The latest book by Michael Lewis, Flash Boys , is an expose of Wall Street in today’s era of high-frequency trading. The major problem the book holds a spotlight to is front-running. Earlier, all stock transactions would get executed on the floor of a single exchange by a human specialist . But with multiple exchanges today, humans have been replaced by computers that match buy and sell orders. Since markets are disaggregated spatially, this makes it impossible to execute an order simultaneously on all exchanges, thus allowing for front-running between exchanges.

As an example, suppose RIL trades at ₹1,000-1,001 on BSE (Bombay), CSE (Calcutta) and DSE (Delhi) at a size of 100x100 at all three places. Now suppose a buyer appears at ₹1001 to purchase 300 shares and the order first hits BSE. Immediately, high-frequency traders will sense the buyer’s interest and front-run him to buy RIL in the other two exchanges and drive the price there to, say, ₹1,002, so that when the buyer shows up there, he gets a higher price instead of ₹1,001.

Some of the more egregious behaviours outlined in the book involve front-running of customers by their brokers (such as Goldman Sachs) who owe them a fiduciary responsibility as well as collusion by public exchanges (such as BATS) which give privileged early access to pricing information (about orders and trades) to their high frequency customers (also known as payment for order flow).

Playing fair Front-running is enabled by technologies such as fibre optics and faster computers and routers to get ahead of orders in the distributed marketplace. Michael Lewis makes the valid observation that high frequency trading is a multi-billion dollar industry that serves no societal useful function — all it does is to allow high frequency traders to enrich themselves at the expense of legitimate buyers and sellers and arguably even impede the efficient allocation of capital, which is the primary function of stock markets.

So what is the fix? In late 2013, Katsuyama and his boys set up their own exchange — ICEX — whose stated mission is to “play fair”. by . They do this by ensuring that pricing information arrives simultaneously (and slightly delayed) at multiple external places to prevent gaming by high frequency traders. ICEX has done very well since its inception in October 2013.

By December 2013, it had exceeded the daily volume on AMEX and it continues to attract market participants. The big question is whether it will eventually dominate stock trading, driving all other exchanges out of the market. Michael Lewis and the founders of ICEX certainly seem to think so and early indications are in support of their point of view.

Need for regulation However, we believe that it is too much to expect a pure market-based solution to what is essentially a problem of regulatory failure. So long as the marketplace is distributed, there will always be a disparity. What is needed is a coordination mechanism that will create a single marketplace for batch auctions to be conducted every few milliseconds. Our pessimistic conclusion is that Flash Boys will sell a lot of copies and ICEX will make its founders wealthy, but nothing will really change — Wall Street and Dalal Street will always continue to be the rigged game.

The writer is professor, Northeastern University, Boston

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