There are good books that make you think differently about the world, and occasionally great books that really make you question the underpinnings of what you think reality is. I believe the new Michael Lewis book, “Flash Boys,” falls into the latter camp.
The new book might be Mr. Lewis' most audacious, scary and infuriating work. For me, it might be his most impactful. I read the book cover to cover on a recent transcontinental flight. At times it felt like I was reading George Orwell's “1984”; at others it felt uncomfortably like I was reading a hidden report about the Watergate scandal. It gave me knots in my stomach. This is an important work that will create debates and re-open the barely healed wounds of the public's trust in the world's capital markets and its participants.
I have been thinking about the implications and lessons that this carefully documented account of high-frequency trading — and the institutions that participate in it — offers. The subject matter might sound obtuse and boring, but the impact for all of us might be more important than the packaged mortgages of a few years ago. Here are some of the important ideas I took from this book:
1. Bad incentives lead to bad actions
We are just a few years removed from the mortgage collapse created by dangerous investment products sold by participating banks to investors around the world. You would think we would have found some way of ensuring that the system of checks and balances that keeps markets fair and honest would have kicked in more effectively by now.
Unfortunately, throughout the book we are reminded that people will do what they are paid to do, and if they can make more by doing more of it, they will do so. Eventually, even good people learn to not ask the tough questions when their livelihood is on the line. Our regulators can hardly keep up with the innovation occurring at breakneck speed. Even when it's obvious to many that bad things are happening, it's hard to dismantle the status quo because there are so many conflicting interests. Only the end consumer, the voiceless investor, is left without a say.
2. Risk is not equally distributed
Mr. Lewis shares a couple of examples where some of the high-frequency trading firms have gone hundreds of days without a single day of losses (to be fair, one firms acknowledges they had one day of losses out of 400). That is logically impossible in a fair and open market. Outsized rewards require some level of risk-taking. As any market maker prior to 2006 would demonstrate, the reason the big firms paid huge amounts to outstanding traders was that they were good at managing the losses. The big banks had to take positions and sometimes they lost. It's clear that these new firms are making billions of dollars and not ever losing money, and closing out all their positions at the end of each day. The risk has gone to someone else, but who? In this case the risk and cost have gone to all of the folks who actually want to buy and own the stocks for longer than a second.
As any of us entrusted with client assets has seen over the past few years, the intraday swings are big, inexplicable and very different to anything we have ever experienced. As much as half of all the daily volume in the markets is going to these high-frequency traders that will not own the stock for even one second. They make more money if the market is volatile. They help create more turbulence. This should concern all of us operating as fiduciaries for our clients.
3. The computers might already have taken over
Perhaps the scariest part of this book was coming to the realization that most of the decisions are being made automatically by machines with no judgment or conscience — that lack of conscience allows people to act in ways that none of us would condone because they aren't doing it, the machines are. The disintermediation between the actions taken by machines and the people who program the software means that no one asks what the final goal and consequence of the combined efforts might be. Bad things happen and no one knows who to blame.
Mr. Lewis mentions that since May 2010, stock ownership has dropped to 50% of American households, from 65%. I suspect that the average investor will use this book to justify their belief that the system is rigged. “Flash Boys” will disturb you and frustrate you, but it might also give you hope that it only takes a few people with integrity and decency to shine a bright light and change the system. In the meantime, it's up to those of us who are aligned with our clients' best interests to help them get past their fears, find the truth and make the right choices.
Joe Duran is chief executive of United Capital and author of “The Money Code: Improve Your Entire Financial Life Right Now." Follow him @DuranMoney.