Flash Boys

It’s a great book by Michael Lewis about High Frequency Trading. It took me ages to start reading it, and I regret it because once open, you barely can’t stop reading.

It always seems easier to me to start with an example, so here’s what was happening before HFT: let’s say you’re a trader and you want to buy stocks. On your computer, you can see stocks available and their prices. Let’s say you want to buy 100 shares of XYZ that are available on the market for $10 each. You press enter, and it’s done.

One day, trader Brad Katsuyama discovers that when he tries to buy 100 shares for $10, it no longer works. The system cannot fulfill his request. He gets 90 shares for $10, but the 10 missing shares are no longer available at $10 on the market and he needs to pay extra money if he wants to buy them.

This wasn’t only happening to Brad Katsuyama. All traders were experiencing the same weird behavior from the market. It even got worst over time, with an increasing percentage of stocks they couldn’t buy at the original price.

To understand what was happening, there are 3 factors to take into account:

  1. The market doesn’t exist as an unified place. The market is made of exchanges. When you buy 100 shares, you don’t necessarily buy them from one exchange only. Your order can be fulfilled by several exchanges: one will have 15 shares, the second will have 30 and a last one will have 55, so you get 100 at the end.
  2. Exchanges are no longer these floors with lots of people and lot of noise, like in the 80s. Exchanges are digital now. Exchanges have servers, where transactions happen. And these servers are hardware devices. They physically exist, and as a consequence are located somewhere.
  3. There’s a law in the US which enforces brokers to buy the cheapest stocks first. As a broker you can’t buy 100 shares at $10 if at the same time there are cheaper options. You’ll start buying at $9.99, and once no more share is available at this price, you can buy for $10.

Based on this, some companies decided to get rid of the old telecom network and to build their own optical fiber network from New-York to Chicago. Their goal was to get a latency way better than what brokers were having. Say hello to HFT firms.

Now let’s get back to our example to understand what happens.

Before HFT, when Brad clicks enter on his keyboard to buy 100 stocks, the order is spread through wires. The signal arrives first to the closest exchange, which means the closest server, where he can buy 15 shares. The signal goes on, until it reaches the server of the second exchanges and buys 30 shares, and continues until the 3rd server where it buys the last 55 shares. As humans, it seems to us that all of this happens at the same time, because all of this take less than a second to be performed. But we’re wrong. There is an order in which things take place.

Now, with HFT, when the signal reaches the first exchange, it turns out that HFT is the first entity it will have to buy from, because HFT companies have small amounts of stocks priced just below the market they use as baits. They take advantage of the regulation to know that you are interested in buying 100 shares, so at the same time that they’re selling to Brad 1 or 2 shares, they send their own signal to buy 85 shares to the other exchanges. Thanks to the speed of their network, their signal reaches the second and third exchanges before Brad. When Brad arrives, the shares are no longer available at the original price, and he ahas to buy them for more.

HTF companies never took no risk on the market. They could simply not lose. One guy’s testimonial is crazy: over 3 years, he said there wasn’t a single day where they’d lose money. And though the advantage they had could seem unfair, it wasn’t illegal at all.

I hope you understand that this is really a basic abstract. The book goes deeper than this. But at least you get the point with HFT.

What I think Ill remember from this is how, when it gets to digital, we tend to forget the physical world.¬† I often smiled seeing stickers saying “There’s no cloud, it’s someone else’s computer”. We’ve got kind of the same idea here, with a more dramatic background I guess. Also, and though they are depicted as the baad guys, I must admit Im impressed by how smart the HFT guys had to be to come up with their idea in the first place.

 

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