The past 15 years have been a fascinating and fertile period for one to first develop their interest in business, economics and investing. From housing market crashes, tech bubbles, rampant institutional fraud by the likes of Bernie Madoff and Enron, unprecedented levels of unemployment and college debt, and a recession that hadn’t been seen for 80 years, contemporary subject matter spans wide and deep. While burdened with a global war on terror, the American people were dually forced to absorb the consequences of short-sighted decision-making by the auto and financial industries through the use of bailouts. With every proven principle, financial instrument, and case study that I was learning about in school and at work, it seems that the entire world- including my professors and bosses- were collectively learning about new ones.
Given the rising complexity of the infrastructure of the financial system, and instances of ethical lapses and myopia on the part of many of those who participated in it, it would seem reasonable for students of these industries, let alone the American public, to develop a healthy level of skepticism for the financial sector and the business leaders that serve it. On the part of the intermediaries that are involved in major financial transactions by the average American, fraud has been exposed. With respect to the 20th century, college is a decidedly less predictable path towards a certain standard of living, a mortgage is a less stable, trusted way to home ownership, and saving for one’s retirement through securities may not be as risk free of a strategy as previously thought.
Of the many ways one might seek to better understand how policy and industry have failed to better serve the interests of the American people, ‘Flash Boys’ by Michael Lewis is a portrayal of the emergence of High-Frequency Trading (HFT) practices that emerged as a dominant means of trading by the end of 2012. The narrative follows the journey of Brad Katsuyama, who began as his career as a business analyst with the Royal Bank of Canada. In 2008, the bank was seeking a more competitive edge in American markets and had identified an HFT firm as an acquisition target and as a means to better develop their competencies in an emerging field. After the acquisition, Katsuyama was sent to Wall Street on RBC’s behalf to run the integration of the firm.
Throughout the process and almost by accident, Katsuyama discovered that the markets had reached a level of speed and complexity that seemed to undermine any action that he might undertake manually. Like a rigged machine at a casino, he would attempt to use the firm’s incumbent systems and enter an order for a stock at a certain price, only to find that it would consistently process the order at a higher price. Most surreally, he found that he could single handedly raise the price of the entire market for a given security at an instant- simply through his actions as a single individual. The troubling nature of this environment, which would be impossible for an outsider like RBC to successfully participate in, led Katsuyama on a several year journey to uncover the true workings of the high-frequency trading community. Developing a complete picture of this environment was not easy for Katsuyama, as many of those who truly understood it were profiting immensely from the status quo.
Over that period, he uncovered a community of technically savvy insiders that were leveraging proprietary communications networks, geographic proximity to exchanges, and automated algorithms to undermine the means by which big banks and everyday investors had used to generate market prices from public exchanges (ie NASDAQ, BATS) and private exchanges (proprietary ‘dark pools’ administered by big banks). Coincidentally, it also undermined legislation preventing such behavior. Some estimates put annual earnings by HFT firms in the tens of billions of dollars and accounted for over 70% of daily trading volume by 2012. By building a diverse team of experts who understood the lack of sustainability for the model, and by generating support with big banks and investors who had experienced a frustration similar to Katsuyama, he was able to successfully introduce a new exchange that sought to level the playing field among investors by significantly reducing the advantages that HFT firms were exploiting within a matter of a few microseconds — or a millionth of a second.
‘Flash Boys’ is one of several works from the past several years that effectively uncover some of the reasons that markets and regulation have not better served the American people. For a better sense of our failings to effectively regulate industry, ‘The Secret Recordings of Carmen Segarra’ is a 1-hour podcast produced by Pro Publica and This American Life that portrays the Stockholm Syndrome-esque culture of the Fed as it attempted to regulate Goldman Sachs in 2008. For an understanding of how investment banks managed reap rewards and pass the risk of their unsustainable behaviors to the American people, the 2010 documentary ‘Inside Job’ breaks down the players that developed and endorsed the complicated and risky financial instruments that contributed to the 2006 financial crisis. For an economic and almost-philosophical analysis of the complexity and unpredictability of the new form of markets emerging over the past 15 years, books from author Nicholas Taleb such as ‘Black Swan’ and ‘Antifragile’ are a broad-based and global perspective on major catastrophic events and the sociopolitical environments that led to them.