In his new book, Flash Boys: A Wall Street Revolt, bestselling author Michael Lewis tells the story of a group of people who each independently discover that the U.S. stock market has been rigged and then band together to do something about it. In this interview with Wharton finance professor Jeremy Siegel, author of Stocks for the Long Run, Lewis explains the “systemic stealth that’s built into the stock market,” why he thinks those on Wall Street have let this go on and who the heroes are.
An edited transcript of the conversation follows.
Jeremy Siegel: On page 232, you write the following: “The stock market at bottom was rigged. The icon of global capitalism was a fraud.” Wow. Those are strong statements. They probably have been misinterpreted in a lot of ways. First of all, let me say that I believe a lot of what you are saying about high-frequency trading. It’s true, and we have to get these regulators off their duff to do something about this. But don’t you think words like that scare people away from legitimate investing in the stock market?
Michael Lewis: I doubt any words I could write would be as scary as what high-frequency traders have done and what exchanges have done with them. When I’m writing that, I’m writing through the eyes of the person who’s been investigating the stock market for the previous 231 pages. That’s his view of the matter. A lot of people, when they read the book and the facts of what he’s uncovered, will come to the same conclusions. It doesn’t mean that you shouldn’t invest in the stock market. It doesn’t mean that you won’t do well in the stock market. But it does mean there’s a systematic stealth that’s built into the stock market. “Rigged” is a fair description of it. It just turns on the connotations of “rigged.” But to my mind, that’s a fair description of it. And to Brad Katsuyama’s mind.
Siegel: He’s wonderful. I saw him on CNBC, and I am all for the IEX [Investors Exchange]…. A few people have e-mailed me: “Jeremy, if Michael is right, does this mean I shouldn’t be in the stock market?” I don’t think you mean that. You mean that there’s a scalp, there’s a cost there that we could eliminate or we should do without. Is that more accurate?
Lewis: That’s correct. I don’t mean people should get out of the stock market but that there is this systematic scalp built in that we can get rid of. From the point of view of the people who are doing the scalping, it’s a rigged game in that you can [trade for] 1,000 days as a high-frequency trader without ever losing money….
“You rightly mention in the book, it’s pretty hard to determine the magnitude of this scalp…. Is it $5 billion? Is it $3 billion a year that they are taking?” –Jeremy Siegel
I certainly … don’t mean you shouldn’t be invested in the stock market, and I don’t mean that I’m not invested in the stock market. I haven’t changed my behavior as a result of what I know. It just outraged me….
Siegel: You rightly mention in the book, it’s pretty hard to determine the magnitude of this scalp…. Is it $5 billion? Is it $3 billion a year that they are taking?
Lewis: It’s a really good question, and it runs right through the book. You can only wonder what it is. Unless high-frequency traders are going to divulge their profits and their strategies, which they don’t seem to be willing to do — in fact, it’s an incredibly secretive industry — there’s no place you can go to get a sense of what high-frequency traders have made. You have to back it out a couple of ways. One way is a really crude way; you start to look at what they spend for speed. If they are spending billions of dollars a year, they are making multiples of billions of dollars a year. But it’s hard to know whether all the speed-generated profits are scalping or they are something else.
The other way you look at it is by looking at what levels of compensation you regard as normal. You have a guy who makes $90 million a year working for Citadel leaving because he’s angry he hasn’t been paid more and going off to create his own firm where he makes even more. You have to figure that it isn’t a few million dollars we’re talking about….
Siegel: I went through some research to try to find some estimates. Frederi Viens from Purdue University said high-frequency profits are big but they are declining. He called them $5 billion in 2009. Now he says $1.25 billion in 2012. There was another piece of research I saw [in a New York Times pieceby] Nathaniel Popper that [cited similar estimates from Rosenblatt Securities]. Would these be ballpark pictures? Do you think those are too low, Michael?
Lewis: I would say that they are probably pretty dramatically too low. The people at IEX look at the individual strategies, and they try to guess how often they can be engaged in. From individuals, they have discovered four strategies, and they kind of figure each one is multi-billions. Not $10 billion each, but maybe $2 or $3 billion each.
Siegel: So you think maybe $20 billion is the predatory [portion]?
Lewis: If I had to bet, I would bet $15 billion is the value of the predatory strategies. But there’s no way to know. You really are guessing. The people call it research, but really the only way to find out is to go ask the high-frequency traders. There’s no good way to find out what the take is. I’m very happy to believe that the take of high-frequency trading is lower now than it was in 2009 because the markets are less volatile.
Siegel: And it’s more competitive, too. I guess more people are competing against each other in it.
Siegel: That doesn’t mean they are taking more out of the market when they are competing more with each other.
Lewis: But the take of high-frequency trading is going to be correlated with the volume and volatility, and that will ebb and flow. If we have another spike in volume and volatility, their take would go back up. It’s important, when you’re looking at the tax, that you’re trying to calculate what’s the tax on investment of the scalp. It’s not their profits that are important; it’s the revenues, right? In 2009, a high-frequency trading firm could make $500 million with a predatory strategy, and they got to keep it all because the exchanges didn’t bill them for special access. Then in 2014, they make $500 million, but they have to give $250 million back to the exchanges; it’s still a $500 million scalp. I think that’s what’s going on; they are being billed more efficiently by people like spread networks and exchanges and the banks.
Siegel: I also want to put in perspective, we have a stock market value today, including some of the foreign stocks that trade on our exchange, of about US$30 trillion. US$15 billion is only five basis points of that.
Lewis: Yes, it’s tiny, I agree.
Siegel: When you get 8% and 9% per year, [which] has been the historical return on the stock market, they are not going to kill you with five basis points.
Lewis: No, no, that’s exactly right. One good question to ask is why this systematic problem has been allowed to happen, and one [answer] is it has been disguised by a great bull market. If stocks were going down, people would be more sensitive to even $15 billion being taken out of it. Two, it’s the perfect game. It’s taking a little bit from a lot of people, so that no one person really feels very much. But when you add it all up, you have a career, an industry.
“It’s a rigged game in that you can [trade for] 1,000 days as a high-frequency trader without ever losing money…. I haven’t changed my behavior as a result of what I know. It just outraged me.” –Michael Lewis
Siegel: You also admit … overall there has been an absolutely dramatic drop in transactions costs for ordinary stock traders and even professionals through all the years of Wall Street. The front-running has gone on for 185 years; it has just been perfected here with high-frequency trading. Even with that scalp, the cost of an average person buying 100 shares or 1,000 shares … has probably never been lower. Would you agree there, Michael?
Lewis: I would agree. I would say it would be lower still if you didn’t have the scalp built in. What’s happened is interesting. You look across industries and a new technology is introduced and the benefits flow through to the consumers. I can make a telephone call from London now for pennies a minute where it used to cost me $10 a minute. But in that industry, I don’t have the telecom operates figuring out how to recapture those benefits just for their industry.
What’s happened is that not all the benefits of the new technology have flowed through to the investor. Most of them have. I agree … the cost of trading for the retail investor has clearly gone down. But that’s a separate issue from scalping….
Siegel: What single measure would you take to fix this problem?… What should be done now, Michael?
Lewis: One of the nice things about what these characters in the book have done is they have created a market solution to a problem that the regulators partly gave birth to. They might argue that any regulatory response is risky because they might just create another problem. And maybe the market can solve the problem. But for the market to solve the problem, it would be very helpful if there was more transparency in what happens to an investor’s order once he hands it over to a broker. [It would be helpful] if it was easier to figure out how the order was handled and who paid to execute it, to trade it.
Siegel: Would you have the SEC [U.S. Securities and Exchange Commission] require that to be revealed to investors on their trades?
Lewis: I can’t think of any good reason why not.
Siegel: I agree. Do you think that would solve the problem?
Lewis: Alone, no, but what it would do is create momentum to the market solution because the customers could see how their orders were being handled, and they could vote with their feet. You see this happening. You see, for example, with online brokers in the retail space, there’s a company called Interactive Brokers. They have, in the last few weeks, come out and said to their customers, “Here’s a button, and the button enables you to send your order to IEX. We’re not going to have anything to do with payments for order flow. We’re selling the right to trade against you to high-frequency traders.” Right there you see market pressure being applied….
“I don’t think of Wall Street people as worse than other people. The financial system has created … really bad incentives for the people in it. And people follow incentives. But I think there have been plenty of heroes on Wall Street.” –Michael Lewis
Schwab’s order flow is up for sale this year. There’s no question they had to think about whether they want to sell it or whether they want to say to me, a Schwab customer, “I’m selling your order to a high-frequency trader to trade against.” Or can I have some control over it? The transparency will just help the market work. And that’s the problem.
Siegel: It’s almost like the regulators have ignored SIP, the [Securities Information] Processor …. Is there any delay that they could bring in on the SIP feed that could mimic what Brad is trying to do with IEX? Do you think there could be a regulatory fix at that level that could work?
Lewis: I don’t know. In a sane world you would think, yeah, what they could do is just say that the market moves at this speed, and nobody moves faster. You throw out the co-location of high-frequency trading computers inside the exchange. But my hunch is that what would then happen is that we would have the appearance of a solution to the problem without the problem actually being solved. You would be creating another game-able system.
Siegel: I think the private sector is always going to be better at solving it than the governments.
Lewis: That’s right. I like the private sector solution. An exchange is going to take the responsibility of making sure the predatory activity is not going to happen on that exchange. They are going to be selling that to their customers. They are going to be employing really, really, really smart people to see if they can game their own exchange just to make sure it’s not game-able.
Siegel: Michael, in reading your book, throughout you have been very skeptical of finance, and there are a lot of bad characters throughout the last 20 or 30 years. Is there anyone in finance outside of a few who saw through the system, that do the big short and everything, that you think have been extremely positive … in terms of making it better for all of us and all of our investors?
Lewis: Absolutely. Charles Schwab is a good example. I think Chuck Schwab himself has been a real force for good. At the same time he’s been successful, he’s been very seditious. He has basically been telling people that your broker is ripping you off…. I don’t think of Wall Street people as worse than other people. I think that the financial system has created — in places, at times — really bad incentives for the people in it. And people follow incentives. But I think there have been plenty of heroes on Wall Street…. Brad Katsuyama and IEX are a force for good. There is a moral impulse on Wall Street, and it’s nice to see.