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Tue April 1, 2014
On A 'Rigged' Wall Street, Milliseconds Make All The Difference
Originally published on Wed April 2, 2014 1:01 pm
"The stock market is rigged," Michael Lewis tells Fresh Air's Terry Gross. "It's rigged for the benefit for really a handful of insiders. It's rigged to ... maximize the take of Wall Street, of banks, the exchanges and the high-frequency traders at the expense of ordinary investors."
Lewis is the author of several books about the world of finance, including Liar's Poker and The Big Short. His new book Flash Boys is about the form of computerized transactions known as high-frequency trading, in which the fastest computers with the highest connection speeds get the information first, and make the trade before anyone else can. A millisecond — even a nanosecond — can make all the difference between how much money is made or lost on any transaction.
You'd be surprised to hear what investment banks do to get that nanosecond edge, and how they often use it in ways Lewis describes as predatory. The victims range from some investment houses to individual investors. Lewis says high-frequency trades can end up hurting the returns on your retirement accounts. The FBI, Wall Street regulators and New York's attorney general are investigating high-frequency trading, and whether it has created an uneven playing field.
"There's a decline of trust in the marketplace because it's not as trustworthy," Lewis says. "And if it's not as trustworthy, then the whole economy suffers. Trust is the grease that keeps the system working."
On high-frequency trading and how milliseconds matter
If I get price changes before everybody else, if I know a stock price is going up or going down before you do, I can act on it. If you're coming in to buy shares in Procter & Gamble and you think the price is 80 ... and I'm sitting there as a high-frequency trader and I know that the price of Procter & Gamble is actually lower — it's gone down [to] 79 — I can buy it [at] 79 and sell it to you at 80. So it's a bit like knowing the result of the horse race before it's run. ... The time advantage of a high-frequency trader is so small, it's literally a millisecond. It takes 100 milliseconds to blink your eye, so it's a fraction of a blink of an eye, but that for a computer is plenty of time.
On how Brad Katsuyama — who worked in New York for the Royal Bank of Canada — discovered the system was rigged
He has 25 traders working for him, he deals in hundreds of millions of dollars of shares every day, he takes risks in the market — and it's in early 2008 he senses something's wrong. What he senses is, when he looks at his trading screens ... his screens will tell him, say, that there are 10,000 shares of Microsoft offered at $30 a share if he wanted to buy them.
And normally, up to this point in his life, if he hit his button and said "buy," he'd get the shares for $30 a share. But all of a sudden, when he hits the button on his computer terminal, the shares disappear. It's like someone knows he's trying to buy Microsoft and the price of Microsoft goes up before he can get it. He doesn't understand why this is happening, and that's the beginning of the story.
On what was going on
What turns out is happening is he's sitting physically in lower Manhattan when he makes his trades. When he pushes the "buy" button, the signal from his computer travels up the fiber optics along the west-side highway of Manhattan and through the Lincoln Tunnel. On the other side of the Lincoln Tunnel is one of the 13 stock exchanges, called the BATS Exchange founded by high-frequency traders.
They're sitting there, and they get the signal that he wants to buy first. ... They can see what he wants to do. They discern his desire to buy Microsoft, and they have faster connections to the 12 other exchanges that are scattered across New Jersey, and they race him to the other exchanges, buy all the Microsoft in front of him, and sell it back to him at a higher price. ...
He was physically being raced by high-frequency traders who had faster and more direct fiber optic lines from the first exchange to all the other exchanges, but it takes him literally 18 months to figure this out, and he has to assemble people who have been essentially in New Jersey laying fiber optic cable to figure out how all this works.
On how this affects the system as a whole
What it does is it neatly divides the market into predator and prey. It creates this relationship between people who are there to actually invest in companies and these artificial middlemen who have been unnecessarily inserted in between buyers and sellers of stock.
On how even insiders don't understand the market
There is this perception that Wall Street insiders understand how Wall Street works — and it's false. It's especially false right now. Here you have this young man, this kid [Katsuyama] at the Royal Bank of Canada who's engaged in this kind of science experiment in the market. He figures out at least one angle the predators are taking ,and he goes and talks to not just ordinary investors ... the biggest investors, the smartest investors in the world, and their jaws are on the floor. ... Even these people have no idea what's going on in the market and are being educated by this Canadian who has basically just arrived on the scene and has decided to make understanding [this] his business.
On attempts to level the playing field
The solution to the problem, [Katsuyama and his team] thought, was, "Well, let's create an actual fair stock exchange. Let's take on the responsibility of essentially restoring trust to the stock market, of creating an environment where every dollar stands the same chance." And who would've thought this would be such a radical act? But it is.
They design an exchange on which high-frequency traders can operate, but they don't have any speed advantage anymore. They make everybody essentially the same speed on this exchange. ... The problem once they create this exchange is they have to persuade brokers and banks to send stock market orders onto it, and that's the war that they create when they do this. The banks and the brokers are also paid a cut of what the high-frequency traders are taking out of investors' orders, so they don't want to send their orders on this fair exchange because there's less money to be made.
On Katsuyama and his team who started IEX, which aims to be a more equitable exchange
They're all people who are making, in some cases, several million dollars a year in very safe jobs, and they were successful, beloved by their firms, etc., etc. There are two things about them that are striking: One is it's amazing how many of them are immigrants. ... They're Canadian, they're Irish, they're Chinese, they're Russian. I don't know what that means, but they came to this country and they had some view about the way the system worked. They were disturbed by what they found, and they wanted to make the system work the way they imagined it. The other thing is, they're all one way or another people who are living their lives as they want to look back on them, rather than thinking about the next quarter's bonus. They were kicked into that state of mind by various events in their lives. There's a peculiar moral quality about all of them that I found just really interesting.
TERRY GROSS, HOST:
This is FRESH AIR. I'm Terry Gross. The stock market is rigged, according to my guest Michael Lewis. His new book, "Flash Boys," explains why. It's about the form of computerized transactions known as high-frequency trading, in which the fastest computers with the most high-speed connections get the information first and make the trade before anyone else can. A couple of nanoseconds can make all the difference between how much money is made or lost on any transaction.
You'd be surprised to hear what investment banks do to get that nanosecond edge and how they often use it in ways Lewis describes as predatory. The victims range from some investment houses to individual investors. In fact, some high-frequency traders may be preying on your retirement accounts.
The FBI, Wall Street regulators and New York's attorney general are investigating high-frequency trading and whether it's created an uneven playing field. Michael Lewis is the author of several books about the stock market, including "Liar's Poker" and "The Big Short." He also wrote the bestseller "Moneyball," about how computer analytics is changing baseball.
Michael Lewis, welcome back to FRESH AIR. So you say the image of the stock exchange, with traders hollering on the floor, that really hasn't existed in reality in several years. The markets, you say, trade inside black boxes in heavily guarded buildings in New Jersey and Chicago. What are those black boxes? What are those buildings?
MICHAEL LEWIS: Well, the most sensational building is the New York Stock Exchange building in Mahwah, New Jersey, which it's a fort. To get to it, you go through, you know, guards and German shepherds, and it feels guarded. And inside the building is the matching engine, the place where buyers and sellers meet on the New York Stock Exchange, not on the floor of the New York Stock Exchange.
There are no human beings - it's just signals going into a box, computer signals. The building is enormous, and the question is sort of why is so big if the exchange is now just a box instead of thousands of people shouting at each other. And it's enormous to house the equipment of all the high-frequency traders who want to be near the exchange so they can get information from the exchange more quickly than you or me.
GROSS: OK, when you say more quickly than you and me, it sounds like there's a messenger running from the exchange to the office of the broker, which is exactly not what's happening. How do you get the edge in terms of time, of getting it a nanosecond before the other people do?
LEWIS: It's a couple of millisecond edge they're usually looking at, and the way you do it is just - is to minimize the physical distance between you and the actual exchange so that the cord that connects your box, that is making your trading decisions, you the high-frequency trader, that leads to the actual exchanges is just shorter than everybody else's cord. So you get closer. And high-frequency traders pay the exchanges vast sums of money to be close to the exchange so they can get the signals from the exchange before everybody else, so they can find out what prices are, where they've moved before everybody else.
GROSS: And these signals are traveling on fiber-optic lines.
LEWIS: Correct, so it's - you know, it's a matter of physics. I mean, there's - light traveling over distance still takes time. It's time that's kind of incomprehensible to the human mind, but to a trader in the stock market now, the difference between getting the information in three milliseconds as opposed to four milliseconds is the difference between knowing the prices before everybody else and not.
GROSS: And why does that give you the edge?
LEWIS: Well, if I get price changes before everybody else, if I know a stock price is going up or going down before you do, I can act on it. If you're coming in to buy, you know, the shares in Proctor & Gamble, and you think the price is 80, and you're saying I'm going to buy Proctor & Gamble for $80 a share, and I'm sitting there are a high-frequency trader, and I know that the price of Proctor & Gamble is actually lower, it's gone down, it's 79, I can buy it a 79 and sell it you at 80.
So it's a bit like knowing the result of the horse race before it's run or getting advance word on where the ball is going to land in the roulette wheel. And it's hard to get your mind around because the amount of time, the time advantage of a high-frequency trader, is so small. It's literally a millisecond or two. It takes 100 milliseconds to blink your eye, so it's a fraction of a blink of an eye.
But that for a computer is plenty of time.
GROSS: Right, because we're talking about computer time, not human time here.
LEWIS: I think that was one of the big things about this story that made it so mind-bending and, you know, in some ways difficult to tell, is that to understand the stock market, in fact all the financial markets these days, you have to stop thinking, kind of seeing the world through the eyes of a human being and try to see it through the eyes of a computer and see - and think about how a computer thinks about time.
I mean for a computer, a millisecond is a lot of time. For a human being it's imperceptible. A computer can make hundreds of trades in a millisecond. A human being can't do anything. So yes, it's the markets are now in a funny way perceived through the minds of computers.
GROSS: A lot of people in our audience are probably thinking I don't really understand high-frequency trading on Wall Street, there's a lot about the stock market I don't understand. Will I be able to follow this story even though it's real important? And so I just want to say that you have created this narrative that is really interesting with different characters who are insiders on Wall Street, and there's points at which they have no idea what's happening.
But that's how kind of covert a lot of this stuff is and how complicated. So let's try to sort through it because the bottom line is, you know, the system's kind of rigged.
LEWIS: The stock market is rigged. It's rigged for the benefit of really a handful of insiders. It's rigged to sort of maximize the take of Wall Street, of banks, the exchanges and the high-frequency traders at the expense of ordinary investors. And what struck me, I mean what I found so fascinating about this story, if all I knew was that the stock market was rigged, I wouldn't have written a book about it. Maybe I'd have written an essay about it.
GROSS: Why? You would've thought, like, so?
LEWIS: I'd have thought, well, so Wall Street's done something bad again. The stock market's rigged. It is amazing that the stock market's rigged, but what I found even more amazing was that there was this collection of characters on Wall Street who have to kind of figure out that it's rigged and how it's rigged and prove it's rigged and then go explain it to investors, big investors, sophisticated investors, none of whom understand how it's rigged, just know that something's funny.
And it was really that story, a story of discovery by people who, you know, kind of thought they knew how the stock market operated but found out that in fact they knew - really didn't know at all. And so they have to learn from the ground up in a way that, you know, a common reader might have to learn from the ground up, the way my mother would have to learn from the ground up.
So my mother can follow them on the journey. That's sort of what engaged me with the story.
GROSS: So the central figure in your book is Brad Katsuyama, who was working with the Royal Bank of Canada when he became the head of electronic trading. And once he gets into electronic trading, things start happening that he just doesn't understand.
LEWIS: So let me - can I back you up?
GROSS: Yes, please.
LEWIS: All right. So Brad Katsuyama is the head of just stock trading at the World Bank of Canada in New York. He has 25 traders working for him. He deals in hundreds of millions of dollars of shares every day, he takes risk in the market, and it's in early 2008 he senses something's wrong. And what he senses is, when he looks at his trading screens, which has the prices of stocks in the market, and the stock market's no longer in one place, they have 13 different public exchange that trade, say, the stock of Microsoft or the stock of Apple Computer - so he's got, you know - he's got - his screens will tell him, say, that there are 10,000 shares of Microsoft offered at $30 a share if he wanted to buy them. And normally, up to this point in his life, if he hit his button on it and said buy, he'd get the 10,000 shares for $30 a share. But all of a sudden when he hits the button on his computer terminal, the shares disappear. It's like someone knows he's trying to buy Microsoft, and the price of Microsoft goes up before he can get it.
And he doesn't understand why this is happening, and that's the beginning of the story. It's sort of like all of a sudden the market he sees on his screens, which is the market every, you know, professional trader and even someone who's sitting at a Schwab terminal or an E-Trade terminal would see on their screens, becomes this kind of illusion.
GROSS: So why are the shares that he's trying to buy disappearing as soon as he hits buy?
LEWIS: You ask that question so facilely. It takes him 18 months to get to the bottom of it.
LEWIS: Eighteen months with some of the most sophisticated minds on Wall Street working with him to answer that simple question: Why are the shares disappearing? Why does someone seem to know what I want to do before I do it? And it may only cost me a few pennies a share each time this happens, but over - spread over the billions of shares that are traded every day on the stock market, it adds up.
So he goes looking. And he started to sort of like test the market with funny kinds of experiments. The short answer is what turns out is happening is he's sitting physically in Lower Manhattan when he makes his trades. When he pushes the buy button, the signal from his computer travels up the fiber-optics along the West Side Highway of Manhattan and through the Lincoln Tunnel.
On the other side of the Lincoln Tunnel is one of the 13 stock exchanges, called the BATS Exchange, founded by high-frequency traders. They're sitting there, and they get the signal that he wants to buy first. They're sitting there offering a few shares of Microsoft so that they can see what he wants to do. They discern his desire to buy Microsoft, and they have faster connections to the 12 other exchanges that are scattered across New Jersey, and they race him to the other exchanges, buy all the Microsoft in front of him and sell it back to him at a higher price.
So what was happening is he was physically being raced by high-frequency traders who had faster and more direct fiber-optic lines from the first exchange to all the other exchanges. But it takes him literally 18 months to figure this out, and he has to assemble people who, you know, have been essentially in manholes in New Jersey laying fiber-optic cable to figure out how all this works.
GROSS: So say the bank and investment company that he was with represented my retirement fund. What would that mean for me?
LEWIS: It would mean for you that every time your retirement fund trades in the market, some high-frequency trader is skimming pennies from each trade, and it adds up to who knows, 10, 20 - no one quite knows, many billions of dollars a year. It's essentially a tax on your investment dollars. So you're essentially being legally robbed from by the system.
And - but that's just really the beginning of the problem. I mean, the beginning of the problem is you're paying this unnecessary tax to Wall Street to make trades in the marketplace. The bigger problem is that the system in order to accommodate high-frequency trading has become ever more complicated. In fact, it's almost designed so you can't understand it, so you don't ask questions about it.
But the complexity brings with it instability, in that making these systems that run the stock exchanges ever more complicated and ever faster for the benefit of high-frequency traders creates a kind of volatility to them. So you have flash crashes. You have outages of stock exchanges. You have stocks doing very strange things. So the bigger problem in addition to the skimming that's going on of your savings, is that there's a decline of trust in the marketplace because it's not as trustworthy, and if it's not as trustworthy, then the whole economy suffers.
I mean trust is the whole - is sort of the grease that keeps the system working.
GROSS: If you're just joining us, my guest is Michael Lewis, and we're talking about his new book "Flash Boys: A Wall Street Revolt." And it's about how Wall Street has changed because of high-frequency trading. Let's take a break, and then we'll talk some more about this new kind of drama on Wall Street. This is FRESH AIR.
(SOUNDBITE OF MUSIC)
GROSS: This is FRESH AIR, and if you're just joining us, my guest is Michael Lewis, who's best known for books like "Moneyball," "The Big Short," "Liar's Poker." His new book, "Flash Boys," is about high-frequency trading on Wall Street, where like a nanosecond makes a really big difference in whether you're making money or losing money. And it's a complicated story, but he's an incredible storyteller.
GROSS: So how are the stock market exchanges benefiting from high-frequency traders? Like what's the relationship that they have that works for them but shuts out a lot of investors?
LEWIS: So places like the New York Stock Exchange and NASDAQ and a lot of lesser known exchanges - there are 13 of these public exchanges now - all make vast sums of money by selling access to their buildings, to their physical premises, to high-frequency traders so that the high-frequency traders can be closer to the black box that is the exchange so that the high-frequency traders can get information about price changes faster than everybody else, so they know the market before everybody else. That's one way they, the exchanges, make money from high-frequency traders.
Then what they do is once they've got all the high-frequency traders in the building, unlike - you and I aren't in the building, you and aren't represented in the building. The high-frequency traders have their computer terminals next to their servers, right next to the exchange computer, and they then compete amongst themselves to be closer and closer, faster and faster in relation to each other.
And this is sort of like, I don't know, it's sort of like a bunch of predators competing to be fastest to get to the prey. You and I are the prey, they are the predators. So the exchange sells small increments of speed to the predators. They'll upgrade their technology so all of a sudden everybody can be two microseconds faster, but they have to pay for that.
That's the business model for these exchanges now. It's to find ways to enable the high-frequency traders to get ever faster and sell them the technology to do so, so that they can be the first to get to us.
GROSS: So it's almost like a pay-to-play system.
LEWIS: It's totally a pay-to-play system. That is what it is, and it's pay a lot to play. I mean, to set up a high-frequency trading sort of system in all the exchanges, you're talking about millions of dollars a year. It's not something that everybody can do. But it is something that a big Wall Street bank can do. A big Wall Street bank might be in the high-frequency trading game. But it's absolutely. And it is - what it does is it neatly divides the market into predator and prey. It creates this relationship between people who are there to actually invest in companies and these artificial middlemen who have been unnecessarily inserted in between buyers and sellers of stock.
GROSS: So let's get back to Brad Katsuyama, and he's again the central figure of your book, who is at the Royal Bank of Canada when he figures out that something's going on that he doesn't comprehend. He assembles a team of experts from all over who have dealt with high-frequency trading and together they figure out what's going on. And then they to circumvent it.
And they create something called Thor. What is Thor?
LEWIS: So Thor is a stock market order router. It sends the orders out in the market, to the 13 different exchanges from Brad's computer terminal. So the problem he was having was that when he hit his button and sent his buy order or his sell order into the market, it arrived at different exchanges at different times because the exchanges were physically located at different distances from his desk, and it takes time for a signal to travel through fiber-optics.
So it would get to an exchange on the other side of the Lincoln Tunnel first, and then it would get to the other exchanges later. With Thor, what they did is they organize the 13 different signals that went to the 13 different exchanges so they all arrived at exactly the same time. So they weren't vulnerable to a high-frequency trader seeing it arrive to buy at one exchange and racing them to all the other exchanges.
And the minute they were able to perfect this, and it was not a simple matter, designing it so that it arrived at the same time at all these exchanges, and it was not even intuitively obvious to them it was a solution to the problem. They were guessing. They'd been experimenting in the markets, and this was just one of their experiments. But when they hit the button, and all their buy orders arrived at exactly the same, you know, microsecond at all 13 exchanges, the market became the market again.
No longer were - was the high-frequency trader able to identify what they were doing at the first exchange they arrived at and exploit them on all the other exchanges. So this was a revelation. This was - in a way it's the beginning of their story because it's the first time they see, oh my God, now we know how we're being exploited. We've being exploited because the first exchange we arrive at there are our predators waiting who identify what we're doing and then prey on us at all the other exchanges.
And they take this, the - I think this is like - there's several moments where there are these moral choices that my main character, that Brad, has to make. And the minute he realizes this, he realizes - he sees what the game is being played, he has a choice. He can play the game with everybody else, and he could probably make a lot of money as a high-frequency trader. But instead he decides to go on an educational campaign and go talk to investors about what he's just discovered.
GROSS: And of course a lot of them don't understand what's going on yet either.
LEWIS: But you know, this is a big, big point. So there is this perception that Wall Street insiders understand how Wall Street works. And it's false. And it's especially false right now, that here you have this young man, this kid at the Royal Bank of Canada who's engaged in this kind of science experiment in the market. He figures out at least one angle the predators are taking, and he goes and talks to not just ordinary investors, he's talking to Bill Ackman, David Einhorn, Dan Loeb, Fidelity, Vanguard, Capital Group, the biggest investors, the smartest investors in the world, and their jaws are on the floor.
Bill Ackman, the hedge fund manager who often, you know, takes big stakes in companies, he's told me, he said, you know, until Brad Katsuyama walked into my office, I thought I had an insider trading problem. I thought people were figuring out what companies I wanted to buy and jumping in front of me in the market before I bought them.
And it was a different kind of insider trading problem than I thought I had, basically, is what he said. So these - even these people have no idea what's going on in the market and are being educated by this Canadian who's basically just arrived on the scene and has decided to make understanding his business.
GROSS: Michael Lewis will be back in the second half of the show. His new book about high-frequency trading is called "Flash Boys." I'm Terry Gross, and this is FRESH AIR.
(SOUNDBITE OF MUSIC)
GROSS: This is FRESH AIR. I'm Terry Gross back with Michael Lewis. His new book "Flash Boys" is about how the stock market has become a rigged game as a result of the computerized transactions known as high-frequency trading, in which the fastest computers but the most high-speed connections compete against each other to get information first and make a trade before anyone else can. A fraction of a second can make all the difference in how much money is made or lost in one of these transactions. Lewis says some high-speed traders are predatory, and their prey may include your retirement account.
So when we left off, you're talking about how Brad Katsuyama, who is the central figure in your book, had figured out how high-frequency trading was kind of becoming predatory and explaining his trade, so that he ended up having to buy at higher prices than he thought he was buying. And he brings a team of people together around the country who really understand insider-trading and they tried to figure out a way of circumventing it. They come up with a program that levels the playing field. And then they figure out what they really need to do is create their own stock exchange. Why would they need to do that?
LEWIS: Well, because what they realized is the American stock exchange has completely fallen down and responsibility to create a fair environment for investors. That they were prejudicing the market in favor of high-frequency traders because the high-frequency traders pay them to do it. And that was in fact, kind of the business model of the new - and the American Stock Exchange, was to create opportunities for strength fast traders to exploit you and me and every other investor. And so long as the exchanges were bent on doing this, no matter how cleverly they routed their stock market orders into the market that they figured the predator would find a way to get them. And so the solution to the problem they thought was well, let's create an actual fair stock exchange. Let's take on the responsibility of essentially, restoring trust to the stock market of creating an environment where every dollar stands the same chance.
I mean who would've thought this would be such a radical act, but it is. And so they design in exchange on which high-frequency traders can operate but they don't have any speed advantage anymore. They make everybody essentially the same speed on this exchange, so you're no longer at risk of being preyed upon. The problem once they create this exchange is that they have to persuade brokers and banks to send stock market orders onto it. That's the word that they create when they do this. I mean the banks and brokers are also paid a cut of what the high-frequency traders are taking out of investor's, so they don't want to send their orders onto this fair exchange because there's not lots of money to be made on this fair exchange for them.
So how does Katsuyama go about trying to persuade them that they do want to trade on this exchange? He's created this war. And the word he's created is between people who have savings investments to make, to manage - money managers, individual investors, hedge funds managers, so on and so forth. And on the other hand, the people who have been mishandling those funds, big Wall Street banks and brokerage houses. And when he does is he tours the world and educates investors about what's happening with their stock market orders. And he tries to persuade the biggest investors to start to pressure the banks to behave more honestly with them. And that is what has happened. I mean if you call up Goldman Sachs or Morgan Stanley or JPMorgan were any of the big banks today, they'll tell you they're being hounded by some of the world's biggest investors to route their stock market orders onto Brad Katsuyama's exchange because it's the only exchange they trust.
GROSS: So a fundamental question I have about these exchanges is why are there so many of them? Why isn't there just one or maybe two exchanges?
LEWIS: Well, it's a really good question. And it's a really good question because not all trading is computerized and we could all meet in a single black box without a lot of human beings in between us, that's probably what should happen, that all buyers and sellers should just agree to meet in a single place. It would simplify the market, make it more transparent, so on and so forth. The answer that a Wall Street person would give you is that exchanges are businesses, that they benefit from having to compete with each other, that they provide services. And if there are more than one, they're kind of forced to be on their game all the time. The problem is that their customers, the people they're trying to please, are not doing me. They're not investors. They are banks and brokers that send them stock market orders and high-frequency traders who buy special access inside them. So they're competing with each other basically to please the predator at the expense of the prey.
GROSS: Because that's where the profits are for them?
LEWIS: Because that's where the profits are. And the reason it doesn't consolidate, the market doesn't consolidate is the more fragmented it is the easier it is for high-frequency traders to explain investors. They can erase them from one exchange or another. The physical distance between exchanges creates opportunity for high-frequency traders.
GROSS: So this new exchange that was started by the central figure in your book, Brad Katsuyama, how has it performed so far?
LEWIS: It was initially named the Investors Exchange and then they went to go get a Web address and they realized that it was www.investors.sex change.com.
LEWIS: So they had to - so really, they bothered them - right from the beginning - they had to introduce another acronym to Wall Street, IEX, and it bothered them to no end. But IEX was opened for business in late October of 2013 and has done extremely well, as new exchanges go. Normally, new exchanges take a while to gain traction. They're already profitable. I mean they're trading, I don't know, 30, 40 million shares a day - which is still, it's small, but it's sustainable. The volume of stock market trading their doing though, is really a very poor education of their effect on the universe because their effect has been profound. The New York Stock Exchange for the last three months has been trying to buy them. And I think there's a chance the New York Stock Exchange will buy them and try to make them the New York Stock Exchange. What they are is they're radically disrupting the environment because investors are increasingly learning that it's the one fair exchange, the one place where they won't be exploited. And the pressure that investors put some banks and brokers to send their stock market orders to this exchange is increasing. At some point it's a bit like, I don't know, it's a bit like a river changing its course. I think you can kind of think of Brad Katsuyama and IEX a sort of stretching on the side of a river that they want to jump its bank at that particular day bank. That at some point the whole market could job onto this exchange, that there is a kind of network effects that the bigger they get the bigger they get. And it's all been good. I mean they've gotten, they've doubled in size every month since they started and I suspect that they're going to continue to do so for a while.
GROSS: So this high-frequency trading that has created the unequal playing field that you write about, this all happened after the financial collapse of 2007, right?
LEWIS: Yes. And that is an incredible footnote to the story, the idea that essentially, the stock market got raised since the financial crisis. You would've thought that here you got the world's most watch, most supposedly democratized, politicized financial market at a time when everybody is skeptical about Wall Street, you would've thought that that would be the least likely time for the sort of shenanigans to happen. But, in fact, no. In fact, there's been a dramatic rise in predatory activity since the financial crisis in the stock market.
GROSS: If you're just joining us, my guest is Michael Lewis and he's the author of many books about Wall Street, including "Liar's Poker" and "The Big Short." His book "Money Ball" was about how algorithms are being used in baseball now. His new book is called "Flash Boys" and it's all about high-frequency trading on Wall Street and how it's created an incredibly uneven playing field - or as he puts it - the system is rigged.
So let's take a short break and then we'll talk some more. This is FRESH Air.
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GROSS: This is FRESH AIR. And if you're just joining us my guest is Michael Lewis. He's written extensively about Wall Street and about the use of computer algorithms to do crazy things. So he's the author of "Money Ball," "Liar's Poker," "The Big Short." His new book is called "Flash Boys" and it's about how high-frequency trading has transformed Wall Street in ways that most people - even a lot of traders - don't know about them don't understand.
so high-frequency trading is dependent on fiber optic lines that can carry information incredibly quickly, that can transmit information incredibly quickly. And earlier in your book, you describe the one of these lines was built in 2010, kind of secretly to connect a Chicago data center with a stock exchange located in Northern Jersey. Was that the New York Stock Exchange?
LEWIS: Well, it was the NASDAQ stock exchange where the line ended, but then it fanned out to all the other stock exchanges.
GROSS: Got it.
LEWIS: The business was called Spread Networks. It was a breathtaking story. There was a former trader on Chicago futures exchanges who saw how much money high-frequency traders were making. And he realized that they needed the fastest possible line between Chicago and New Jersey. And the reason they needed was that in the stock market, stock futures trading in Chicago and the actual stocks trade in New Jersey. And price movements in the market, in the overall market goes up or down tend to register first in Chicago in the futures market. So if you want to know if you're making markets and all the stocks in New Jersey and you want to know what the overall market is going to so you can get out, you know, if the market is going to fall you don't want to be buying, you need to know that first or else you're in trouble. Or else other people who know it first are going to sell stock to you when the market's falling. So this, his name is Dan Spivey, this trader. He essentially dug a tunnel between Chicago and New Jersey as straight as possible. He laid a string across a map and said how straight can I make this line? Because the straight year it is, the shorter it is, the faster it is. And he was trying to be the fastest line that was out there, which was owned by Verizon Wireless and they didn't know it was the fastest line. They didn't even know what they had. But Verizon Wireless could get a signal from Chicago to New Jersey like 17 milliseconds. And he spends - Spivey spends - $300 million, $400 million digging this tunnel incomplete secrecy - no one has any idea why he's doing it or what he's doing - and laying this line that enables him to get a signal back and forth in about 12 and one half milliseconds. And then is able to go out and demand from high-frequency traders $10 million a pop just to be on the line because they can't afford not to be on the low.
GROSS: And this amazes me that one firm, one investment company that he was dealing with, they wanted it to double the price so that competitors couldn't afford to the underlying.
LEWIS: Yes. Well, so this is, I mean it's a great business school case study. So you have come he sort of is like creating scarcity. He digs this line that the high-frequency traders already have the fastest line between Chicago and New Jersey. It's irritating to them that someone has gone and done the faster one because now they have to have it and they have to pay for it. They were getting the fastest line previously or not very much money. He walks into their offices and their series with him, basically. How dare you do this? How dare you demand we paid $10 million just to get on your line? But then they realize they can't not be on it. And it is one of the great moments, he thought, was when one of the high-frequency trading firms, after being angry with him said, you know, let us cool down and let us think about this for a minute. And then they come back in the room and they say, can you double the price? Because the more expensive it is they figured that you were people would be on it anymore and the more of an advantage they would have over the rest of the stock market.
GROSS: You know, it was algorithms and things invisible to the public into most traders that created the financial collapse of 2007 - or at least partly created it. Our experts expecting that they're going to be more flash crashes in the near future because of how complicated and also convert so much of high-frequency trading is now?
LEWIS: The answer to that is yes. You look around, there's a flash crash - there are flash crashes in stocks every day, individual stocks. There are outages at the exchanges. There's technical glitch after technical glitch. This is all symptomatic of a system that's out of control, too complicated, nobody completely understands. It's unstable. And Goldman Sachs in just the last few weeks has essentially thrown its support behind Brad Katsuyama's exchange because they think that what is needed is simplicity and transparency. And they're starting to route all their customer's orders onto that exchange for that reason. And the head of Goldman Sachs' stock market division said to me, he said if we don't change the system there's going to be a flash crash times 10. There's going to be some extremely unpleasant crisis in the stock market. So I think it's becoming conventional wisdom that the system itself is a problem. And that's a problem for all of us because of the system is unstable, if the house is built on sand, it does not engender trust. And there's no trust in the market, it costs companies more to raise money in the market. And it could cost companies more to raise money in the market, they don't supply as many jobs to the economy, they don't innovate in the way they might innovate, they don't invest in the way they might invest. And it's a problem. It gets to the very root of the American economy.
GROSS: Part of the reason why you're so good at reporting on Wall Street as that used to work there, so you are an insider for a while. And this was in the mid-1980s when you worked...
LEWIS: A long time ago. Yeah.
GROSS: Yes. And it's changed a lot since then. But still, you grasp it. So this was in the mid-80s. You market Salomon Brothers. You were the...
...'80s when you were...
LEWIS: A long time ago. Yeah.
GROSS: Yes. And it's changed a lot since then but still, you grasp it. So this was in the mid-'80s. You worked at Salomon Brothers. You were there during the crash of October '87. You say Wall Street firms have grown more concerned than they were in the late '80s with what journalists might say about them. Why do you think that is? And how did that affect your reporting of this high frequency trading story?
LEWIS: It's interesting because if you think back what I did with "Liar's Poker," I walked out of a job at Salomon Brothers, told my bosses I was going to write a book about Wall Street and they kind of smiled and said go do it if you want to, you're crazy because you could make a lot more money here. But you know, do your best kind of thing.
If you tried to do that now, well, for a start, the version of me on Wall Street would've signed all kinds of non-disclosure agreements when he came into the firm. And you would've been hounded by lawyers on your way out the door. The firms have become so concerned about their public faces and so reluctant to share what's going on inside of them. Now, why has that happened?
I think it's because Wall Street, to some extent, depends for its profits on people not understanding what's going on in Wall Street. The firms generate complicated situations, complicated securities, precisely so that other people don't understand them, creating an advantage for the Wall Street firms. I think that technology has naturally rendered a lot of what Wall Street's formerly useful function was moot, that you don't need a human being in between buyers and sellers of stock anymore. It could all be done electronically without Wall Street in between the buyers and the sellers. So Wall Street has been put in a position of having to scramble to find sources of revenues that are just less justified, that are more kind of manufactured.
Subprime mortgage CDOs are one example. The incredibly complicated things they did in the subprime mortgage market were not actually economically useful. They were damaging but they generate a lot of profits for Wall Street. This breathtakingly complicated stock market that's been constructed is not actually socially or economically useful but it generates a lot of money for Wall Street.
So when you are running one of these firms and you sense that a lot of what you do is not socially or economically useful, it's just enabling a kind of skim, the last thing you want is transparency or people from the inside talking about what's going on in the inside. You want to hide what you're doing. I mean I think they're naturally kind of more frightened of having the public genuinely understand what their businesses are.
And it's not that all of the business on Wall Street is bad or not useful, but it's just an increasing chunk of Wall Street is essentially predatory. So I think that's what's going on. And I think that the sort of technology has caused a crisis in the financial services industry and the financial services industry has responded by, you know, trying to defend its profitability and it's been very good at doing it. But it requires this kind of opacity.
GROSS: So one final question for you. The central characters in your book are people who walked away from their jobs at various banks and brokerage houses to create this new exchange that they thought would be an even playing field without giving high frequency traders the edge. So what was in it for them? Because they gave up a lot of money at the jobs that they were for an uncertain future.
LEWIS: This is what intrigued me about these characters, that they are all people who are making, in some cases, several million dollars a year in very safe jobs and they were successful, beloved by their firms, etc., etc. And there are two things about them that are striking. One is it's amazing how many of them are immigrants, how few of them are actually Americans. They're Canadian, they're Irish, they're Chinese, they're Russian.
And I don't know what that means, but they came to this country and they had some view about the way the system worked. They were disturbed by what they found and they wanted to make the system work the way they imagined it. The other thing is they are all, in one way or another, people who are living their lives as they want to look back on them, rather than like thinking about the next quarter's bonus.
And they were kicked into that state of mind by various events in their lives. There's a peculiar moral quality about all of them that I found just really interesting.
GROSS: Michael Lewis, it's been great to have you back on the show.
LEWIS: Thank you.
GROSS: Thank you for explaining stuff that's really complicated and doing such a good job with it. Michael Lewis's new book is called "Flash Boys." High frequency trading is currently being investigated by the FBI, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and New York's attorney general. Transcript provided by NPR, Copyright NPR.