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Michael Lewis: American author claims high frequency trading firms are exploiting speed to jump in on share trades and manipulate prices in their own favour

Controversial claims that high frequency traders are rigging stock markets have prompted outrage in the investing world and are being probed by US regulators.

American author Michael Lewis, who accuses almost the entire financial establishment of either colluding in or tolerating the practice, was in London recently to promote his book Flash Boys: Cracking the Money Code.

He suggests that a cohort of firms are exploiting speed — an advantage of just a few thousandths of a second — to fleece big money rivals and by extension ordinary savers and investors.

Lewis’s book tells the story of how an obscure Royal Bank of Canada trader and a small band of allies decided to fight back by creating a ‘fair’ stock market in the US.

IEX was launched at the end of last year with the goal of preventing predatory high-speed activity on its system and giving investors a safe place to trade.

Since the publication of Flash Boys, the US Justice Department has announced it was scrutinising high-speed trading for possible insider trading violations. The FBI and US financial watchdogs are also probing the industry.

This is Money interviewed Lewis about his claims, the backlash against them, and what he thinks will come of all the official investigations.

We also asked Lewis where he invests his money given his scathing views about how financial markets are run. Answer: tracker funds and Warren Buffett’s firm Berkshire Hathaway.

WHAT DOES MICHAEL LEWIS CLAIM HIGH FREQUENCY TRADERS ARE DOING?

Lewis believes high frequency trading firms are deploying a host of strategies which exploit speed to jump in on share trades and manipulate prices in their own favour.

The staggering speeds now achieved by modern technology mean it is possible to do all this trading faster than a human eye could possibly follow, in a few milliseconds or thousandths of a second. A blink of an eye takes 100 to 400 milliseconds, or thousandths of a second.

The financial rewards for the HFT middlemen are hard to calculate but in Flash Boys it is suggested that one example of their trades could impose a daily ‘tax’ on the US stock market of $160million (£96million) on an average daily volume of $225billion (£135billion). Read more here about Lewis’s explosive allegations and the reaction to them.

What evidence do you have that high frequency traders are operating in the UK the way you describe them doing in the US?

I don’t. I’ll tell you what I know. All I know is what I hear from people like Goldman Sachs who have been watching this and see it as a problem. What I am told by money managers is that it is a problem but not nearly to the [same] extent because the regulation is different.

The big difference is we have something in the States called Reg NMS which requires, if you control a stock market order, that you go to any exchange that offers the best price regardless of the conditions under which it offers the best price.

So if you want to buy a million shares of Microsoft and there are a million shares for sale at $20 a share on the New York Stock Exchange but there’s a hundred shares for sale at $19.99 at the BATS exchange, you have to go to BATS first.

Which means that high frequency traders can detect you there and race you to the other [million share] pot, whereas any sensible person would just say go grab the million instead of getting a hundred and then be out of luck.

That regulation doesn’t exist here so that is one big difference. However, I do know the markets have been fragmented in a similar sort of way, that there are the same securities traded in multiple places — to less of an extent, but still, that’s so. And that high frequency trading pays for a faster speed than the market so it will have a better view of the market.

I just don’t know the magnitude of it though. I’ve been told it’s a problem. I just don’t know how big of a problem.

Flash Boys: Michael Lewis’s book tells the story of how an obscure Royal Bank of Canada trader and a small band of allies created a ‘fair’ stock market

If you’re an ordinary person investing for the long term, how worried should you be about high frequency trading?

Well, in terms of how much you get scalped it’s trivial. It’s trivial even for a big money manager — in the context of what they’re doing, it’s trivial. It’s a trival tax applied over huge volumes. So it adds up to non-trival sums in the aggregate.

The way I think about it is it’s an obnoxious tax on investment that is wholly unnecessary and symptomatic of a larger problem in the financial culture. [It’s] looking for ways to insert yourself as a middleman when you don’t belong there.

So there’s a principle problem that should disturb you. The actual money you lose should bother you a little bit, should irritate you, but not much. The real problem is the system that needs to be built to accommodate high frequency trading — to maximise the number of collisions between high frequency middlemen and ordinary investors — is more complicated than the system needs to be and it’s less stable and so you have things like flash crashes.

We’ve seen it much more in the States than here — outages at exchanges, initial public offerings of stocks going haywire, computers going berserk and making trades they should never make. It’s created a technical risk that is totally unnecessary and everybody should worry about that because if you get market collapses it affects you big time.

The truth is that as a society here and in the States we really need to rein in our financiers. There is a sense that people in the financial system can make a lot of money doing a lot of damage [and] are providing absolutely no value. That’s a very corrupting idea, that that is OK

Wall Street: Michael Lewis accuses almost the entire financial establishment of either colluding in or tolerating predatory high speed trading activity

Can ordinary investors, even given that the sums that they might be losing are trivial, do anything about it? Are ordinary investors completely helpless and reliant on regulators and the system to fix itself?

So I think the answer is you are practically helpless if you are an ordinary investor. As a practical matter, you’re helpless, unless you are an activist type of person.

If you are the kind of person who wants to devote an absurd amount of your time to solving this problem, you can cause a lot of trouble and the way you cause trouble is you ask — you insist — on knowing how any stock market order you have is routed. You ask your broker: ‘I want to know where this goes’.

The problem is here in this country right now, you don’t have what my story is about in the United States — an actual fair market that’s been built to prevent high frequency traders from exploiting you [IEX, the newly-created stock market at the centre of Lewis’s book Flash Boys]. You don’t have that option unless you are investing in the States, in the American stock markets. So it’s not like you have a place to go that’s a safe place.

However, if you wanted to make trouble you would insist on knowing how your stock market orders were routed, and you would ask how you get control to direct your stock order to one of the exchanges that you want it to go to, and that in itself would set little bells off inside of the heads of people who are handling your money.

It’s so much trouble that even though I have a broker in the States — I have asked and bothered them, I have written a book about it, and I’ve asked and bothered them, and it’s gotten me nowhere. And they know I’ve written a book about it and they know I go on TV and talk about it, and it’s gotten me nowhere.

So, I think that as a practical matter the little guy is stiffed in this case.

However, the world is waking up to the problem and just educating yourself about the way the stock market works is going to be useful in responding to the politics of the time. I think it’s going to be a big political issue, how society grapples with the runaway financial culture.