Flash Boys

As I mentioned in my previous post I recently read "Flash Boys" a 2014 book by Michael Lewis. Most of this book is about the creation of IEX, a recently formed dark pool (private stock exchange) which claims to be fairer to its clients than other stock trading forums.  A couple of chapters are devoted to the case of Sergey Aleynikov a computer programmer for Goldman Sachs who was criminally charged for allegedly stealing computer code after he quit to take another job.  His federal conviction was overturned on appeal but he still faces New York State charges.  These chapters have little to do with the rest of the book.

The founders of IEX have apparently constructed a narrative in which the previously existing US stock markets were rigged and corrupt inducing the outraged founders to create IEX to clean things up.  Lewis appears to have bought into this entirely and his book reflects this.  As I said in my review of Lewis's earlier book, "The Big Short":

There is a bit of a danger with an entertaining writer like Lewis that you will give undue credence to his point of view simply because he is such a good story teller. Lewis has been criticized along these lines but for the most part I think his books get the big picture (if not every detail) correct.

Lewis remains entertaining but in this book I don't believe he has gotten the big picture correct.  He doesn't seem to realize that if you try to buy or sell a large amount of a stock you will move the price against you (up if you trying to buy, down if you are trying to sell).  This is just how markets work by balancing supply and demand and doesn't mean they are corrupt or rigged.  But Lewis seems to think there is something nefarious about this process. 

On page 109 Lewis writes:

... After the market was computerized and decimalized, in 2000, spreads in the market had narrowed--that much was true.  Part of that narrowing would have happened anyway, with the automation of the stock market, which make it easier to trade stocks priced in decimals rather than in fractions. Part of that narrowing was an illusion: What appeared to be the spread was not actually the spread.  The minute you went to buy or sell at the stated market price, the price moved.  ...   

First decimalization narrowed spreads because as part of decimalization the tick size was reduced from .0625 (1/16) to .01 (not because decimal fractions have some inherent superiority to binary fractions).   It became apparent that the larger tick size had been keeping spreads artificially high and they narrowed when it became possible for them to do so.  Second the smaller tick size (and resulting narrower spreads) made it possible to observe stock prices to greater precision.  Which made it possible to observe smaller changes in stock prices.  In particular it became easier to observe the price changes induced by a moderate sized order which a larger tick size might have obscured.  This doesn't mean the narrower spread isn't real, it is quite real for small scale traders like most individual investors including me.

On page 114 Lewis writes:

... The algos had names like Ambush and Nighthawk and Raider and Dark Attack and Sumo.  Citi had one called Dagger, Deutsche Bank had Slicer and Credit Suisse had one named Guerilla, ... , Their very names made Rich Gates wary; he also didn't like how loudly the brokers selling them told him they'd come to protect him.  Protect him from what?  Why did he need protection? From whom did he need to be protected? ...

Although Lewis doesn't bother to explain it appears these programs mostly just disguise large orders by splitting them into smaller orders (enabling a better average price to be obtained).  As for from whom Gates needed to protected, apparently he needed to be protected from himself, from revealing his intent to buy or sell a large block of stock before he had to and thereby getting a worse price.

No doubt there are many ways US stock markets could be improved, the big players are all seeking private advantage.  But this unbalanced book while entertaining is not in my view a reliable guide to the issues.