifeblood of the market.

A new problem, a new solution

The moment Brad Katsuyama hit “Enter,” he knew there was a problem. It was 2007, and Katsuyama was working in New York for the Royal Bank of Canada (known as RBC). The problem was, whenever he hit Enter to place an order – like buying 10,000 shares of Intel – the price would suddenly go haywire. Thinking he’d be able to turn around and sell for $22 a share, the moment he pressed that button, the share price would plummet, leaving him with massive losses. Suddenly, Katsuyama could no longer trust the market.

The problem was compounded by the fact that the stock market had become so complex that even veteran Wall Street brokers were largely clueless about the finer details. But by gathering a team of experts in various fields and merging their minds, Katsuyama was able to figure out exactly what was going on.

The problem was that Katsuyama’s orders were being “front-run.” The instant a big order – like 10,000 shares of Intel – appeared on the market, the algorithms being used by high-frequency trading firms (known as HFT firms) were able to get ahead of that order before it was broken up and distributed to the various stock exchanges. We’re talking about milliseconds here: the time it takes for an electronic order to make its way from Manhattan to New Jersey. But that was enough time to bombard the markets with competing orders, which would cause the price to change before the transaction was complete. This is what’s known as “front-running.”

Now, thanks to expert knowledge of the fiber optic networks in the tri-state area, Katsuyama and his team were able to develop a tool known as “Thor.” This program could stagger the release of an order so that it reached the various stock exchanges at exactly the same time, effectively ruining any opportunity for front-running.

But as it turned out, Thor was a tiny band-aid on a widespread problem that was being enabled by some of Wall Street’s biggest banks. A complex system of incentives was in place that allowed HFT firms to earn as much as $160 million a day by essentially screwing over investors. A loophole in electronic trading had been discovered and was being ruthlessly exploited, with little consideration for the long-term damage it was causing to both investor confidence and market stability.

It was going to take more than Thor to fix this problem.

A brave new stock exchange

Brad Katsuyama’s solution was twofold. First was an education campaign. He met with some of the biggest and most influential investors and hedge fund managers and explained how they were getting ripped off in the market as it currently existed. But then he started thinking bigger: What if we created our own stock exchange that was fully transparent and could guarantee protection from the market’s predatory elements?

There were some roadblocks, however. As crazy as it may sound, when investors placed orders with banks and brokers, those investors had no real way of knowing which stock exchanges their orders ultimately went to. Banks largely benefited from this lack of transparency. Many banks had what are known as “dark pools,” which are essentially private stock markets where all kinds of business happened away from the prying eyes of the public. The more business, the better it was for the banks. And no one was doing more business than HFT firms – even if that business was getting in the way of more legitimate transactions.