The long and short of algos

The Flash Boys by Michael Lewis exposes the practice of high frequency traders (HFTs) in the US, and how they allegedly rigged the financial markets for undue gain. In a world where orders for the trading of securities are executed through complex computer systems and matched electronically, HFTs appeared as a breed to benefit by undertaking certain technological advancements. Lewis says that the usage of high-speed fibre optic cables is what led to the rise of new breed of traders.

The plot centres around certain HFTs moving closer to exchanges and employing complex computer algorithms. This is done with an objective of receiving trading orders a split second ahead of the rest of the market and then trading based on this unequal receipt of information for gain. The book looks into a series of investigations by the US authorities into the practice of HFTs. However, recently, one of the larger investment banks obtained a reprieve from the US district court at Manhattan for the alleged market rigging by HFTs.

The district judge made a statement in relation to the allegations set out by Lewis in the book — “Lewis and the critics of HFT may be right in arguing that it serves no productive purpose and merely allows certain traders to exploit technological inefficiencies in the markets at the expense of other traders. They may also be right that there is a need for regulatory or other action from the SEC or entities such as the exchanges and Barclays. Those, however, are debates and tasks for others.” 

The other issue that Lewis alludes to in the book is the usage of dark pools by the larger investment banks in conjunction with the exchanges and HFTs for alleged unlawful gains. Dark pools are marketable asset pools maintained by the large investment banks. What is noteworthy is that the trading of dark pool assets took place behind an opaque screen. In other words, trades were conducted privately by the exchanges and trading information was not made available to the general public.     

The larger issue that Lewis focusses is the increasing dependence on technology and how it can be tweaked for unfair gains. Using technology, these HFTs managed to eliminate the risk attributed to trades. The element of chance associated with an investment decision, which as per law should be based on publicly available information about the securities’ issuer, is done away with high frequency trading. HFTs base their investment decision on the unequal receipt of information ahead of the market, thereby making a trading gain infallible.

Even though there is an over arching moral breach in which high frequency trades were executed, the US regulators have struggled to establish a breach of insider trading and other regulations relating to market rigging and manipulation in relation to trades by HFTs. The book is a must read for those interested in global markets as it provides a fascinating insight into the modus operandi of how the HFTs allegedly rigged the financial markets.