Author Michael Lewis’ newest book, Flash Boys: A Wall Street Revolt, topped The New York Times bestseller list a week after release, and a screen version is rumored to be in the works with bigwig film producer Scott Rudin, whose long list of credits includes There Will Be Blood, The Girl with the Dragon Tattoo, and Lewis’ book about the Oakland A’s, Moneyball.
Flash Boys explores the world of high-frequency trading, a scheme in which traders use ultra-fast network connections to sniff out the intentions of other, slower traders, thereby acting before others can respond. Critics of the practice--Lewis chief among them--argue that high-frequency trading creates something akin to insider trading: a predatory environment for less advantaged investors. WIRED spoke with Lewis at an event organized by Live Talks in downtown Los Angeles.
WIRED: The central character in your book, Brad Katsuyama, calls today’s stock trading system "a Pandora’s box of ridiculousness." What does he mean?
Lewis: Right now there’s vast amounts of financial intermediation that doesn’t need to happen. You have technology innovation being dreamed up to create misunderstanding, to create an advantage for insiders. What’s going on in the stock market is a reprisal of the madness that preceded the credit crisis, where you had people dreaming up instruments, like collateralized debt obligations, not to make the risks in our financial system more transparent, but to obscure them.
>All of the balances of the industry, except their volumes in the stock market, are bunk.
The characters in this story are different from Wall Street characters I’ve had before. You can almost argue that all three books that are about Wall Street—Liar’s Poker, The Big Short, and Flash Boys--are about a character trying to figure out how Wall Street works. In the first book, it’s me, working at Salomon Brothers, and in The Big Short it’s these guys who figure out that the subprime mortgage market is a fraud. In this case, it’s a guy, Brad Katsuyama, who thinks of himself, rightly, as a professional in the stock market. He runs the institutional stock market trading department of the Royal Bank of Canada, yet he realizes he does not understand how the stock market works. It requires an investigation of years for him to assemble a picture of the market.
WIRED: It’s surprising in the world of Wall Street that Katsuyama has support from his organization to investigate. The Royal Bank of Canada says to him, ‘You want to figure out what’s going on? Take up to $10,000 a day, lose it, and use that to figure out what’s going on here.’
Lewis: There’s no way Brad Katsuyama is the first person to figure this out. He’s just the first person to care to explain it to other people. Why is he able to do this in the first place? Why is he able to be good in an environment that’s not so good? The first answer is where he happens to be situated, which is at the Royal Bank of Canada. It’s unlike any other institution on Wall Street. It’s a horrible stereotype, but they want everyone to be nice. They have a ‘no assholes’ rule on the trading floor, which is the opposite of every other Wall Street trading floor, where they have a pro-asshole rule.
WIRED: He’s a good guy.
Lewis: He’s Canadian. He is genuinely shocked by American finance. It created problems for me as a writer: you want a main character who’s not nice. When I got into the middle of the story, I was reminded that when I worked at The New Republic, we used to have a boring newspaper headline competition. Every week we’d have readers send in the most boring headlines they could clip out of their newspaper, and we’d print a winner, and then at the end of the year we’d have a competition of the most boring of the most boring. And the winner the first year was, “Worthwhile Canadian Initiative.” And I thought, I am writing a book -- a whole book! -- about a worthwhile Canadian initiative.
WIRED: You do have some villains in this book; it’s just that they weren’t willing to talk on the record.
Lewis: There are several. This story is the Brad Katsuyama story; that’s the book I’m writing. But when you write that book, to do that responsibly and properly, you need to know the other side of the story. So I interviewed two dozen high-frequency traders, but very little of it finds its way into the book because very little of it is relevant to Brad’s quest to understand. The world he is investigating -- which is now the main intermediary of the US stock market -- is unbelievably secretive. The firms don’t know what each other are doing; nobody knows how much money anyone is making. All of the balances of the industry, except their volumes in the stock market, are bunk. People just make up numbers. The closest reliable estimates of what they’re making come from Brad Katsuyama. But the other part of the story is basically un-gettable in a full and satisfying way. You’ll get stuff when you talk to people off the record, but when you’re talking to people on the record, what you get is a lot of misinformation.
WIRED: I saw William O'Brien, who's the head of the BATS exchange...
Lewis: The well-named BATS exchange.
WIRED: ... complaining on CNBC that this book essentially a 300-page commercial for Brad Katsuyama. Some claim* that you are an investor in IEX, the exchange that Katsuyama founded.
Lewis: That was the first thing that people said. A bank circulated a memo saying that Michael Lewis has an undisclosed stake in IEX. I do not have an undisclosed stake in Brad. I'm not insane! It's insane.
WIRED: There was quite a debate about this.
Lewis: CNBC’s Power Lunch show had Brad Katsuyama, the founder of this fair exchange, and beside him was O’Brien, the head of an exchange founded by high-frequency traders, on which all types of predatory activity happens. It was a shoutfest. This guy went berserk. He started throwing around charges that were just false. Two things came out of this that were riveting. One was, as they argued, the people at the New York Stock Exchange just stopped doing what they were doing. They just stopped. This was the most-watched show in the history of CNBC. I had descriptions from inside trading firms saying that there were a thousand people at trading terminals just looking at the television sets, not answering their phones. And the guys at the New York Stock Exchange would start to cheer whenever Brad Katsuyama said something.
The best story is from Goldman Sachs, which is an investor in the BATS exchange. A guy in their equity department told me he was standing next to someone who said, “So the angry guy, we have a stake in his exchange?” And the first guy said yes, and the second guy said, “And the little guy, we don’t have a stake in his exchange?” And the first guy said no, and the second guy goes, “We’re fucked!”
The substantial shocker from this encounter is that Katsuyama tried to get O’Brien to admit that the BATS Exchange uses one very slow data feed to give investors the prices in the market, while selling, for vast sums of money, a faster feed to high-frequency traders, the effect being that the high-frequency trader knows the prices in the exchange before your order. So he has the privilege of trading against you at an old price if he wants to. And O’Brien says, no that’s not true. He lied, on national television, about a central fact about his business. And they had to apologize.
WIRED: They had to issue a correction.
Lewis: They had a correction. The exchange apologized on behalf of the president. I felt like I was watching a moment in financial history, I really did. Poor Brad Katsuyama, the mild-mannered worthwhile Canadian initiative. He isn’t erratic. In spirit, he’s kind of like a hobbit. He doesn’t want trouble; he doesn’t want to leave the shire, but he gets pulled, and all of a sudden he’s in the middle of Mordor.
WIRED: He kept his composure pretty well; O’Brien was getting in his face and you almost thought they were going to come to blows.
Lewis: To finish answering the previous question: I made a point of not naming a single high-frequency trader in the book. The reason is that everyone is a bad actor. There’s an ecosystem that has risen up around a broken pipe on Wall Street. You have high-frequency traders who are scalping the market. They pay exchanges for the tools they need to scalp investors; the exchanges pay banks to essentially mishandle the stock orders so high-frequency traders can maximize the take. It’s a system designed to extract taxes from investors.
The story I’m telling is a man figuring out how a system works. He’s not trying to destroy any single person; he wants to bring down the system. It’s a man versus system story. The minute you take one high-frequency trader or one exchange or bank and make them the example, you create the likelihood that someone gets blamed. So I intentionally left the villain faceless, and into that vacuum walks this jerk from the BATS exchange who presents himself as a cartoon villain. Someone should have advised him: ‘Michael Lewis’ book is a very devastating portrait of our business, but he hasn’t actually fingered anybody in particular. If you lay low, maybe it will pass. Don’t stand up and make an ass of yourself and be the first person anybody sees.’
>The people at the New York Stock Exchange just stopped doing what they were doing. They just stopped. This was the most-watched show in the history of CNBC.
WIRED: The solution Katsuyama’s team comes up with is surprising: Traditionally when someone is beating you, your thought is, go faster. But IEX does precisely the opposite. On 60 Minutes Steve Kroft described this as “beating speed by slowing it down."
Lewis: Katsuyama figures out that there’s a new predator in the market, and he’s the prey. All of the predatory strategies he identified require a high-frequency trader to be faster than the exchange he’s trading on. He’s not going to be able to reform the system from the Royal Bank of Canada; a bank is too small a part of the market. So he leaves his millions of dollar a year job to create a stock exchange with a bunch of other people who leave their millions of dollars a year jobs. They’re paying themselves $2,000 a month out of money they put into the company, which doesn’t happen on Wall Street.
It’s a Silicon Valley story in the middle of Wall Street. That doesn’t happen because people get paid too well to take that kind of risk; the incentives are all wrong. And not only is it an act of disruptive entrepreneurship, it's an act of disruptive entrepreneurship that is pointedly insulting to the whole industry. So he's going to war with his industry, and all he is is a worthwhile Canadian initiative. He's just Frodo. He doesn't want to be out there this way.
WIRED: So what does he do?
Lewis: The answer is to coil 60 kilometers of cable between every high-frequency trader and Katsuyama’s exchange. So the high-frequency trader can find out what’s going on in the market before other participants in the stock market, but they can’t react to what’s on IEX fast enough to take advantage of it. It’s the only exchange that takes the responsibility of protecting the investors’ orders on the exchange, and it does so by slowing down the high-frequency traders.
What high-frequency traders do in other markets is get as physically close to the box that’s the stock market matching engine, and they pay vast sums of money for feet of difference. With IEX, it’s as if they’re in Long Island instead of northern New Jersey. The effect on the market is imperceptible; it slows them down just a few hundred microseconds. This doesn’t disrupt the market in any way; it just means they can’t frontrun it.
WIRED: The other problem is that investors don’t know which exchanges are handling their orders.
Lewis: That’s right. Katsuyama has produced the evidence that big investors are being ripped off. Then he has to seize control of their stock market orders so that the banks and the online brokers can no longer deliver them on a platter to high-frequency traders. So this is the bigger part of the story, this war. He’s created this war between two great forces in American money: investors and the middle men who handle the money. And the banks and the brokers are terrified and angry at the same time.
WIRED: If one of the current exchanges tried the same strategy, people wouldn’t have trust in that exchange.
Lewis: Correct. Trust is the heart of the story. How does the mild-mannered Canadian end up being the person that the biggest investors in America want to talk to about how the stock market works? Why is he the messenger? Because he’s actually trustworthy and there’s a total lacking of trust.
>He's going to war with his industry. He's just Frodo. He doesn't want to be out there this way.
There are many examples of big institutional investors saying, ‘I want my stock order to be sent to Brad Katsuyama’s exchange,’ and the bank says ‘yeah, yeah, yeah we'll do it,’ and then not doing it. And that's actually against the law. Laws are being broken right now to prevent this exchange from getting off the ground. The book ends before the war's over. Really, the book ends with the war breaking out in some ways.
WIRED: The SEC has been looking into high-frequency trading for a long time. Now the FBI and New York attorney general are on the case. What degree of confidence do you have in these regulatory or law enforcement bodies to solve this problem?
Lewis: Very low. Very low. The big problem is that Wall Street makes so much more money than the person who works at the SEC. This point was made by a retiring prosecutor at the SEC a few days ago in a goodbye speech. He said, this place is broken because everyone here would rather be working at a Wall Street firm and making more money. The Royal Bank of Canada commissioned a study that found that previous three years, something like 200 employees from the SEC had gone to work for high-frequency traders or lobbying firms run by them. There was your problem in a nutshell.
If there is public pressure brought on the problem, the SEC will do something. But then that becomes another problem: they might do the wrong thing. And the worst thing that could happen is they introduce a half-assed regulation that seems to fix the problem, but just creates another system to game. What I love about this story is you don't need them. Just get out of the way and let the market fix it — just make sure the market's transparent. Make sure investors can see that people can see how the banks are handling stock orders, and punish people for lying and everything else will take care of itself.
*An earlier version of this article misattributed this claim to BATS. The allegation was made on air by a CNBC moderator, and the post has been updated accordingly.
