Flash Boys author Michael Lewis: 'The market is rigged' by high frequency trades

Moneyball and Liar's Poker writer Michael Lewis has a new book out looking into the world of high frequency trading (HFT), and his determination is, according to an interview today on Bloomberg TV, that the market is 'rigged'.

His treatise alleges HFT companies buy the right to execute other companies' trades, which allows them to 'run in front' of those trades with their own trades, thereby profiting from inside knowledge of the market.

The interview, and others in promtoion of the book, has brought widespread calls for changes to the system.

A partial transcript follows, and the full video is below.



STEPHANIE RUHLE, BLOOMBERG NEWS: And we have a very special hour, as we mentioned, ahead. Michael Lewis is here. He is the author of the hottest book out there right now, "Flash Boys". It has sparked quite a revolt against high-frequency trading. Erik said top selling book on Amazon today and it's already had a huge impact on the national conversation. The FBI says it's opened an investigation into whether any laws have been broken. And today, high frequency trading firm Virtu announced it's delaying its planned IPO because of all the bad publicity.

Michael, thank you for being here. Clearly, you are the author when it comes to Wall Street culture. There is no one else out there. But in terms of reaction, you have never gotten such a visceral reaction in such a short time. What do you make of all this?

MICHAEL LEWIS, AUTHOR, "FLASH BOYS": It does - I've had one experience kind of like this, and it was when I published "Moneyball," but in that case they weren't threatening to throw old baseball scouts in jail for what they did. But the disruption to the industry that that caused feels a lot like this.

And the instigator, there is a character kind of who has taken a different view of the industry and has kind of investigated it one way or another -- the main character in this book, Brad Katsuyama -- is got a similar feel to me to Billy Beane. And the reaction feels, it reminds me of that, that everybody has to have an opinion about the book right away, no matter whether they have read it or not. So that's similar.

RUHLE: But is the opinion about the book or about the claim the market is rigged? That's a big claim.

LEWIS: Yes. Well, it is rigged. So it's not that big a - if you've read the book, I don't think you could put it down and say the market's not rigged. I really don't think you - I mean, unless -- we can parse the word rig.

ERIK SCHATZKER, BLOOMBERG NEWS: Maybe we should.

(CROSSTALK)

LEWIS: Let me give you an analogy and I think is a very close analogy to the way the stock market is structured. It's a casino analogy. So I have a casino and I want to start a poker game in the casino, so I get three card sharks and I tell them, go sit there and start the game. Make it look like a good game's going on. There are no 4s, 9s, there are no queens in the deck. Only you will know that. And we will pay some tour group operators to bring like a bunch of dumb tourists in to pay with you. They won't know. You'll --

RUHLE: Hold on, a bunch of dumb tourists? So is David Einhorn is a dumb tourist?

LEWIS: Yes.

RUHLE: Come on now.

LEWIS: In this analogy. Hold on. In this analogy, every investor -- David Einhorn did not know; he did not understand. He understood that whenever he tried to do something in the market, the market moved like someone knew what he was up to. In the same way that big pension fund managers and mutual fund managers saw when they tried to execute big orders, oh my god, it's like someone knows I want to buy before I buy. But he didn't know why. He didn't know - he didn't understand that high-frequency traders were putting machines in exchanges to be closer to the exchange so that they could get price information in two milliseconds before him. And so on and so forth.

Let me -- can I finish my analogy?

SCHATZKER: Absolutely.

LEWIS: So of course the tourists get fleeced all the time in the poker games, because they don't know the deck is rigged. The poker players pay the casino a cut of what they make. The casinos, operators, pay the tour group - the tour group company money to bring in the tourists.

So in this case, casino's the exchange, the poker players are the high-frequency traders, and the tour group operators are the banks and the brokers that handle the stock market orders. And I think the analogy is pretty close. So is that rigged? Is that a rigged game? I think it is a rigged game.

SCHATZKER: Well, it's rigged only inasmuch as - rigged, so -

(CROSSTALK)

LEWIS: Why are you so invested in the idea this is fair? Why are you even arguing about this? It's so clear.

SCHATZKER: Me?

LEWIS: Yes, you seem to be.

RUHLE: He's barely even spoken.

LEWIS: No, no, no, I mean, it's very interesting. But you seem to be - you can see, it's very clear that people are being front run in the market. There's plenty of evidence in the book. People making -

SCHATZKER: Their orders are being anticipated (inaudible).

LEWIS: Anticipated and run in front of, that's right. And --

SCHATZKER: Well, no, there's some people - in all fairness, I don't have a stake in the proceedings here, certainly not like you because you're the author of the book, Michael, but there are some people - you've probably met some of them -- who would say in order to front run, you have to have a client. In order to front run, you have to have a client. And the HTF firms don't have clients.

LEWIS: They buy the order flow. They buy - they pay -

SCHATZKER: They pay to see things.

LEWIS: No, they pay to execute the orders. They pay TD Ameritrade tens of million dollars a year. Schwab, they pay eTrade. So they pay for the right to execute the orders at a delayed price. So why would you - I mean, ask that question. Why would anybody pay for the right to execute someone else's stock market order? That in itself is a little curious. I mean, I can understand why, if I'm a stock market investor, why I would pay a commission to a broker to handle my order. But why, on top of that, is the broker turn around and selling my order to some high-frequency trader for the right to execute? What is the value in that? The value in that is quite clear. It's that that order for the high-frequency trader is an opportunity to exploit. And it's an opportunity because he has advanced information about the pricing in the stock market. Is that fair?

SCHATZKER: He's also getting paid by the exchange to print, right? To print the trades.

LEWIS: It depends. I mean, there you're getting into a complicated discussion because exchange pricing, sometimes you pay and sometimes you get paid. But - so that is almost a separate issue. It is true that the exchanges create incentives to be on one side of the trade or the other.

And I think that basically when you look at it, at the bottom of this, it's a bit like the financial crisis. At the bottom of this, is that the system is riddled with really bad incentives. It doesn't make a lot of sense for brokers to be owning exchanges, I think. In fact, and the exchanges are for investors, not brokers, not for middlemen -- when the brokers own the exchanges, the exchange is going to be essentially an instrument of the intermediary rather than the investor.

RUHLE: All right, then are the exchanges sort of the - like how the rating agencies - what the rating agencies were in “The Big Short”, is that with the exchanges are here? And if they were not for profit, would they be a better force, a force we could trust more?

LEWIS: It's a similar sort of role. That analogy is probably - but, yes, it occurred to me that's actually sort of the role. That they're thought to be - their role is a kind of utility role. You need them to be an honest broker, you need them to create a fair experience for a customer that walks onto them. And if they, because they are for-profit, they are incentivized, and because of the way markets work, the way they work, they have to meet quarterly earnings and so on and so forth - it's not a long term view they're taking. It's a very short-term view they're taking. They are constantly subjected to temptation of taking money from one faction of their clientele to put the other faction in a bad place.

RUHLE: Would we like these HFTs more if they actually were putting money at risk, if they had positions? The fact that they are just taking a scrape here, is that why we dislike them so much?

LEWIS: The fact that they - they're sort of set up not to take on market risk. It's funny --

RUHLE: I want you to have skin the game. If you have skin in the game and you can lose, I like it more.

LEWIS: If you can have 4,000 trading days without a single day's loss, something's a little weird, right?

SCHATZKER: Yes, but let's rewind the clock to pre-1975 when there weren't really market makers the way there are now. Trading was largely an agency business. This was before Gus Levy and before the arbitrage (ph) desk at Goldman Sachs, and Robert Rubin -- they didn't lose any money either. You don't lose any money as an agency trader.

LEWIS: It's not true that they didn't lose any money when you rewind the clock. I worked on Wall Street. The Salomon brothers, the traders would have down days and they would up days. And they would just hope that the up days were better than the down days.

SCHATZKER: But they were putting money at risk.

LEWIS: Right. The position they were taking -- I'm not saying that that was pure and innocent and great either. But there were different problems in different days. But the role they were playing was a buffer the market. They were playing the role that Brad Katsuyama played at RBC, that someone needs to sell a million shares of something and the market won't, isn't ready --

SCHATZKER: But you know what? You're actually - here's one - I'll phrase it s a question instead of making a statement. Would you knowledge that your critics perhaps have one fair point, which is that it's hard to generalize? That much of what you're talking about, the people whom you identify as the victims in the book, are by and large institutional traders. Some of them are mutual fund managers, like --

LEWIS: So could I stop you there? I'm sorry, but in the book, there's a long interview with a guy who spent years selling the order flow for TD Ameritrade. I mean, that's not institutional investors, that's you and me. That's mom and pop. And he says, what's the most valuable order for a high-frequency trader to exploit? It's a market order from an individual because the individual investor has such a slow feed, basically.

RUHLE: But -

LEWIS: No, it's true. What is true, if the order is a 100-share order, that's probably not that big a deal. It's not that big a deal. That's true.

SCHATZKER: Well, a lot of retail orders are 100 shares.

LEWIS: But who manages the savings a lot of people in America? It isn't people trading 100-share allots on eTrade or Ameritrade, it is mutual funds, it's pension funds --

SCHATZKER: True, but be careful of who you defend here. Actively managed mutual funds, we could talk about the passive ones separately, but actively managed mutual funds, on the whole, do a terrible job of overseeing Americans' money. They fail to beat the market more than 50 percent of the time and they charge a fee on top of that. Are they really - I mean, here ,we were going to get down to this, but let's do it now. How do you decide who to put the white hat on? Are these white hat guys?

LEWIS: I didn't actually put a white hat on the mutual fund industry, I hope you don't think that I just did that. But it doesn't help that, in addition to the ineptitude of mutual fund managers, they have to pay tax. It's all a cost to the ultimate investor. So I'm not an apologist for the mutual fund industry. That's not the point. The point is, the people whose money who they're managing is ultimately damaged by this are lots of little individual investors.

And so it's to say that this doesn't touch the individual investor is crazy. The second reason it's crazy, and this gets to Goldman Sachs' involvement, is that, in order to preserve essentially a stock market system that enables this sort of activity, the level of complexity has gone through the roof.

And the reason I wrote a book about this, nobody understands the stock market. This guy can walk in and describe a stock market that nobody understands. David Einhorn listens to it and says, oh my god, this I did not know.

The complexity is a source of instability. The people at Goldman Sachs that I talked to who have thrown their weight behind this exchange said the main reason they did it was that they -- the outages of the exchanges, the flash crash, whatever it is - the various technical mishaps that seem to punctuate the life of the stock market these days, they see it all as symptomatic of a much bigger problem. There's going to be a massive flash crash times ten and Goldman's going to get blamed, so we go to get out of this before that happens. So that's not good for the individual investor either.

RUHLE: But is this so material to the individual investors? Because, today, when I go to execute a stock, I definitely feel like, man, how did that get jacked right before my face? Every time, I do feel that way. But 15 years ago when I did a trade, I was paying significantly more to do it with a specialist because of what the fees were.

LEWIS: So you got to make a distinction here.

RUHLE: So it's a different problem a different day. Is it really worse today than it was when specialists were on the floor?

LEWIS: I never said that.

RUHLE: And has the system always been rigged?

LEWIS: Yes, in different ways. Hold on. In different ways. The problems then were different from the problems today. And you're not making a making a distinction I think is really important to make. Yes, technology has brought incredible benefits to the individual investor. It's really good that trading is computerized. I'm not against computerized trading. It's that it does not have to be computerized scalping going on with computerized trading. The two are not inextricably linked. They can be separate things.

What really should happen is that you get all the benefits of the computerized trading without someone running in front of you when you trade. That's what should happen. And there's no reason that can't happen. And I think part of -- this is a larger discussion about the state of Wall Street, but what has happened here is that technology has basically eliminated a role that Wall Street used to play. You used to need a human being to bring together a buyer and a seller. You couldn't do it yourself. Now you hit a button on your computer and your stock market order goes into a box with everyone else's stock market order.

RUHLE: And you don’t feel good about that?

LEWIS: That's good. That is good.

RUHLE: That's what I'm saying. I don't want some guy jacking me.

LEWIS: The problem is - but some guy is still jacking you, and that's the problem. Is you've got traders, all of this unnecessary financial intermediation happening. Wall Street's found a way to insert itself into the stock market where it's no longer necessary, and there's all this trading happening between intermediaries and you and me that just don't need to happen.

SCHATZKER: Michael, we've got to take a quick commercial break. We will be back in two short minutes with Michael Lewis, author of "Flash Boys."