Skilled Wall Street-botherer Michael Lewis has a new book out claiming the stock market is hopelessly rigged against investors, and the backlash from Wall Street has been predictably ferocious.
The backlash is not entirely wrong! It is just wrong about some of the most important stuff. To help explain what I mean, I will list some of the standard reactions to Lewis' book, Flash Boys, which claims that the stock market favors high-speed traders. These are the guys that use super-fast computers, fiber-optic cables, microwaves and frickin' laser beams to trade milliseconds ahead of the rest of the pack, sucking up kajillions of dollars for themselves in penny increments while adding little to the march of human progress.
I will grade these critiques on a truthiness scale from A to F, with "F" representing "Excuse me, but your pants are on fire," and "A" representing the chiseled-in-stone gospel truth.
Claim: The market is not rigged!!!! This was the line from Politico's Ben White and a parade of jittery New York Stock Exchange traders on CNBC on Monday.
F Gentleman's C: The market is of course rigged in favor of people and companies who have more information and more technological prowess than other people and companies. If you think otherwise, then boy does Stratton Oakmont have a can't-miss investment opportunity for you.
Update: Ben White protested his grade. Because I am a fair grader, unlike some college professors I could name, I listened and realized I may have been too hasty with the "F" pen, maybe because I found this argument less compelling than others and because I wanted to avoid grade inflation.
White's point, like that of Yahoo Finance's Michael Santoli, is that the whole stock market is not rigged to favor high-speed traders. I agree with that, as you'll see below -- your 401(k) is probably safe from the flash traders, unless they accidentally destroy the market somehow. If you're not playing their game, you're not losing. You might even be winning. The market will always favor some players over others, but not some players over everybody else all the time. It's only fair to give some credit to this argument.
Claim: So what if the market is rigged, it has always been rigged! This was the reaction of The Reformed Broker blogger Josh Brown, FT Alphaville and, really, me (see above).
Truthiness Grade: B+: As Brown and FT Alphaville pointed out, the guys who gathered under that buttonwood tree in downtown New York in 1792 and formed what would eventually be the New York Stock Exchange did not do so out of any sense of charity. They did it because they could make a Ye Olde Fucktonne of money monopolizing the trading of stocks. Throughout the decades, market specialists of the human variety squeezed rents out of the market that were often more egregious than what the high-speed traders do.
So why does this reaction not get a Truthiness grade of A? Because the near-permanence of a bad thing -- herpes, say, or the New York Mets -- does not necessarily make it acceptable.
Claim: Bah, this is old news! The Wall Street Journal has been writing about this stuff for years. The WSJ's Scott Patterson wrote his own book nearly two years ago, Dark Pools, which made pretty much the same case Lewis is making. The hero of Lewis' book, Brad Katsuyama, called Patterson's book a "Must Read."
Truthiness Grade: B+: It is indeed quite old news. So old, in fact, that slowpoke regulators have already gotten around to launching years-long investigations into some of high-speed trading's shadier practices. Nearly a year ago, Bloomberg Businessweek declared the robots had lost, that flash trading was in retreat along with profits. It is telling that the vampire squid itself, Goldman Sachs, has joined other Wall Street banks and hedge funds in getting on the right side of history to back Katsuyama's new exchange, IEX, which purports to make it impossible for flash traders to skim money on trades.
But just because high-speed trading is old news, and even if it is in retreat, that doesn't mean we shouldn't shine a light on its worst practices and try to fix them. Then Goldman and the hedge funds and the flash traders can find a way to work around the reforms, and the cycle of life continues, hooray.
Claim: So what if the market is rigged, high-speed trading doesn't hurt the average investor. This was the reaction of New York magazine's Kevin Roose and, again, me.
Truthiness Grade: C+: High-speed trading mainly hurts the other traders who are competing with the high-speed traders. If you quietly invest in low-cost index funds and aren't trying to make a killing in the market, then high-speed trading is not a problem for you. I'm finding it difficult to work up very much outrage about hedge funders like David Einhorn or the artist formerly known as SAC Capital -- two of the flash-trading "victims" mentioned in Lewis' book -- losing money on trades. Individual investors trying to day-trade against these firms, meanwhile, are like windsurfers taking on the U.S. Navy's Third Fleet. Michael Lewis has done those people a great service by reminding them that they are hopelessly outmatched.
So, again, why no A+ for this reaction? Because not everybody is investing quietly in low-cost index funds. A lot of us are, by accident or design, invested in actively traded mutual funds. Institutions might be eating the extra costs of high-speed trading or starting to use countermeasures like IEX. But these costs could be getting passed on to you, the consumer.
And more importantly, we still don't fully understand the potential for market disruption (the bad kind of disruption, not the Silicon Valley happy kind) high-speed trading can cause. It has already led to scary flash crashes and botched IPOs, which have already caused investors to lose faith in the capital markets, surveys have shown. That is generally not healthy for the economy.
Claim: High-speed trading is a net good for the markets and the economy. You can't make an efficient market without breaking a few Facebook IPOs.
Truthiness Grade: C: High-speed trading has lowered trading costs, even if it does still extract some cost. You could argue, as Bloomberg View's Matthew Levine did, that it makes markets more efficient. A stock price is whatever the market says it is, even if that price changes a zillion times per second.
But as Lewis notes, we also need to consider the costs to the economy of some of our best and brightest minds working on how to milk a little bit more money out of stock trading instead of on stuff like cold fusion or flying cars.
There's also a potential cost here of making our markets even more complex and more opaque, as Quartz's Matt Phillips pointed out. Financial innovation is always awesome right up until the time it stops being awesome, at which point it occasionally destroys the economy.