Monday, August 5, 2013

Michael Lewis On High Frequency Trading and Goldman Sachs

It is always pretty easy to recommend any article or book that Michael Lewis writes.

Starting with Liars Poker, Lewis's insightful and sometimes funny look at his time trading mortgage-backed securities with Salomon Brothers, Lewis has produced a series of well-written articles about the sometimes arcane world of Wall Street.

This month's Vanity Fair carries a lengthy article written by Lewis about Serge Aleynikov, a computer programmer who worked for a time at Goldman Sachs helping them develop their high frequency trading capabilities.

As the article relates, Aleynikov attempted to leave Goldman to work for a small quantitative hedge fund.  However, Goldman claimed that he was stealing proprietary software, and enlisted the help of the New York attorney general to prosecute and eventually jail Alevnikov.

It's a long article, but I think it is well worth a read by anyone trading in the securities market today.

Besides the story that Lewis relates about Goldman's zeal in going after its former employee, Lewis also gives us a front row seat into the world of high frequency trading, where trades are executed within nanoseconds, and competition is based on algorithms and speed.

Here's an excerpt:

The fragmentation of the American stock market was fueled, in part, by a rule created in 2007 by the S.E.C. The rule, known inelegantly as Reg NMS, was designed to protect investors from their brokers. Instead it wound up creating, as such rules often do, new ways for brokers to abuse their clients. Reg NMS requires stockbrokers to route their clients’ orders to whichever exchange offers the best price. For example: if you tell your Goldman Sachs broker to buy a million shares of Apple, and Apple shares are being offered at $400 a share on NASDAQ and $401 inside the Goldman Sachs dark pool, Goldman is now required to send your order first to NASDAQ. (You might think that brokers might do this naturally to please their clients. Think again.)

For reasons not entirely obvious (yet another question for another day), the new rule stimulated a huge amount of stock-market trading. Much of the new volume was generated not by old-fashioned investors but by extremely fast computers controlled by high-frequency-trading firms, like Getco and Citadel and D. E. Shaw and Renaissance Capital, and the high-frequency-trading divisions of big Wall Street firms, especially Goldman Sachs. Essentially, the more places there were to trade stocks, the greater the opportunity there was for high-frequency traders to interpose themselves between buyers on one exchange and sellers on another. This was perverse. The initial promise of computer technology was to remove the intermediary from the financial market, or at least reduce the amount he could scalp from that market. The reality has turned out to be a boom in financial intermediation and an estimated take for Wall Street of somewhere between $10 and $20 billion a year, depending on whose estimates you wish to believe. As high-frequency-trading firms aren’t required to disclose their profits (with the exception of public firms, like Knight, which have disclosed profits in the past), and big banks like Goldman that engage in the practice are assumed to hide their own profits on their balance sheets, no one really knows just how much money is being made. But when a single high-frequency trader is paid $75 million in cash for a single year of trading (as was Misha Malyshev in 2008, when he worked at Citadel) and then quits because he is “dissatisfied,” a new beast is afoot.

Vanity Fair also carries a separate interview with Michael Lewis mostly about the characters in his story, but also his take on high frequency trading:

Critics say it has become more volatile. Who exactly is hurt by the competitive advantage offered by high-frequency trading?

It’s essentially a tax on productive investment, and it’s a tax that’s largely unnecessary. The reason people aren’t more outraged about it is that the cost of financial intermediation in the stock market—the old-fashioned stockbroker system—has gone down because of the technology. There is this whole separate question, which I’m actually not prepared to answer right now: has it introduced new instabilities in the markets for which we all pay a price? I suspect so, but I don’t know. What I know is not true is that high-frequency trading provides liquidity.

There’s a line in The Big Short; one of the characters, who was cynical about the subprime-mortgage market, says, “When I hear Chinese Wall, I think you’re a fucking liar.” I feel that way about liquidity. When I hear the word liquidity, I think you’re a fucking liar. If this is liquidity, we don’t need it.