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Lewis Through the Looking Glass

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Michael Lewis claimed on '60 Minutes' (and then the 'Daily Show', 'Charlie Rose', CNBC, Bloomberg TV...surely 'Rachael Ray' is next) that the stock market is rigged for superfast pro traders (aka HFTs) at the expense of everyone else, as he elucidates in his new book Flash Boys. Then came the rebuttals-- in the WSJ, CNBC et al, that yes, today's electronic market has flaws, but overall it's less 'rigged' against the little guy than years past. According to at least one survey 51% of people agree with Lewis. Are they right?

Historically Lewis has more credibility than his detractors. Lewis' work, from Liars Poker to The Big Short, has been well received by outsiders and insiders alike. Meanwhile CNBC helped inflate every bubble since Pet Rocks, and the WSJ publishes op eds that claim insider trading is a victimless crime, so it should take some doing to convince us that Lewis is wrong here.

To revisit his argument, Lewis' asserts that the bad stuff started happening in earnest around 2009 when Brad Katsuyama, Royal Bank of Canada sales trader, noticed he was getting worse fills for his customers' large orders than in the past. This claim is hard to prove one way or the other, though many market participants, yours truly among them, don't see a definitive difference in fill quality now v 2009. The example Lewis cites involves orders large enough that they need to go to multiple exchanges to get filled. In the example there was clearly front-running, but it's unclear if the cost was worse, let alone far worse than that extracted by the block traders that pre-dated computerized trading. Lewis' opponents point to pre-computer days as far more costly, and that some forms of HFT actually improved market structure for the little guy. Lewis told Charlie Rose he looked at both sides of the story, the HFTs and Katsuyama's, and found only Katsuyama's was credible. Should we trust him?

Some other talk show statements made by Lewis:

Lewis told Jon Stewart that 'front running is illegal, unless a computer does it'. Untrue-- front funning is illegal if you are a broker front running your customer's order. If you sniff out an order that is not your customers, you can front run it all you like. Computers v humans have nothing to do with this.

Lewis told Charlie Rose that HFTs don't provide liquidity, when in fact that is the main method by which they make money. When Goldman paid $6.5bb for market making firm Spear Leeds in 2000, it wasn't because providing liquidity is a charitable endeavor. Its highly profitable, and to be good at it you need to be fast. It's a big part of the HFT playbook.

Lewis told Rose that Katsuyama was in line to be the CEO of 'the' RBC. Katsuyama was highly regarded at RBC, but no more so than 100 other young, smart, hard working guys. Did a person at RBC (there is no 'the' in front) tell Lewis that Katsuyama could be CEO someday? Probably. But my first grade teacher said I'd be President someday, and if someone was going to go on national TV to repeat that the assertion they should at least get corroboration from the gym teacher.

Charlie Rose asked Lewis how much money HFTs were making front running, and Lewis used the range '$8 billion to $30 billion'. We know that Houston HFT firm Quantlab, which trades 2.5% of market volume on a given day, and thus 5% of HFT volume, made 'hundreds of millions' over a 7-year span. If you assume Quantlab made $50mm a year the total HFT annual profits are $1bb per year. Not chicken feed, but only 12.5% of Lewis low end. (And that's assuming all their profits are coming from front running, and not productive areas like market making.)

There is an old phrase 'the most dangerous idea is when you have only one' which means you can get wedded to something that simply won't work if you don't have a plan b. In this case its more clear with each talk show appearance that Lewis became committed to the idea that the market is 'more rigged than ever', that it's a many billion dollar problem, and that Brad Katsuyama was 'the only guy that understands how the market works'--it sure makes for a good yarn. But that yarn has many holes, including the assertion that Katsuyama is the 'only one who understands the market' , which flies in the face of the book which chronicles Katsuyama's efforts to catch up to what the HFTs knew 4 years earlier.

The shame of this is that Lewis' hyperbole masks the very legitimate point that our market structure has obvious room for improvement--starting with eliminating premium access for those that can pay for it. In fact, I would go further than what Lewis advocates in terms of market reform. I'd like to see our market go to two fixings (matching of buyers and sellers at a single price) a day rather than continuous trading. If you think online gambling is bad for society because it makes it too easy for people to give away money with no net benefit to society, then you would see the value in eliminating continuous trading. With two fixings we'd still get the price discovery the market needs, without as much money going from pension funds to HFTs, and our physicists would migrate from trading floors back to laboratories. A draw-win-win. But as long as Lewis overstates his case, real reform is obscured.