Michael Lewis: shilling for the buyside
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.
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.
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.
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.
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.
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.
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
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.
This trader gives a really great review.