Saturday 16 December 2017

Wolf hunters of Wall Street

€163bn of share trading zips up and down fibre optics every day and that was an opportunity that stock market flash boys couldn't resist exploiting. Until Irishman Ronan Ryan found them out. Dan White reports

New York Stock Exchange
New York Stock Exchange
Author Michael Lewis
Dan White

Dan White

In financial circles writer Michael Lewis enjoys rock star status. The former Salomon Brothers bond trader has penned a series of bestsellers chronicling the misdeeds of the masters of the universe.

Now, in his latest book Flash Boys, Mr Lewis has taken aim at so-called high-frequency traders.

Which of course begs the question: who or what are high-frequency traders? High-frequency trading is a generic term that describes automated share trading techniques which use computers linked to high-speed fibre optic cables to place buy and sell orders faster than other investors.

So far, so boring. Where it gets interesting is Lewis' allegation, that the high-frequency traders have been able to gain an unfair advantage over other investors.

The first thing to bear in mind is that most share trading is now conducted electronically. The Wall Street trading floor of the New York Stock Exchange, with traders gesticulating wildly as they attempt to execute "buy" and "sell" orders, is now little more than a glorified TV set for channels like CNBC and Bloomberg.

The central nervous system of the modern stock market is the fibre optic cables which can transmit data, including "buy" and "sell" orders, at the speed of light – 186,000 miles per second. To mere mortals like you and me data travelling at the speed of light will reach its destination anywhere on the planet virtually instantaneously.

That's not how the geeks and nerds who now dominate stock trading see things. They will spend millions of dollars on super-duper new fibre optic cables in order to shave millionths of a second off the time it takes them to execute their trades. In the modern stock market time is literally money.

According to Lewis, the high-frequency traders have gone way beyond merely using fibre optic cables to speed up their own orders. He alleges that, often with the connivance of the existing stock exchanges, they have been able to gain advance knowledge of other investors' orders and profit at their expense.

How have they been able to do this? It all comes back to those fibre optic cables. The high-frequency traders have paid the existing stock exchanges to allow them to place their computers in the same buildings as the exchanges. This means that they can shave precious microseconds (millionths of a second) off the time it takes them to place their orders compared to investors who are located further from the exchanges.

However, if Lewis is to be believed, the high-frequency traders have gone even further to gain an unfair advantage over investors. He alleges they have been able to exploit their physical proximity to the exchanges to eavesdrop on other investors' orders and place their orders first – what is known on Wall Street as "front running".

What this means in practice is that when an investor places a "buy" or a "sell" order, the high-frequency traders use their speed advantage to get in ahead of them, forcing the investor to pay a higher price if they are buying or accept a lower price if they are selling. It's a bit like trying to play cards with someone who can see your hand as well as their own.

And a very expensive game of cards at that. The average volume of shares traded on the US stock market every day is huge – $225bn (€163bn). If the high-frequency traders were skimming off even 0.1pc of this amount then the cost to the market would be $225m (€163m) every day, or more than $58bn (€42.3bn) a year. Readers of Lewis's previous books will be familiar with the Flash Boys formula. There is a problem in the world of finance and the financial establishment doesn't want to know. Things go from bad to worse until a group of iconoclastic outsiders storm the citadel.

The heroes of Flash Boys are Dubliner Ronan Ryan and Brad Katsuyama. As the head of Canadian bank RBC's New York stock trading desk, Katsuyama noticed virtually every time he placed an order the market seemed to move against him. It was as if somebody, somewhere had advance knowledge of his orders and was beating him to the punch.

After first putting it down to a computer glitch, Katsuyama learned from talking to other investors that they believed that they too were the victims of "front running".

Unfortunately, while Katsuyama had worked out that there was a problem, he was still no closer to discovering what the problem actually was.

Enter Ryan. The Dublin-born telecommunications expert had worked for many of the major phone companies installing the fibre optic cables that the high-frequency traders relied upon to give them an edge over the rest of the market.

The two men were introduced in 2009 and Ryan explained to Mr Katsuyama that the high-frequency traders enjoyed a huge speed advantage over other investors. Mr Katsuyama had finally discovered the precise nature of the problem.

That in retrospect turned out to be easy part. While investors were not unnaturally outraged when they discovered that the high-frequency traders were gouging them, persuading the existing exchanges or the regulatory authorities to do anything about it proved far more difficult.

Frustrated by his failure to reform the existing exchanges, Katsuyama decided on a radical move. He left his job with RBC and set up his own exchange and hired Ryan as his chief strategy officer. Unlike the existing exchanges, which are largely owned by brokers, the new exchange IEX would be owned by investors and the high-frequency traders would be banished from the premises, forcing them to compete on the same terms as other investors.

The IEX opened for business last October and so far the omens are good with trading volumes exceeding 50 million shares a day in recent weeks. In the early days many of the leading investment banks stood aloof from IEX but that too has begun to change with the mighty Goldman Sachs (aka ''Golden Sacks") placing its first order with the fledgling exchange in December 2013.

So will IEX succeed in forcing Wall Street to clean up its act? While it would be nice to believe in a fairytale happy ending that's not how things usually work in real life.

Regardless of the eventual outcome, the only guaranteed winner is probably Lewis for whom Wall Street's shenanigans seem to provide an inexhaustible treasure trove of material for his bestsellers.


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