Locklin on science

Michael Lewis: shilling for the buyside

Posted in finance journalism, microstructure by Scott Locklin on April 4, 2014

Journalism, in the ideal world, is supposed to inform the citizenry of facts important to their well being. Modern journalism seems to involve issuing press releases from the oligarchical reptiles who are destroying Western Civilization. Maybe I am a naive fool, and it was always thus. Either way, Michael Lewis’s latest book lends credence to the view that he is a very modern journalist.

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lookin a bit scaly, bub

Lewis’s book purports to be about high frequency trading. He manages to write several hundred pages of gobbledeygook without actually speaking to a High Frequency Trader (unless you count his incongruous encounter with poor Sergey Aleynikov ). The story Lewis actually tells is one of incompetent sell side traders who started an exchange which serves the interests of wealthy buy siders and shady brokers.

Brad Katsuyama is the hero of the book. Lewis’s recent books use the dreary trope: the band of clever and plucky outsider misfits who take on the establishment. Katsuyama’s misfittery is he’s an Asian who is good at sports, bad at math and computers; and even though he worked for a Wall Street bank, he went to a crappy Canadian school instead of Yale-vard. Among his misfit sidekicks are a potato-wog who is good at network ops, but who could never get a break on the street (I can relate). Also, a fat grouch from Brooklyn, a computer genius, a puzzle wizard and a few other guys who fade into the woodwork. They worked for RBC: a Canook bank which is supposedly the least Wall Streety place on the Street.

The plucky outsiders in this story are not portrayed in a particularly flattering way. In fact, they come off as  dimwitted incompetents. Katsuyama was an old school block shopping sell side trader. If you remember my previous pieces on  HFT nay sayers: Joe Saluzzi was also a sell side block shopper. Old fashioned sell side guys have obsolete jobs. Their jobs are to find liquidity for “buy side” customers buying into or liquidating a large position. Katsuyama’s anger at the idea that “the market is rigged” seems the simple rage of a man who has been assigned a task he is not qualified for. There are tales of he and his team wasting hundreds of thousands in RBC money executing bad trades to see what happens. They seemed shocked, shocked, that the market would move away from their ham-fisted dumpings of huge blocks of shares to someone else’s routing system.

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Lewis keeps going on about how “nobody understood” any of this back in 2009, except for his plucky outsider heroes. If “nobody” understood it, how was I was able to write about it on my blog in 2009? Over 100,000 people read my various blogs on HFT that year.  If you were not among the elite group of more than 100,000 insiders who read blogs, any punter could have purchased the Larry Harris book “Trading and Exchanges” available on Amazon.com for $71.58 + tax. This is how I originally clued myself in (thanks FDAX-H). Larry’s book was published in 2002.  In early 2010 Barry Johnson published the book, “Algorithmic Trading and DMA” which explains the profession dedicated to getting a good fill on the modern electronic trading landscape. So, in 2010, there was not only a  job description, “algorithmic trader,” for getting a good buy-side fill, there was also a “how to” book on the subject.  Such people perform the function that used to be done by sell side people like Katsuyama and Joe Saluzzi. Lewis repeatedly states that this was a mysterious topic and nobody was talking. Actually, it is an extremely well understood topic;  library shelves groan with volumes dedicated to the subject.

No books were really needed; history and experience should suffice. Back in the days of pit traders, if you threw a huge order at the pit, you might get a fill on a couple of round lots. The rest of the pit is going to change their prices, because they figure anyone swinging 10,000 or 100,000 share orders around must be informed traders. If they’re informed traders, they need to pay for their immediacy. Informed traders may be criminal insider-trader creeps,  they may be people with really good trading strategies; it doesn’t matter -they’re informed somehow: they know stuff. If the market maker doesn’t adjust their prices in front of an informed trader, the market maker will go bankrupt. That’s market economics 101. As I previously described it in 2009 in the Three Stooges of the High Frequency Apocalypse;

What happens when you buy something? …  If you want it for cheap, you sit around and look at different markets (ebay, amazon, craigslist) until someone displays a price you find acceptable. If you want that “something” right now, you drive to a store and buy it. You’ll almost certainly pay a little more at the store, because they need to make enough money to pay employees to prevent barbarians from stealing everything, and to keep the lights on and other such things for your convenience. You can also generally return what you bought to the store much easier than to ebay or amazon. You’re paying for the immediacy (buy it now!) and liquidity (buy as many as you want!) provided by the store. This is a service which costs money.

Immediacy costs money. Markets have always moved prices away from large orders. Market participants  have always been able to cancel or move a limit order. That’s one of the features of the limit order. If  Katsuyama didn’t understand these simple facts, he had no business collecting a $2 million a year paycheck shopping blocks for his customers, because he didn’t understand the basics of his profession. It’s  possible that Lewis simply misunderstood something Katsuyama explained to him. It’s also  possible that Katsuyama is a shark who told Lewis a lot of bullshit to get good press for IEX.  This leaves only two possibilities: either Lewis is a credulous idiot who is not competent as a journalist, or Katsuyama is an idiot who was not competent as a trader. Take your pick.

 

CBOTpit1900-GB

They made their money trading flow as well

Where it gets interesting is where Lewis claims bigshot buysider crybabies like Loeb and Einhorn  never heard of any of this. They made it sound as if, back in the day when Loeb and Einhorn were paying 1/8 of a dollar spreads to knuckle-dragging pit orcs, no rock-ribbed he-man trader with 10lbs of undigested beef in his lower intestine would would dare move his price away from where Loeb and Einhorn wanted it. Why, moving the price away from a big order: that’s un-American!

So … these “plucky underdogs” helped Katsuyama form a new stock exchange, IEX. They claim that no sort of nefarious activity is possible on IEX, because, well, “trust us!”  Liquidnet’s average cross is 45,000 shares; over 100 times the vaunted liquidity figures provided by IEX.  If I traded stocks, why should I trust IEX over Liquidnet? Because Michael Lewis says they’re honest guys? If I believe the tales of Michael Lewis, the founders of  IEX are a collection of “traders” who do not know how to trade, and the market itself is owned by … buy side traders. He seems to give IEX sloppy wet kisses for honesty, yet sees nothing wrong with the fact that they’re owned by a bunch of buy side guys. They’re also owned by some unknown buy side guys, which does not inspire confidence. Buy side guys, if they’re good at their jobs are informed traders.  Nobody wants to trade against informed traders. Everyone wants to trade against noise traders.

cbot1929

IEX  has simple order types; limit, midpoint, fill or kill and market: I  approve of this. On the other hand:

“IEX follows a price-priority model first, then by displayed order second. Then comes broker priority, which means a broker will always trade with itself first, which Katsuyama described as “free internalization.” He explained that brokers do not pay IEX to trade should an order be matched against another order from that same broker. This, he added, offers brokers incentive to trade in IEX.”

Hey now, wait a minute. Internalization and broker priority is pretty much the same thing as dark crossing, which Lewis was trying to tell us was bad. Now it’s supposed to be OK when Goldman does it?  Later, Lewis actually quotes Katsuyama saying there were only a few brokers acting in their customer’s interests:

“Ten,” Katsuyama said. (IEX had dealings with 94.) The 10 included RBC, Bernstein and a bunch of even smaller outfits that seemed to be acting in the best interests of their investors. “Three are meaningful,” he added: Morgan Stanley, J. P. Morgan and Goldman Sachs.

I think this is the crux of this story: according to Michael Lewis and Katsuyama, we’re supposed to trust people like Einhorn who have been convicted of insider trading, people who are suspected of insider trading (buy side is by definition rife with this; particularly firms that do merger arb and special events), J.P. Morgan, Goldman and Morgan Stanley: we’re supposed to trust these guys more than we’re supposed to trust a bunch of tiny little market making firms who had been inconveniencing them by taking away some of their flow. Lewis tries to make this seem like a battle between the underdog “good guys” and the evil establishment. To believe this, you’d have to believe that Goldman Sachs and people like Einhorn are underdogs, rather than the actual establishment. To believe this, you’d have to believe the tiny industry of HFT traders actually rules the world and buys off congressmen and the SEC more than … J.P. Morgan and Goldman.

To give you a sense of scale: the largest HFT firm I know of, KCG, has operating cash flows of $140 million a year and a  modest market cap of $1.4 billion (betcha didn’t know it was a publicly traded company: Lewis certainly doesn’t mention it). JPM has operating cash flows of  $100 billion a year, almost a trillion on the balance sheets, and a quarter trillion or so in market cap. David Einhorn is personally worth $1.25 billion dollars. KCG’s entire market cap is only slightly more than that, and it employs 1200 people. Yet, somehow the HFT firms are the evil establishment, and JPM and Einhorn are … the plucky underdogs standing up for truth, justice and market makers not changing their quotes when some reptilian oligarch dumps 200,000 shares of YoyoDyne on the market.

Yeah, I might believe that. I might believe that if I were a dribbling retard.

they-live-16

Put down Lewis’s book; read one by Bernays

Doing a bit of investigation into who owns IEX: we have the $13.2 billion  activist shareholder fund Pershing Square, owned by Bill Ackman, another “underdog” worth $1.2 billion. We have the $6.7 billion Senator Investment Group. Scoggin Capital is only worth $1.8 billion; they do distressed debt and mergers, and have managed to only have one down year in 25. Another investor is venture capitalist  Jim Clark, net worth $1.4 billion. He is particularly noteworthy as being a pal of Michael Lewis, and almost certainly the guy who made the introductions to the “flash boys” at IEX. Brandes Investment Partners is an old $29 billion AUM politically influential money management firm doing value investments, and is run by another billionaire. Third point, a hedge fund with $15 billion, also working in special situations aka “distressed debt and mergers,” run by  Danny Loeb (who also miraculously has only one down year). Another investor in IEX is a little place called  Capital Group Companies, one of the biggest buy side investors in the world, with $1.15 trillion AUM. Capital Group has been more or less scientifically proven to be one of the most powerful and influential corporations in the world.

You get the idea: IEX is not owned by plucky underdogs. It is owned by very rich and powerful “buy side” people. People who find the present system of liquidity provision inconvenient.  Buy side has always found liquidity providers inconvenient; they had to pay old school “sell side” traders like Katusyama to work the trades for them at the very least. There wasn’t much they could do about it until now. Now that they own  almost everything, they can open their own damn stock exchange and buy some cheap brokerage flow. That and unleash Michael Lewis, the FBI and New York Attourney General on the peasants who make them pay for liquidity.

TheyLive1

IEX … little investor… blah blah blah

I  don’t think IEX and their investors represent the interests of “the little guy” at all. The actual little guy (aka people like me) does pretty well making small orders with the present system. If you  believe Lewis’s book, the thing we’re supposed to be worried about is telegraphing a big buy or sell by routing  your order to several different exchanges. The thing is, “the little guy” doesn’t make large buy or sell orders, and unless he does, what Lewis describes is impossible. The people IEX benefits are exclusively preposterously wealthy buy side people. That and the brokerages who get to trade against the pieces of their flow that they want. Pardon me if I notice that such people aren’t exactly tribunes of the people. What’s actually going on here is the brokers are, as usual, taking the flow. They’re giving up some of the leftovers to the buy side guys, who also pocket the exchange fees. If you’re worried about flow or think the present system of liquidity provision is somehow predatory: this is a buzzard and a hyena sharing a carcass.

I have no dog in this race: I’m not a HFT, I have never taken a dime from any exchange, and I haven’t so much as executed a stock trade in 4 years.  Everything I’ve read, and all the traders (buy side and otherwise) I’ve spoken with seem to think that HFT market makers have improved things from the pre-decimalization bad old days of pit traders who got their jobs because they went to the right New York City high schools.  I know for a fact that HFT market making as a business is nowhere near as profitable as it was even a few years ago. This is exactly what you would expect when you have lots of smart people competing in a not-so profitable business. I don’t think the use of computers makes markets any more inherently dangerous, any more than the use of computers in automobiles makes them  more inherently dangerous. If you asked me what I thought the worst thing about the present system was, it would be the profusion of weird order types. Something that IEX, to their credit, gets right.  There are actual frauds in HFT, just like there are in any other business involving money, from the Avon lady on up the food chain. The worst HFT tort I can think of is the practice of “quote stuffing.”  Lewis (of course) never mentions this, and I have read nothing which indicates IEX is ready for it.

I know a few HFT type people. One of ‘em might be even be as rich as Michael Lewis.  So far, all the ones I have met are clever and decent people, and I figure whatever they’ve managed to earn by the sweat of their brows, they deserve it. I’m not real pleased with the idea of a small group of decently paid, politically helpless nerds being the fall guys for a bunch of crooked oligarchs who don’t want to pay for their liquidity.

Speaking of which: FREE SERGEY

 

sergey-aleynikov-1.png

despite the awesomeness of his pantaloons, this man’s legal problems are a bad sign for America

 

Edit Add:
This review by a trader lists 15 more technical inaccuracies in the book. He also noticed that broker priority is shady business if we’re talking about helping “the little guy” here.

Edit Add2:

This trader gives a really great review.

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69 Responses

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  1. weltview said, on April 4, 2014 at 8:57 am

    I was waiting for your opinion on Flash Boys

  2. brucecharlton said, on April 4, 2014 at 10:19 am

    It’s a pity about Michael Lewis.

    I was really excited and impressed by Moneyball – for me it captured what *real science* is about. At that time I exchanged a few e-mails with Lewis, and he seemed like a nice guy who might be interested in the real world.

    But he was a Liberal married to an even-more Liberal and you could see which way the wind was blowing – nowadays you cannot be well known and powerful and not a Leftist – so as a Leftist becomes famous after doing some reality-orientated work, he must decide between reality-based honesty on teh one hand, and continued-further success on the other: it is a matter of either/ or.

    I don’t think ML struggled much with this decision.

    Since then, everything ML did was worse than the thing before.

    The Blind Side was a good read, but there was a dishonesty to it, a selectivity and a spin which were obtrusive. I also recall a shocklingly-bad Big Article on Iceland from a couple of years later, then of course he spent a year contributing to the BHO legend – and then obviously I stopped reading him altogether; since by that point it was impossible he could ever be trusted again (unless he was to repent, tear his hair and cover himself in ashes – which I don’t think has happened?…)

    Yet another gifted man corrupted. And if he had not been corrupted we would not be talking about him now; because he would be nothing more than a web presence whose books (coming from an obscure publisher) sold a few thousand copies at best.

    • Scott Locklin said, on April 4, 2014 at 11:03 am

      As I have said before (regarding the Iceland and German thing, FWIIW) I think Lewis is a very talented writer. He is not a very good journalist. If he could find his way out of the trap of pretending to know something about financial things, and turned himself into a Tom Wolfe type character, he could get somewhere in life. Alas, what he presently does pays well, and he has a wife and kids to feed.

      • brucecharlton said, on April 4, 2014 at 1:04 pm

        Incompetence and dishonesty are a deadly – but common – combination in journalism.

        • nitpicker said, on April 4, 2014 at 3:06 pm

          Even more common combination in politics.

      • James B. Stewart said, on April 4, 2014 at 3:38 pm

        Scott: I read your article with interest. I reviewed the book for the New York Times Book Review, so I can’t say anything more until it’s published, but I think you’ll find it interesting.
        Jim Stewart

        • Amicus said, on April 6, 2014 at 8:52 am

          I hope you, like I, was especially touched by the implication that large buy-siders were “informed”. * chuckle *

        • Scott Locklin said, on April 15, 2014 at 8:44 am

          I must say, I’ve been a fan of yours since that Liberty Valance movie, and am impressed you’re such a good writer as well.

          As pointed out elsewhere, Virtu does well because of the central limit theorem, and the fact that they are executing millions of trades a day (with some small probability of success). No mystery there. It’s a lot more suspicious when a guy makes 25 years of big/infrequent trades and only has one down year. There’s also plenty of execution risk involved: Knight did pretty well before they screwed the pooch.

          I think we can agree, though, that Lewis really needs to work the investigative part of his reporting. He’s a great writer, but it seems the man shouldn’t take on technical subjects unless he’s willing to understand the basics of what he is talking about.

    • Toddy Cat said, on April 9, 2014 at 4:07 pm

      Of course, a big part of the problem is that Lewis is addicted to a “plucky misfit underdog outsiders vs the Corrupt Establishment” narrative, and he’s also a very conventional liberal who can’t admit that almost every corrupt establishment worth going up against these days is liberal through and through, and we can’t have plucky outsiders going up against them, now can we? So Lewis has to create conservative (or at least non-liberal) “Establishments” pretty much out of thin air for his heros to take on. “Moneyball” sort of worked because there wasn’t really much of a political angle, but his aversion to taking on corrupt liberal establishments makes his work increasingly absurd. I mean, Goldman Sachs a plucky outsider? Next we’ll be reading Lewis’s take on the 1991 Gulf War , as the plucky underdog U.S. Army goes up against the mighty Iraqi Republican Fuard…

  3. […] Scott Locklin:  Michael Lews: Shilling For the Buy Side […]

  4. me said, on April 4, 2014 at 4:28 pm

    I don’t follow the HFT firms are market makers argument. Market makers are required to provide liquidity, but what are the requirements of HFT firms? It seems to me they are just toll takers and add nothing.

    • Scott Locklin said, on April 4, 2014 at 7:09 pm

      Who do you think provides liquidity these days? Grandma’s pension fund?
      While the bizarro system of rebates, weird order types and dark pools may seem sinister and ridiculous, just on sociological arguments, you’d have to believe some really bizarro shit to think that all the exchanges in the world would cater to a couple of tiny companies like the former GETCO, offering them allegedly giant piles of money for no apparent reason, because, you know, Wall Street loves to shovel money at nerds for no apparent reason.

  5. […] Is IEX really built for the ‘little guy’?  (Scott Locklin) […]

  6. Ange Purs said, on April 4, 2014 at 7:15 pm

    All the sheep are saluting an axe-to-grind blogger who by his own admission hasnt made a trade in 4 yrs. Bah bah bah.

    • Scott Locklin said, on April 4, 2014 at 7:21 pm

      I haven’t made a trade on the stock market in 4 years, dipshit. That doesn’t mean I haven’t made a trade.

      Yeah, look at my legions of sheep, Michael Lewis, and despair!

  7. Brett said, on April 4, 2014 at 9:25 pm

    what a joke you are with this review. if only you had a clue on what really happens on Wall Street. Perhaps BATS and Direct Edge along with the NYSE should decompose their revenue lines and inform the public about how they really make money. Seems only fair given they are supposed to be for the public.

    • Scott Locklin said, on April 4, 2014 at 10:23 pm

      None of the exchanges are there “for the public.” They’re all there for traders, and always have been. If you don’t like BATS policies, don’t trade there.
      As for NYSE, its financials were public record the last time I checked; same as NASDAQ and many other publicly traded exchanges.

      • Brett said, on April 7, 2014 at 11:41 am

        Scott – perhaps you are the type to take an aggregated revenue line at face value and not question the underpinnings. I think you have to question the role of incentives when you have exchanges making 2/3 of their revenue via sales to HFT firms (which is how NASDAQ earns their money). Exchanges have morphed into profit centres that have displaced their primary importance and reason for being, to fairly connect buyers and sellers on a forum to trade equitieis. They are not there to be exploited by HFT, especially when that exploitation is a zero sum game where HFTs are scalping other investors and creating zero economic value. Shame on Exchanges for permitting this behaviour and it seems like you are educated on the subject so I’m a little surprised by your lack of true knowledge.

  8. Anon Cowherd said, on April 4, 2014 at 9:48 pm

    You got one thing exactly right: “Modern journalism seems to involve issuing press releases from the oligarchical reptiles who are destroying Western Civilization.”

    But what the fuck was the rest of this article? You concentrate on smearing some random guy who wrote a book, and yammering on and on about buy side this and sell side that.

    > He seems to give IEX sloppy wet kisses for honesty, yet sees nothing wrong with the fact that they’re owned by a bunch of buy side guys

    Huh? He should understand that IEX are not honest because they’re buy side guys? .. Because people who buy stuff are crooks?

    > I have no dog in this race: I’m not a HFT, I have never taken a dime from any exchange

    That’s weird, considering the whole post reads like some butt-hurt HFT guy lashing out at someone for having the audacity to question the nobility of his field.

    Well, I couldn’t make heads or tails of all this jargon, so it was at this point where I decided to check Wikipedia for “sell side” and read a tiny bit about what Lewis says in his book.

    So let’s see:

    > “Sell side is a term used in the financial services industry. It is a general term that indicates a firm that sells investment services to asset management firms, typically referred to as the buy side, or corporate entities. These services encompass a broad range of activities, including broking/dealing, investment banking, advisory functions, and investment research.”

    – In other words, “sell side” is Wall Street. But yeah, *they’re* not evil. It’s those naughty buy side guys like pension funds. It’s not like pension funds and other “retail investors” have ever been taken for a ride by Wall Street.

    > “Lewis reaches a stark conclusion: US stock markets are now rigged by traders who go to astonishing lengths to gain a millisecond edge over their rivals. As the innocent investor presses a button to buy shares, they leap invisibly into electronic markets to profit from the order and thousands of others, siphoning off billions of dollars a year.”

    Well yeah. The market very much *is* rigged, he certainly got that right. So is everything else in society, by the way. Rigged to benefit the ruling class (ie. “the oligarchs” you mention). But this seems to be the gist of Lewis’ book. What exactly is wrong with it?

    > Who do you think provides liquidity these days? Grandma’s pension fund?

    Ah yes. The classic old HFT-defense, “providing liquidity”. That one never gets old, eh? Trading bots are providing a valuable service to mankind by providing tiny slices of liquidity millions of times per second, so that all the, erm.. *investors* can take advantage of it! It works out great for everyone involved!

    But I shouldn’t waste any more time on this post. Now this is just my personal hunch based on knowing just about nothing about “finance”, or you, but I think you’re chock-full of shit.

    HFT is obviously meant to be a magical, automatic money-making-machine. The fundamental idea behind it all is just to sit back and watch money roll in. Naturally, it evolved into an arms race between competing algorithms produced by brilliant programmers working for sociopaths. What value is there, for society at large, in a bunch of algorithms trying to skim tiny slivers of profit off of each other? Most trades are algorithmic already. You’re telling me it’s for the better?

    • Scott Locklin said, on April 4, 2014 at 10:10 pm

      “The market very much *is* rigged, he certainly got that right. So is everything else in society, by the way. Rigged to benefit the ruling class (ie. “the oligarchs” you mention). But this seems to be the gist of Lewis’ book. What exactly is wrong with it?”

      For a longwinded gasbag, you certainly can’t read. As I painstakingly detailed, Lewis has not only misidentified who the “ruling class” is, and sent the witch hunters against a comparatively powerless group of comparatively middle class people; he’s written a 280 page advert for the oligarchy’s new exchange.

    • Where's the Tofu? said, on April 4, 2014 at 11:47 pm

      *But I shouldn’t waste any more time on this post. Now this is just my personal hunch based on knowing just about nothing about “finance”, or you, but I think you’re chock-full of shit. *

      Personally, I don’t know anything about soccer. Sure, I know what the ball looks like, how goals are scored, and roughly how many players and refs are on the field at a given time. But I really don’t understand any of the details involved in playing the sport. I know this. And I wouldn’t presume to share my ignorant opinions with the rest of the world. It’s amazing to me that you think your thoughts about something as complicated as the modern equity markets are worth the time it takes you to write them down.

    • Andrew Bissell said, on April 5, 2014 at 1:21 am

      Anyone who describes HFT as “sit back and watch money roll in” is an uninformed dolt holding forth on a subject they don’t remotely understand.

      • Amicus said, on April 6, 2014 at 8:30 am

        er… both might be true, in a sense, e.g. how much risk is there in a latency arbitrage? (I mean, technically, if it is a true arbitrage, then it is a riskless profit.)

        How much has the compensation for various “HFT” market activities changed over time? Did it start out with a lot of fat arbitrage opportunities that have steadily been eroded?

        And what’s the end-game for the HFT industry? It looks like the big will keep getting bigger and smaller participants bought-up or driven out (someone on FT was already calling for regulatory permission a zero bid-ask, which tells you that power has shifted from making money off liquidity provision in that way, maybe – I mean it’s one datapoint, but still…).

        • Andrew Bissell said, on April 8, 2014 at 6:39 am

          Any time you put headless trading code into the market, you’re taking the risk of a catastrophic error which wipes out your entire trading capital in a matter of minutes. Program safeties and unit & functional tests can help mitigate the risk, but the market often has a way of finding an obscure, unconsidered path through your algorithm or trading platform. As far as “latency arbitrage” goes, the version Michael Lewis describes in his book would be so easy to game I find it hard to believe that it represents a significant percentage of HFT volume. If it does, it’s just one more indictment of the buy side’s staggering incompetence when it comes to execution.

          The HFT industry’s day in the sun was the mid-late 2000s. Since then a lot of new capacity has come into the market and the profitability of most algo trading firms has plummeted. The decline in market volatility hasn’t been kind to market-making P&L either. Basically, HFT is becoming like many other mature and highly competitive industries, where profit opportunities can still be found by nimble players but are mostly difficult to come by.

          Left to its own devices, I actually think the long-term trend in HFT would be toward relatively small, very lean firms. The costs of entry are fairly low. Established code libraries help incumbents, but not as much as you might think; algorithms “decay” fairly quickly and most of the basic techniques are pretty straightforward to implement (if not to optimize). Of course, all this is subject to change if this latest publicity campaign results in some ill-considered regulations which (let’s not kid ourselves) will favor the big Wall Street banks and buy side players.

        • John said, on April 9, 2014 at 11:59 pm

          Actually, one risk is that you spend a gigantic fortune in both initial and ongoing costs, to build out your low-latency private network. Then you find out that this didn’t actually buy you enough of a latency advantage compared to the other firms which all did the same thing. GETCO made huge money for several years by building out their network early, but the money stopped rolling in when enough competitors also built out their own links.

          Even “pure” arbitrage has leg risk: you get one trade at one price you want, but when you go to lay it off, you miss the price you wanted, and wind up laying it off at a worse price and eat the loss. If your arb system is significantly faster than the next fastest system, you will make money pretty reliably. But as soon as there’s just one other guy who’s nearly as fast as you, you both wind up getting legged a lot, and that can severely impact both your profitability and the other guy’s. It’s not zero-sum. If one guy does it, he can make money, but if two guys do it, they can wind up both losing money.

          What generally happens then is that both firms work like hell trying to speed things up, until one guy winds up having to give up or find some non-competing trade to do instead. But at the same time, there’s always another guy out there who will try to come in as fresh competition. It’s not a “sit back and print money” job so much as a Red Queen’s Race. And you’ll get tired sooner or later.

      • David said, on April 7, 2014 at 12:54 am

        Actually, your the moron who doesn’t understand. “Good” HFT firms don’t have a losing month. “Great” HFT firms don’t have a losing day. There’s something seriously wrong when you basically have a risk free trading strategy.

        • Scooter said, on April 7, 2014 at 10:16 am

          David,

          You may want to take a look at this deconstruction of Virtu’s business model, as reported in their S-1. It was written by CNBC’s Bob Pisani:

          http://www.cnbc.com/id/101535762

          Also, you may want to see the explanation offered by Matt Levine over at Bloomberg View:

          http://www.bloombergview.com/articles/2014-03-20/why-do-high-frequency-traders-never-lose-money

          I think you will find that there is a very reasonable answer to address your concern.

        • Andrew Bissell said, on April 8, 2014 at 6:50 am

          Most HFT strategies have nearly as many losing trades as winners — profit is made by a slim majority of winning trades where the average amount gained is slightly higher than the average loss taken by the losers.

          Of course, average that out over thousands of trades per day for a strategy, and thousands of strategies in a given firm, and simple, junior high school level statistics is all it takes to understand why that would generate some very even (but really, not all that high) returns. It’s the same thing as those lizard people buy-siders Locklin mentions having 19 winning years out of 20, just averaged out over many more trades within smaller timeframes, and without the insider information advantages most of them are employing.

          Knight Capital was one of the firms everyone used to point to as having preternaturally steady returns, right up until they blew up. As CDS writers found out in 2008, steady P&L is not, ipso facto, an indication that risk is not being assumed.

        • Matt Hurd said, on April 10, 2014 at 7:12 am

          It’s not rigged. It’s just math! Here’s why: http://meanderful.blogspot.com/2014/04/hft-two-choices-making-money-every-day.html

  9. Brian said, on April 4, 2014 at 10:40 pm

    Thanks Scott. He’s been making the rounds on the talk shows promoting his book. I disagree that Lewis doesn’t understand or know what he’s talking about. He’s been around the block a few times. My take is that he’s like Malcom Gladwell in the sense that he’s more of a writer than analyst, in other words he gravitates toward a good narrative above all else. So his work is compromised. My only issue with your post is that you make no distinction between criminal insider trading and informed trading. I don’t know where to draw the line since I’m not in finance, but I think there needs to be a clear boundary.

    • Scott Locklin said, on April 4, 2014 at 11:03 pm

      From the point of view of the trader, it doesn’t matter where the informed trader gets his information: it only matters that he is informed. That means he has a very real informational advantage over you. This is a technical term from financial economics; if you check google scholar, you’ll find lots of papers on the subject.
      From a legal and moral point of view, insider traders are, of course, different from merely clever traders.

      I know Lewis has been around for a while. That doesn’t mean he has bothered to know what he is talking about. If he does, he has less excuses for this recent book.

  10. Lew Burton said, on April 5, 2014 at 3:36 am

    Well said, Scott

  11. Bogdan Pou said, on April 5, 2014 at 11:33 am

    I guess the best way to descibe is exactly “sit back and watch money roll in”

  12. pittrader1988 said, on April 5, 2014 at 12:31 pm

    Nice piece. I don’t think the little guy is affected by HFT. I come from futures markets where co-location really does make a difference. I used to trade in the pit-so I can speak from pretty good authority that about what that was like. Pit traders had many different styles of trading.

    Admittedly, this is all pretty inside baseball stuff. Hard to understand and not relevant to casual observers. But, it’s important. It’s important because big pension funds are getting ripped off. It’s important because it is undermining confidence in free markets.

    In the current market structure on the futures side, traders are getting run over and put out of business by HFT. It doesn’t have anything to do with skill, but it has a lot to do with co-lo, fee rebates, order types and speed. You cite order types as one example. At CME they are actively prosecuting floor traders that bid/ask on large lots, but not prosecuting HFT that use flash orders.

    As a person who advocated for electronic trading, I can say that the industry hasn’t evolved in its market structure to keep pace with the changes that electronic trading brings. Been blogging about it at pointsandfigures.com since 2010.

    • Scott Locklin said, on April 5, 2014 at 8:55 pm

      The problem I have with the book is, indeed, it is undermining confidence in free markets, completely without reason. If the pension funds can’t find competent algo guys to work their trades, maybe they should find another line of work. Otherwise, I guess they can call me: I’d be a rank beginner, but knowing something about linear programming, I’m pretty sure I can work a trade better than, say, the Katsuyama described in this book. I also know a lot of unemployed HFT prop traders who wouldn’t mind such a job.

      Since when does CME use flash orders? The nice thing about the futures markets is 99% of the complexity in liquidity finding doesn’t exist, because there is only “one” market (the open outcry one and the electronic one counting as one). You don’t have to route your order through a zillion little exchanges with different rules: just one exchange with one (OK, maybe two) set of rules.

      The whole HFT thing is a horse-shit red herring. The dangers we face as a society are the Fed inflating another bubble, and the banks being even larger than they were the last time they blew up over a lot of levered punts on the Fed’s last bubble. Structurally, the West suffers from being oligopolistic in many important parts of the economy (newsmedia, internets, finance), and turning viciously oligarchical in general. While all societies have a ruling claque, the festering carbuncle we are developing at the top is probably uniquely nasty in our history. They produce no great art, they do not work for the good and future of their host countries (witness Buffet and Gates crying for the third world to impress their Davos pals, rather than doing some good for the countries which made them rich, and Sheldon Adelson trying to buy yet another middle eastern tribal war), and they have developed the delusion that they actually deserve the power they have. They’ve even managed to turn the left into a circular firing squad of accusations of … racism and homophobia: not even the left cares about income inequity these days. Combine that with the fact that big capital moves more easily than human beings, vast swathes of the Western economy are now obsolete and non-productive, and the movement of peoples from third world to first, and you have a recipe for a human disaster so monstrous, it’s almost beyond belief. The Michael Lewises of the world won’t write about this. Much easier to blame a couple of middle class market making math nerds for all the troubles in the world.

  13. Thinkfirst said, on April 5, 2014 at 1:23 pm

    There may be big monies interests on both sides of this debate, but that means almost nothing. If you don’t understand the topic, then don’t write about it. Oh you know some HFT guys who seem really nice and are very smart? Well great, I’m happy for you. None of that is relevant whatsoever. Remember, everyone loved Bernie maddoff too until they didn’t. The fact is that it’s really very simple to understand that HFTs getting market information is illegal and in direct violation of reg NMS, period. That has happened, is happening, and is illegal. It’s a fact, and not up for debate. This doesn’t even cover activities like quote stuffing or momentum ignition which themselves are highly dubious and purposely destabilizing. Again, you obviously don’t know what you’re talking about here so spare the uninformed commentary. Oh and the conflating of electronic trading, algorithmic trading, and these few HFT strategies that are rightly under fire now is completely moronic and does more to confuse people than almost anything else in this discussion. Also, don’t trump the benefits of their liquidity because it’s not real. It’s phantom and HFTs will be the first ones gone when liquidity is most needed.

    • Scott Locklin said, on April 5, 2014 at 8:31 pm

      I understand this crap a lot better than Michael Lewis, who basically wrote a science fiction book. Are you telling me that Lewis made any kind of distinction between the alleged arb situation he spoke of, and “HFT?” Because if he did, I certainly missed it. If you read his book, you would come away with the idea that anyone who is smart, trades with a computer, and who doesn’t work for Goldman is some kind of criminal svengali.
      “HFTs getting market information” violates NMS? Have you read NMS? I have. You don’t know what you’re talking about. If you want to do Michael Lewis’ job and inform us about something shady going on: go for it. Meanwhile, Michael Lewis is an ignorant boob stirring up a witch hunt to sell books and shill for his pals on IEX.

  14. selesko said, on April 6, 2014 at 3:31 am

    I have enjoyed your writing and reviews for a while…thanks for the effort!

    As a small independent commodities trader there is no doubt in my mind that HFT is beneficial to me. I have been trading 20+ yrs and it was not that long ago that I had to deal with d-bags on the phone, pray for a decent fill and pay redonk commish…..my fills have only gotten better over time, commish has only decreased over time. Having said that, I also believe that quote stuffing is criminally fraudulent, and if they are going to prosecute the Queen of cupcakes over a low six figure insider trade then they have to go after quote stuffers.

    Are you really telling me that Lewis wrote a book about HFT and did not cover quote stuffing???? At all ?????

    • Scott Locklin said, on April 6, 2014 at 4:03 am

      Thanks for the kind words.

      Lewis wrote a book he claims is about HFT without mentioning quote stuffing, at all.

      I agree, someone should hang for the quote stuffing thing. I will laugh my ass off if it’s one of the big banks, or some deserving asshole like Steve Cohen.

      • selesko said, on April 6, 2014 at 5:04 am

        PERFECT use of screen shot !!!! Best of luck to you in the future.

  15. More Qs than Answers said, on April 6, 2014 at 6:23 am

    Scott,

    Sounds like you have a lot of knowlegde in the area. The problem is with your style. Michael Lewis (and Brad Katsuyama) come out as extremely nice and honest guys, while you come out as a name calliing true arrogant ahole. You would have much better success in getting people to listen to you by merely changing the style of your writing and lighten up on name calling.

    Having said this, and having no dog in this race either, and having read the book, I have to agree with you on many points, including:
    1) The morality of what you call ‘sell side’ (Wall Street big banks and brokers) is near non-existent. They have always been about fleecing the small and big guys (investment firms, and hedge funds) alike while obfuscating the fact. I would go as far as saying that the more one look at the ways of Wall Street big firms, from crap CDO packaging, to LIBOR manipulation, the more they look as bona-fide criminal enterprises.
    2) The fed liquidity bubble and extreme (and growing) polarization between the have and have nots is a major issue of our times.
    3) The coders who write the HFTs are only tools in the hands of the crooks, and the fact they are striking it on their own is probably one of the main reasons that led to the recent campaign against the HFTs.
    4) Serge Aleynikov is a totally innocent guy, and should be freed.

    Where I disagree with you is on your view that the HFTs are a bunch of innocent guys trying to improve the market and make it more efficient. Even if you ignore predatory flash quotes, quote stuffing (financial spamming), and the simple fact that they trade on advance information with almost zero risk – their “liquidity benefit” is a mirage. In my view are creating an arms race which has no end in sight, draining huge productive resources from society for the benefit of very few sociopaths. Jim Barksdale line from NJ to Chicago in the story; the great lenghts the HFTs are going through just to gain a 10 microsecond advantage; Wall Street grabbing the best coders to work for “the reptilian oligarchs” instead of them working on the next cure for cancer etc. all these are very bad for society and the sooner they stop, the better.

    But yes, you’re probably correct that Lewis and Katsuyama are not 100% “honest”, and definitely NOT fighting for the “little guy” as they like to appear.

    Thank you for your illuminating critique.

    • Scott Locklin said, on April 6, 2014 at 6:44 am

      You’re putting words in my mouth: I think quote stuffing is bad. Flash quotes: that’s debatable. The “advance information with no risk” thing is a canard: chances are, if anybody is doing that, it is a crime. However, I am reviewing a book here: the one that Michael Lewis wrote. He didn’t mention any of these things. He did describe a strategy, if it was in fact legit, which could be described as latency arbitrage. It’s not a crime, and shouldn’t be a crime. It’s also not taking much money from anybody, excepting perhaps for really, really stupid people with waaay too much money (Katsuyama and his employers). The way I see that: it’s a tax on the stupid. I support stupid people taxes. I think they should be graduated, so the really rich stupid people lose all their money and give it to smart friends of mine. Voila, that’s how the system works; at least if you believe Michael Lewis (which you shouldn’t, since he got everything else wrong).

      I agree with you: I am an asshole. I’d like to blame this personality flaw on a lifetime of listening to prevaricating gasbags like Michael Lewis telling me things that I know are not true. If people don’t want to listen to me because I’m an asshole: well, maybe they should ranger up. Or, go through life listening to sweet talking liars: makes no difference to me.

  16. More Qs than Answers said, on April 6, 2014 at 8:14 am

    Thanks for your response. Highly appreciated.

    The front-running with no risk trading has been demonstrated by:
    1) The recent publicity of “no losses” record of some of these HFTs.
    2) The fact that they buy the “order flow” (information not available to “the public”) from the exchanges

    Quote stuffing: I’m pretty sure I’ve seen it mentioned in Lewis’ book several times. I think your search didn’t work right.

    The problem is that there’s no fairness in any of these systems. IEX only addresses one part of it (leveling the playing field only among a subset of participants, the ones you call “buy side” at the expense of the faster smaller plaers).

    What do you think about a system that:

    1) Gets orders from everyone (without any bias towards buy or sell side, big or small).
    2) Once per second (based on atomic clocks/ntp) does a round of matching best offer vs best bid.
    3) In case of excess bids vs offer, does a random (that’s critical) selection of who wins

    “Once per second” is an arbitrary interval and its main intention is 1) to be inclusive of the small trader at home who sees all “real-time” quotes as they were in the distant past. 2) To disincentivise investing in speed as an end for no real benefit to society.

    You agree with Lewis on Aleynikov, this is refreshing.

    Make an effort to be nice. As an informed truth seeker, what you say has a lot of value and you definitely know how to write. Hey, maybe if you just write the truth, you may become as successful as Michael Lewis :)

    • Scott Locklin said, on April 6, 2014 at 8:38 am

      Lewis is lying about “no losses.” Knight Capital, mentioned above, almost went backrupt because they fucked up. They had to merge with their competitor GETCO. Nothing mysterious or supernatural about it: it happened in public, and you can go buy a share in KCG if you think it’s so all fired profitable. If it were, the company would probably have cash flows bigger than what they do, and they wouldn’t need 1200 people to generate those paltry cash flows.

      Also, “no losses” doesn’t mean no risk: it very well might mean careful execution in a market making context. If you are making lots of trades and know what you are doing, you shouldn’t have any losses on a quarterly or monthly time scale. If you don’t know what you are doing, you will lose everything very quickly. That’s just the central limit theorem in action. We’re talking upwards of 1E6 trades a month. People like Einhorn might make a few hundred trades in their lifetimes.

      If the public wants to take the same risks as HFTs, they can go look at the flow. Meanwhile, they are the flow. So it has always been. If you want a continuous market, that’s the price you pay for it. If you don’t, make a better dark crossing network, or trade OTC with your friends. IEX does not solve this problem. Going back to the bad old days of 0.25 spreads certainly does not solve this problem.

      As for your suggestions on changing my personality: fuck you!

    • Scooter said, on April 6, 2014 at 10:22 am

      As for your Point 2 about “no losses,” I suggest that you take a look at this explanation offered by Matt Levine over at Bloomberg View:

      http://www.bloombergview.com/articles/2014-03-20/why-do-high-frequency-traders-never-lose-money

      In addition, I found this deconstruction of Virtu’s business model, as reported in their S-1, to be very helpful. It was written by CNBC’s Bob Pisani:

      http://www.cnbc.com/id/101535762 – See more at: http://streetwiseprofessor.com/?p=8333#comments

      I think you will find that there is a very reasonable answer to address your concern.

  17. More Qs than Answers said, on April 6, 2014 at 9:18 am

    :)
    I didn’t suggest going back to 0.25 spreads. In fact, I think the price small traders should be able to enter is any floating point number so that, among other things, small-price stocks can be traded more efficiently too.

    I did ask what do you think of one second (or whatever levels the playing field and makes available info transparent to all) quantum interval and matching order at the end of each interval. Oh that and also get rid of the terrible “20-min delay” idea we still see enforced/implemented in so many places.

    Sorry if this has little to do with the good critique of the book. It is relevant for the general subject of market fairness, about which the book was written and criticized for.

  18. Amicus said, on April 6, 2014 at 9:52 am

    It’s going to take a while to get the technical knowledge to sort this out. I read the Amazon review you linked and thought, “WTF, just get the L2 data and, you know, we’ll have a non subjective measure of how much of one thing that Lewis describes is really going on.”

    Then I read this, so now I’m not sure:

    “Post Trade Transparency – The data collected on the post trade tape is inadequate to evaluate the quality
    of an execution since the events listed (i.e. executions and changes in the consolidated data) are (A) not in
    chronological order and (8) have timestamps that describe when an event was reported to the consolidated tape as opposed to when the event took place. The data reporting method should be adjusted to fix both of these issues. Furthermore, the measurement of time on the post trade tape should have precision that at least matches the speed at which the fastest high frequency traders execute orders. Otherwise, market participants will continue to have varying levels of transparency. ”

    ref
    http://www.sec.gov/comments/s7-02-10/s70210-25.pdf

  19. Scooter said, on April 6, 2014 at 10:17 am

    Streetwise Professor has a good post entitled: “Pinging: Who is the Predator, and Who Is the Prey?” Found at:

    http://streetwiseprofessor.com/?p=8340

  20. Scooter said, on April 6, 2014 at 10:29 am

    Readers of this thread may be interested in this Reuters’ video on Flash Boys with Manoj Narang of Tradeworx and HFT critic Haim Bodek discussing the book:

    https://www.youtube.com/watch?v=665JOLJCGOc

  21. More Qs than Answers said, on April 6, 2014 at 6:24 pm

    Scooter. I highly appreciate all your links. I followed them and I feel (a tad) more informed now. I think the #1 flaw in Flash Boys is that it picked a hero at the beginning and most of the “facts” in the book are coming from one side (Katsuyama and the people who created IEX). In the end they are not protecting the small guy but the big “buy side” guys. On that score, Scott is right on. I still can’t disagree with his, in my humble view, overzealous defense of the “decent” guys in the HFT industry.

    • Scooter said, on April 7, 2014 at 1:21 am

      I would add one additional observation: not all buy side order flow is the same. It is the informed, or alpha-generating, order flow that the market maker regards as toxic. So these buy side firms can look to protect information leakage by using an ATS venue like IEX or they can use execution algorithms to disguise their intentions and trade in lit markets. UnInformed order flow, such as that from a passive index fund, does not pose the same adverse selection risk to the market maker and therefore is not regarded as toxic. This difference may explain why mutual funds that predominantly offer index products do not seem to be too worked up about HFT. Certainly The Vanguard Group, judging from these two recent links below, do not seem too upset with HFT and the current market structure. In fact, they think their customers have greatly benefitted from it:

      http://www.bloomberg.com/news/2014-04-03/vanguard-says-minority-of-high-speed-traders-may-abuse.html

      http://www.cbsnews.com/news/jack-bogle-michael-lewis-is-wrong-about-rigged-markets/

  22. Brian said, on April 7, 2014 at 2:34 am

    And here’s a little article by the Chinese nerd girl over at UM. http://www.theguardian.com/commentisfree/2014/apr/04/michael-lewis-market-rigged-flash-boys-high-speed-trading

  23. […] The same day, Scott Lockling posted a highly critical review of Michael Lewis’ book: Michael Lewis: shilling for the buyside: […]

  24. More Qs than Answers said, on April 8, 2014 at 2:08 pm

    Must read for those who seek the truth:
    http://www.zerohedge.com/news/2014-04-07/1215095-flash-boys-mystery-solved

    • Scott Locklin said, on April 8, 2014 at 9:19 pm

      Joe Saluzzi’s good for a laugh. Maybe he and Michael Lewis can team up with Eric Drexler against the mighty Locklin-Salmon-Bloomberg-Tradeworks HFT microwave conspiracy.

      • Kevin Stevens said, on April 10, 2014 at 1:40 pm

        Agreed. Saluzzi made about three good posts in 2009, then it became clear that he found a platform where people would listen to him, and then he just pandered to that crowd. He also has an inherent conflict of interest- its small brokerages like his that have just gotten run over by the technological advances of the mid 2000s- they can’t afford to keep up.

        And Zerohedge, that’s another blog that had about three good posts in 2009, and then just went off the deep end, and I mean DEEP end. Those guys have been predicting an imminent calamity for five years now, I wonder when its readership is going to start seeing through their BS.

        I left the algo trading/HFT world about a month ago for the tech world. Surprisingly the pay was better, and I sleep better at night now that I don’t have engines I own trading tens of billions of dollar in notional value 24×7.

        -K

    • Andrew Bissell said, on April 8, 2014 at 11:21 pm

      It’s pretty rich for Joe Saluzzi to criticize someone for having an undisclosed conflict of interest. I’ve never seen him mention in his TV interviews that his execution business would be a direct beneficiary of the regulations he’s pimping.

      • Scott Locklin said, on April 9, 2014 at 12:11 am

        Well, he also quoted Irene Aldridge…

  25. Mattia Landoni said, on April 11, 2014 at 2:51 pm

    Just a curiosity: why do you say that Capital Group is the largest buy side firm in the world, when there are many firms with larger assets under management? (e.g. BlackRock)

    • Scott Locklin said, on April 11, 2014 at 5:57 pm

      Should have said, “one of the largest” -thanks for the correction. Capital Group is older: according to the PRE network analysis, they’re more politically powerful than Blackrock.

  26. […] Continue reading here. […]

    • Scott Locklin said, on April 15, 2014 at 12:06 am

      Financialization is probably a bad trend in society. Of course, I have no idea what to do about it. I don’t think Krugman does either.

      • Brian said, on April 15, 2014 at 1:14 am

        Government regulation.Tricky because banks own a lot of the politicians.

    • Matt Hurd said, on April 15, 2014 at 1:42 am

      Krugman sounds sensible with the line of too much finance and not enough production. However, there is quite the problem in agreeing with what constitutes the share of financial services with respect to GDP. Krugman’s Philippon reference quotes around 9% of GDP but FT, about a month ago, reported on a story where the Bureau of Economic Analysis revised back, all the way to 1997, the finance share of GDP, “On the new estimates, finance makes up 6.4 per cent of the US economy, compared with about 7 per cent before the revisions.” [1]

      6.4% still seems high but it is less than what Philippon was thinking may be a reasonable number at his paper’s conclusion. All of that with just jiggery pokery in the definition and numbers. Aren’t we lucky to have the dismal science as our guide ;-)

      I’m quite sanguine and feel that new tech at last has the opportunity to provide a great deal of disinter-mediation in vanilla product delivery via efficiencies and thus hopefully a lower % to GDP. Just as HFT has disintermediated the old school and wrung some inefficiencies out of the system…

      ____________
      [1] “Wall Street less important to US economy than thought,” http://www.ft.com/intl/cms/s/0/c1ec53b4-a938-11e3-9b71-00144feab7de.html#axzz2yuad2Fsd , March 11, 2014, Robin Harding

      • Toddy Cat said, on April 16, 2014 at 6:32 pm

        Krugman is an idiot, but even a stopped clock is right twice a day. He’s right about financialization vs. production.

  27. Tbv said, on April 17, 2014 at 8:53 pm

    Scott, this is a great post.

  28. […] came to mind as I was reading Scott Locklin’s review of the new Michael Lewis book. I’m a big Lewis fan (a highlight of my career was being CCed […]


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