Flash Boys, Fraud, and the Need for New Rules

April 8, 2014

From Gordon Gecko to Lloyd Blankfein, titans of finance both very real and very emblematic leave Americans with an indelible suspicion that clever Wall Street insiders contort the rules of the game on the backs of honest Main Street investors. Michael Lewis’s book “Flash Boys” certainly does not help. Lewis contends that high-frequency trading (“HFT”) firms, primarily hedge funds, have rigged the securities markets through advanced formulas, computer terminals, and interstate fiber-optics. Speed traders use sophisticated algorithms to identify a large trade in the works, such as by your mutual fund, and then these programs fire an identical trade through their own fiber-optic cable to beat that same transaction to the punch by a fraction of a second at secondary exchanges. The HFT firm sells that purchased stock right back to the original initiator of the transaction—now the second place finisher—at a premium.
This trading trick combines different fields of technological complexity. First, fiber optic cables, present an extremely fast way to transmit data, but like any conduit, they transmit data faster when going directly from A to B. But while that may seem intuitive, it would also seem intuitively a moot point, because whatever difference exists in ‘straightening’ the path of one fiber cable optic cable versus another (a competitor) from the point of trade to the exchange servers in northern New Jersey would only be measured in milliseconds. However, milliseconds is enough. One HFT firm paid a fiber optics company $300 million to lay and dig a straighter fiber optics line from the exchanges in New Jersey to the commodities exchanges in Chicago for a three millisecond increase in transaction speed. A sliver of a second, but enough to beat non-HFT traders (and slower HFT traders) left paying the slightly higher price to the HFT firm effectively selling back to the conventional trader the trader’s own purchase order. As HFT firms begin to compete with one another, lasers (yes, lasers) could soon replace the fiber optics.
Second, HFT computers facilitate the speed in part because of their inside access. “Inside” in this context could not be more literal. The exchanges themselves, such as NYSE and NASDAQ, offer HFT traders the premium spots inside the exchange floors for their server installation, all at a premium price of course.

These trades may be cancerous to the market and unfair to market participants who unwillingly pay HFT traders this toll, but that does not mean the toll breaks the law.

These trades may be cancerous to the market and unfair to market participants who unwillingly pay HFT traders this toll, but that does not mean the toll breaks the law.  While the reporting on Flash Boys accompanied reports that regulators and law enforcement of all stripes were investigating the high speed trading, little came in the reporting of the actual rules broken. Insider trading under the Securities Exchange Act of 1934 may be the most intuitive charge, but the elements do not fit because the activity has been public for years (so no deception or fraud) and so has the information they capitalize on. That latter fact, that the information of an impending large trade is public information even if it is hard to obtain and harder to exploit, means charges of front-running are just as inapplicable.
The role of government might not be in enforcing laws do not apply, but rather in having the debate about if the rules need updating to adopt to the technological realities of the modern trading floor. The 1934 Act gives the SEC leeway to create rules to enforce the act, but those rules must operate within the bounds of the law, and those eighty year-old limits may not comprehend the unfairness of a millisecond.