Michael Lewis Book 'Flash Boys' Shines Light On High-Frequency Trading: 'You're Enabling People To Screw Their Customers'

Best-selling author Michael Lewis, who has placed the spotlight on risky Wall Street practices from the use of junk bonds in the 1980s to toxic derivatives during the mortgage crisis, has a new area of concern: high-frequency trading.

In “Flash Boys,” set for release on Monday, Lewis says that high-frequency trading, one of the most lucrative and fast-growing practices on Wall Street, has sometimes been exploited by banks and hedge funds to give them an extra advantage over retail investors, according to an excerpt reviewed by International Business Times. Ahead of its release, the book is already making waves in financial circles: “The sh-- is going to hit the fan when this book comes out,” says one trader, predicting that some high-frequency trading firms and banks will be forced to change their practices.

The controversial practice, in which firms strategically locate servers and use sophisticated computer algorithms to accelerate transactions by mere microseconds -- and thus reap huge profits -- is the subject of a probe by New York Attorney General Eric Schneiderman. Last week, he announced an inquiry into how such traders have gained an unfair advantage in the timing of their trades by paying fees to exchanges such as the New York Stock Exchange and Nasdaq to locate their servers in the exchanges’ own data centers. “I have been focused on cracking down on fundamentally unfair – and potentially illegal – situations that give elite groups of traders early access to market-moving information at the expense of the rest of the market,” Schneiderman said in a speech. Several regulators, including the Securities and Exchange Commission and the Commodity Futures Trading Commission, are exploring new regulations of high-frequency trading to limit such abuses.

The idea for the book came to Lewis when he started reading about the case of Sergey Aleynikov, a low-level employee of Goldman Sachs Group Inc. (NYSE:GS) charged with stealing computer code. He was intrigued when federal prosecutors denied bail for Aleynikov, citing concerns that the computer code could be used to “manipulate markets in unfair ways.” And Lewis, a former Wall Street trader who had covered the financial world for decades, was curious that even the most sophisticated observers had a hard time explaining what Aleynikov, a high-frequency trading programmer, actually did for a living.

The answer to that question gave Lewis an insight into how Wall Street has transformed over the decades from a New York Stock Exchange trading pit full of men in color-coded jackets screaming at each other to quietly humming black boxes in highly secure buildings in New Jersey and Chicago.

In the world of high-frequency trading, a half a millionth of a second can make all the difference. Programs designed by math geniuses exploit tiny movements in stock – buying at $10 and selling at $10.0001 – and though that yield is tiny, when you’re trading more than 10,000 times a second, the proceeds skyrocket. To execute smart trades as fast as possible, the traders need to get information as fast as possible and act on that information in less than one second.

Thus, many high-frequency traders have set up shop in the same building as the New York Stock Exchange and Nasdaq’s servers in the suburbs of New Jersey. In some cases, they were paranoid enough about their competitors that they have tried to disguise the location of their servers – one firm kept old Toys “R” Us store logos on its machines and another wrapped its server in wire gauze to hide its flashing lights.

And one company, Spread, even built an 825-mile-long $300 million fiber-optic cable between Wall Street and the Chicago Mercantile Exchange so its traders could get ever-so-slightly faster information on the prices of commodities, such as aluminum futures, and use that as soon as possible to make a smart trade on Alcoa Inc. (NYSE:AA), a giant aluminum producer.

When Spread first built its cable, the company tried getting the big Wall Street banks to pay $300,000 a month to use its network. The reaction they got expressed a lot about the personalities of the different banks. Citigroup asked to have the line rerouted from the building in a Jersey suburb near the Nasdaq servers to its headquarters in Lower Manhattan, costing milliseconds and defeating the whole purpose of the line.

Because Spread’s contract allowed banks to use it to trade with their own money (known as proprietary trading) but restricted them from sharing it with their regular brokerage customers, some banks were outraged. Credit Suisse Group AG (NYSE:CS) told Spread: “You’re enabling people to screw their customers.”

On the other hand, Morgan Stanley (NYSE:MS) was fine with shutting out its customers and reaping the benefits for itself, as long as the language was tweaked in its contract with Spread to give them plausible deniability, writes Lewis. “This is totally about optics,” a bank official told a Spread employee.

And “of all the big Wall Street banks, Goldman Sachs was the easiest to deal with. ‘Goldman had no problem signing it,’” the Spread employee told Lewis.

Spread quickly found that most Wall Street banks really wanted access to the line – and for others not to get access. At one meeting, a bank official offered to double the upfront cost of $20 million just to make it prohibitively expensive for competitors.