Payback: From Michael Milken to HFT

Tongues have been wagging since 60 minutes and Michael Lewis ran a lengthy infomercial on a new exchange, the "honest" one for those not paying attention. After watching said infomercial and observing with amusement some news items: FBI raid and the big G coming out against flashing.... I had a flashback of my own to a book called Payback by Daniel Fischel.

In Payback, Fischel tells the tale of another period of significant financial innovation,the 1980's and specifically about Michael Milken one of it's chief innovators. The story is about the take down of this man, and many others during the period in what looks as much like a witch hunt, as a search for justice. It also demonstrates an important series of precedents that might be worthy of note for the upcoming HFT "field leveling".

Thanks to Amazon, another high speed tech company that provides effective liquidity, I was able to get Lewis' book in about 10 seconds and subsequently work through the highly readable story.

Flash Boys was in some respects an eye opener, but the way that it is written and presented on 60 minutes, seemed to deliver a tale wrapped in the cloak of morality, without effectively challenging the high priests of moral authority. There is an obvious reluctance to focus the argument on the real culprit and origin or various market infidelities: Regulators.

I found numerous interesting insights into Wall Street and other parts of the financial sector throughout which may be a benefit to those starting out. The book contains several small pieces of wisdom wrapped deceptively within the story itself.

The unsaid part of the book, but clearly alluded to at times is the role of the regulators and SRO’s in this entire story. The fact of the matter is that these organizations bear full responsibility for many of the criticisms and deficiencies that Lewis and his protagonists are attempting to shine a light on.

While the focus is on HFT, it is also clear that the role that HFT plays is a direct response to and natural evolution of regulatory changes and their unintended consequences.

That Lewis, and 60 minutes failed to focus their attention here I think is the major deficiency of both presentations. The subsequent FBI announcement and it's specious nature only confirms this for me.

The rule makers and their product, have an incentive problem like everyone else related to the business; which is to say that many writing these rules easily move over to the other side to assist in the exploitation of the various loopholes provided. One might be able to argue that regulatory loopholes could be created as a way of generating more lucrative employment in the future at a firm that can exploit these regulatory deficiencies.

Nobody talks about incentives provided to guys in the regulatory realm. Perhaps it’s time to focus some attention here as well.

Lewis offers one stat in the book delivered by his protagonist demonstrating the significant level of regulatory capture, and in my opinion a major regulatory flaw.

It is also interesting to see that exchanges are not apparently bound by the same fiduciary duty as the firms they oversee and do business with. The orders that they are provided with are merely information to be sold for a fee and they appear to have no duty towards the protection of that information. The extensive efforts to enhance high speed trading advantages throughout the book, clearly demonstrate this trend.

This begs the question: does providing some participants an advantage with regard to everyone's information constitute a breach of an exchanges’ duty to the investing public? If not then why are HFT firms reluctant to give up their code?.

HFT activity is in fact a natural by-product of poor regulation and these numerous advantages which have been provided apparently willingly....and for an appropriate fee. In my view the HFT crowd are doing their job as market participants: to exploit every possible opportunity afforded to them. Like the rest of us.

For various market luminaries to define these activities in moral terms as a result seems a bit trite to me.

That the regulators continue to provide these incredible opportunities at the apparent expense of everyone else certainly should generate some thoughtful examination. Perhaps the most important question should be why these advantages are provided without any real ability to regulate, fully understand or constrain these activities.

If it can’t be regulated, understood or constrained in a timely and cost effective manner, should these advantages exist?

My single biggest objection to HFT is based on the fact that any human trader who is registered with the regulators is on speed dial and being monitored closely for even the most rudimentary infractions. A win is a win apparently.

The fact that millions of quotes and a tangled web of lights is expensive and time consuming to unravel, means that the human always gets the short straw when the draw is taken. It’s cheaper, more expedient, and easier to fuck a living person than find the programmers responsible for the code that generated an infraction or a flash crash.

It’s also a credibility destroying way to regulate a market.

The book wisely devotes a chapter to the tale of Sergey Alenynikov, his trial related to the code from Goldman Sachs and the life he is left with after that debacle.

The Alenynikov story was important because it demonstrates all the hallmarks of overzealous prosecution, an uninformed jury and a grossly misinformed and uninformed teams of legal officials.

This chapter should stand as a warning about what might be coming.

With the typical career ambitions in New York’s Attorney Generals office, you can expect a witch hunt. As a trader and a market participant, I loath these ridiculous spectacles. They are carefully crafted, and considering the performance of these "gate keepers" in the post 2007-2009 period (and a number of others), they have little or no credibility as far as I'm concerned.

The seemingly well timed announcement of the FBI taking on HFT is a perfect example of a choreographed farce. If the activities these firms are engaged in are really illegal, shouldn't they be raiding the facilitators of that FINRA and the SEC amongst others?

In Daniel Fischels Payback he has some choice quotes that should be considered when watching this unfold.
Fischel utilized court documents to weave a story almost unbelievable in its audacity. It was an ambitious AG utilizing his power to bring down “criminals”, although many of the alleged "criminal actions" engaged in were prior to when these infractions were actually infractions.

Several laws were created and applied retroactively.

By utilizing the full weight and unlimited resources of the government, Milken and many others were caught up in the ambitions of a few zealous bureaucrats. That is not to say there weren't some criminals, but the disproportionate attention on the highly successful Milken and his team was unprecedented in it's scope and ruthlessness. His competition had been virtually locked out of a lucrative market, and his competitors wanted to "level the playing field".

Does this sound familiar?

Here are a couple quotes from the assessment section of the book:

“But the 1980’s like all periods of rapid change and innovation, also produced dislocation and backlash. Old-line Wall Street investment banking firms that watched on the sidelines while the upstart Drexel went from near bankruptcy to become the most profitable investment banking firm in the country deeply resented Drexel and Milken’s meteoric rise.”

This rise was based not on the rules created by regulators to favor him, but rather by a brilliant product related insight.

…..”When the losers in the marketplace went to the government for help, the government should have refused and allowed the financial revolution to take its course……..Instead Rudy Giuliani, formed an alliance with the losers in the financial revolution to attack the winners. Freely using the rhetoric of greed to enlist popular support, the government waged its campaign against the winners by expanding the scope of criminal law beyond recognition and trampling civil liberties in the process.”

It is funny that the "losers" in the contemporary period, the very firms that have been eating this up for the last few years, and those that always have their own informational advantages, have only found religion when it was all exposed and their revenues have begun to decline. Schwab sells their client orders to an HFT firm and then calls HFT a cancer? ...otherwise known as talking out of both sides of your mouth.

“We should also learn from the 1980’s that government intervention in the economy frequently has unanticipated and perverse consequences. One such consequence is the incentive and ability to engage in criminal conduct that would otherwise not exist.”

In the case of your fractured and opaque marketplace, the regulators have created the winners through poor regulatory choices and a lack of foresight. HFT is appropriately receiving some scrutiny, as all significant market participants should expect. However while they require some adjustment to their activities, a witch hunt is not the answer and a poorly targeted place to begin this cleanup.

If we are to examine all of the arguments about HFT, we find that the core problem is regulation: poorly conceived, poorly executed, poorly managed, almost never rescinded and seldom adjusted. We can see regulatory capture and the potential for corruption; but what we are not doing, is more closely examining the incentive structures and biases of those charged with “protecting” investors and managing the regulatory environment in which our markets reside.

Now lets take a look at some of those brilliantly marketed HFT claims:
Spreads tighter than a cows ass at fly time
god like liquidity that would awe even the great Noah and
Better fucking markets than any of us stupid mortals deserve

These firms should welcome the scrutiny and changes.


Because if their claims are accurate, appropriate changes should have no material impact on their business.

Lets look a a few.

The emphasis on the liquidity providing and spread tightening of HFT is in my opinion weak. Considering the instant access and menial costs per trade that many if not all traders have today, it begs the question as to whether market makers are even necessary. When access was slow and privileged and transactions were expensive this made a great deal of sense. I don’t think that applies today.

To say they will (or should) pull their "liquidity" and we will all be screwed is laughable. Go ahead. Make my day. Those gaping holes that are hidden by your soon to be cancelled 100 share orders will expose the hollowness of this claim....and they will be filled by other players in short order.

Any time you hear this bullshit, you should say: Bring it.

The argument that HFT hurts small investors is lazy, unless you are saying that the integrity of their order should be preserved, not commoditized and sold to the highest bidder. Small investors only appear to be negatively impacted by flash events which are increasingly ubiquitous in today’s market. This problem does require some serious attention.

If there are 50 "exchanges" (or should we call them Quicky Marts), then investors should also have the right to direct their orders to their preferred venue, and for that to be honored. Less exchanges and more transparency would make this unnecessary.

It is perhaps ironic that it is ok to have a small number of enormous, systemically important financial institutions, a concentration of risk and scale; but that you need multiple venues (60 plus?) in order to facilitate 100 share sub penny transactions. Perhaps these roles need to be reversed.

The central claim of the 60 minutes program and the book is about the “rigged” nature of the market. Anyone who has read any marketing material knows that using emotionally charged language gets a better reaction than those that don’t. In other words, extraneous over the top language should be a warning as to the veracity of a claim.

Can a market or product be rigged for a short span of time? Yes, probably. Can the entire market be rigged by a small cohort of highly competitive groups in a highly competitive market environment for any length of time? I don’t think so. To make this claim is to provide these groups with unearned praise and god like powers; but remember the purpose of these over the top claims is Payback.

I enjoyed Michael Lewis’ new book. It is highly readable. It has some interesting insights on the business. It sheds some light on a subject that is of significance to all market participants and investors. It uncovers some ugly realities in the financial business and demonstrates a world of near perfect competition both fair and dirty.

It has some, or many deficiencies depending on your point of view.

At the periphery of this story is a regulatory regime that is increasingly ineffective, inconsistent and slow moving. They should be the focus of this debate. The fact that it is not is the only surprise for me.

It's great to have a new honest exchange....although it would be better if we could have an open, transparent discussion about the diminishing quality of the regulatory bodies in the securities industry.

Lots of firms utilized these various structures and technological advances over the last few years and were quite happy to profit from them when the going was good. Others have had a longstanding informational advantage in other areas and are getting a taste of their own....medicine?

However, now that revenues seem to be falling, volumes dropping and profitability waning. It's time to take down the weak sister, the greedy ones, the ones fucking it up for everyone else because:

….everything is fucking rigged goddamnit.

Now it’s payback time.

If you want to see Wall Street at their best, watch and learn.

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