Motley Fool CEO Tom Gardner recently sat down with acclaimed author Michael Lewis to talk about Lewis' new book, Flash Boys, and how high-frequency traders skim billions off the market -- and never risk a dime. What's the impact of HFT on long-term investors like us, both for better and for worse? And, in the coming war on Wall Street, who plays Frodo, who plays Gandalf, and who's an Orc? Watch the full interview below! A complete transcript follows the video.
Transcript
MICHAEL LEWIS:
Can I just start?
TOM GARDNER:
Yes.
MICHAEL LEWIS:
Are you ready?
TOM GARDNER:
Yes.
MICHAEL LEWIS:
All right. Rather than you ask me a question ...
TOM GARDNER:
Great! This is great ...
MICHAEL LEWIS:
... because before we went on camera, you just said, "And a Fool was a good thing." And you just triggered a thought that the experience of writing this book has hammered home, and it's that a big part of the problem in the stock market right now — or has been — [is] that the investors do not want to acknowledge their ignorance about how the stock market worked, so they're willing to believe the noise that came out of brokers' mouths about how electronic trading worked. And everybody is still, to this moment ...
TOM GARDNER:
And not just investors like small investors, but CEOs of the large mutual fund companies ...
MICHAEL LEWIS:
No. I mean the heads of mutual funds, the heads of pensions funds. The big hedge fund managers. The thing that they get quickly offended by, coming out of my mouth, is the idea that the hero of my book explains to them how the stock now works ... even though that's what happened. That two or three years ago, they had no idea how they were being front-run by high-frequency traders.
This guy comes and explains. They respond by saying, "Oh, my God! I can't believe this is happening." Flash Boys is out, and when they tell the story, "Oh, I knew most of what was happening. He helped me round out my understanding." And it's funny. It's a problem in finance. And I don't know quite why it's a particular problem in finance. The idea that ignorance is a sin — and so everybody's terrified about not knowing — when it's such an unhealthy ...
TOM GARDNER:
I'm not defending finance by asking this, but in what industry is ignorance not a sin? I mean, obviously it's maybe the greatest sin in finance where you're essentially, in many cases in finance, acting as salesperson for ....
MICHAEL LEWIS:
I have an answer for you ...
TOM GARDNER:
Yes ...
MICHAEL LEWIS:
My industry. Journalism. Being a detective. Columbo. Not knowing is an excuse to learn. That not being a know-it-all is a huge advantage in being a journalist. It's better to seem to know less than you know.
TOM GARDNER:
Have you read the book, The Outsiders, by Will Thorndike?
MICHAEL LEWIS:
I have not.
TOM GARDNER:
Okay. Oh, I've read this, you haven't, so I get to sound smart momentarily.
MICHAEL LEWIS:
I admitted it, though.
TOM GARDNER:
Will points out eight CEOs that performed incredibly well over 20-plus year periods as CEOs and he looks for the patterns across them. And what he finds is that virtually all of these CEOs came from outside their industry. So, they acted as detectives. They had to figure out what was really happening. They brought fresh eyes to it. They didn't have the reputation to protect ...
MICHAEL LEWIS:
And there was no stigma associated with not knowing ...
TOM GARDNER:
Right ...
MICHAEL LEWIS:
And there's this stigma associated with not knowing things in a rapidly changing environment, which is finance. So, things are always not known. There's all this innovation going on, much of it maligned. Nobody knows what a subprime CDO really is, or whether it's really AAA. Nobody asks. I don't know why this is particularly a problem. I think it particularly is a problem.
TOM GARDNER:
Oh, yes ...
MICHAEL LEWIS:
It's very noticeable in finance — and it may be because finance is filled with people who are rich and they're used to people thinking they know everything and they like that pose of, "I know everything ..."
TOM GARDNER:
Well, it creates an incredibly interesting dynamic now that technology is coming front and center into finance and, of course, into every industry ...
MICHAEL LEWIS:
And nobody is mentioning that ...
TOM GARDNER:
[crosstalk 00:03:15] algorithms and what a 61-year-old CEO of a large financial firm should know. Thinks about that going in. And so they're seriously hurt by the fact that they can't willingly admit that they don't understand.
MICHAEL LEWIS:
Let me tell you a quick story I heard. I didn't put it in the book while I was working on it. A guy who I met who experimented in designing high-frequency trading strategies, but never really put them into practice ... he was a professorial type ... collided with an old trader who ran a money management firm. This was five or six years ago.
[He said], "Let's try your algo. Let's go trade with the thing you dreamed up." And so the guy says, "I've never done it before, but let's do it." They hook it up. They're hooked up to doing trades. They hit the button to go and the thing starts doing maniacal things.Boom! It's like losing money.
TOM GARDNER:
It's like an IBM commercial, right?
MICHAEL LEWIS:
And the 61-year-old CEO, the money manager, [says], "Turn it off! Turn it off!" And they keep hitting buttons and they can't turn it off. He goes and he yanks the plug out of the wall to shut the machine down. It is sort of like the mark of the Wall Street man — overconfidence. Male overconfidence is responsible for so much trouble in the financial system, and when it collides with technology, it's particularly toxic.
TOM GARDNER:
Let's go with some of the basic themes of the book just for those of us who aren't familiar with them. I was saying to you off-camera that high-frequency trading, dark pools, the whole dynamic between the two, flash trades ... I've heard the terms, but I've never really spent much time digging into them because I'm buying stocks and holding them for five-plus years.
MICHAEL LEWIS:
So, there's no particular reason for you to know.
TOM GARDNER:
Nonetheless, it would be good for me to know and now ...
MICHAEL LEWIS:
For one reason. Do you know what the reason is? That you're talking about the structure of the market you're operating in. So, while you just sitting on stocks may not be getting scalped that often, the market is becoming increasingly unstable in the service ... just to serve the high-frequency traders ...
TOM GARDNER:
Flash crash.
MICHAEL LEWIS:
Flash crash is one symptom. Outages at Nasdaq. BATS IPO going crazy. Facebook IPO. It's one thing after another. At some point — you shouldn't have to — but it probably behooves you to pay attention to [whether] this market [is] stable.
TOM GARDNER:
What is high-frequency trading?
MICHAEL LEWIS:
It's a term of art that really didn't hit the newspapers or the public consciousness until maybe 2009 when a Goldman Sachs programmer, who was labelled a Goldman Sachs high-frequency trading [programmer], was arrested by the FBI for taking Goldman's code. And it's not easy to define. I guess you could say, if you want to [use] the loose definition, it would be "trading by computer algorithm at very high speeds."
TOM GARDNER:
Microseconds.
MICHAEL LEWIS:
What's a microsecond? You may be right. It's milliseconds. In fact, at this moment, the cutting-edge high-frequency trading firms are talking about picoseconds, which is worse than nanoseconds. So, to put that in context, I'm told that a blink of an eye takes between 100 and 200 milliseconds and there's a thousand microseconds in a millisecond, a thousand nanoseconds in a microsecond and a thousand picoseconds in a [nanosecond]. So, it gives you an idea. I like to think I can blink my eye faster than that. See?
TOM GARDNER:
You are ready to trade.
MICHAEL LEWIS:
I'm ready to go.
TOM GARDNER:
Talk about spread networks. Essentially, as I was reading I was thinking, "This is like the very first oil pipeline."
MICHAEL LEWIS:
I was thinking the railroads.
TOM GARDNER:
Yes.
MICHAEL LEWIS:
Can I frame this just by saying ...?
TOM GARDNER:
Please.
MICHAEL LEWIS:
The book is a very simple structure. It's about one guy who's a trader on Wall Street figuring out how the stock market actually works. Even though he's in the stock market, he realizes around 2008 something's changed and I don't know. What is it? And spread networks enters into the story even though it opens the story as an important data point for him in what's happening.
So, spread networks. There was a trader on the Chicago Mercantile Exchange who realized that people were willing to pay for speed — incredible speed — but without totally knowing what it was for. His name was Dan Spivey. Spivey in 2009 looks at the fiber optic line that runs from the Chicago Mercantile Exchange to the New Jersey Stock Exchange where the actual stocks are traded. Futures are in Chicago. Individual stocks are in New Jersey.
He sees that the fastest line goes like this, from one place to the other. It's a Verizon line. It takes like 16 milliseconds to go back and forth, which is not much time, but nevertheless, he realizes that if you just lay the straight line fiber from the exchange in Chicago to the exchange in New Jersey, you could get it down to 11 milliseconds and that whoever was faster ... winning by a microsecond was enough.
TOM GARDNER:
And people were already trying to capture good areas of the Verizon line ...
MICHAEL LEWIS:
That's right ...
TOM GARDNER:
And Verizon didn't even know what they had. They didn't realize that they were using it this way.
MICHAEL LEWIS:
They didn't realize just how valuable very small increments of speed had become to stock market traders. And he did. He didn't know exactly how, either. In fact, he was flying blind in a lot of ways. But, he persuades Jim Barksdale, who is the former CEO of Netscape, and some other investors (but mainly Barksdale) to give him $300+ million to dig a hole, to dig a tunnel from Chicago to New Jersey on a straight line to lay this fiber.
Completely in stealth he is able to string this line. Pennsylvania turned out to be the problem. It's pretty easy to run a straight line through Ohio, but when you get to Pennsylvania ...
TOM GARDNER:
Some mountains ...
MICHAEL LEWIS:
Mountains were the problem. And the mountains run diagonally. So, he blasts holes through mountains. He goes through farmer's fields. He goes through parking lots. He buys rights away.
TOM GARDNER:
What year is this?
MICHAEL LEWIS:
2009 and 2010. So, not that long ago?
TOM GARDNER:
Yes.
MICHAEL LEWIS:
He finishes it in the summer of 2010. And he's able to do it without anybody — anybody — asking him what exactly [the line is for]. Or at least not having to answer the question. People just [thought], "Oh, it's just some fiber." And the sole purpose of the line is to speed up stock market trades. And what it's really supposed to do — I don't think even he completely got this, because he thought he was building a line that enabled people to do the arbitrage between the futures and the cash.
The way the high-frequency traders work is they're making lots of little markets in small amounts of shares in all the stocks in New Jersey. They don't actually want to own these things. They're trying to tease out the information. They're making the markets to tease out information about what investors are doing so they can react to it.
TOM GARDNER:
So, they're listing 100 shares available ...
MICHAEL LEWIS:
On either side ...
TOM GARDNER:
When an order's coming for 10,000 ...
MICHAEL LEWIS:
Right. So, they find it. "Ah! I want to get on the other side of that. I want to get in front of that." But the big risk for them is that the whole market goes down. They're sitting here dangling out 100-share orders in 4,000 different stocks and they get hit. They own all that stock. So, they are very sensitive to overall market movements. They need to know. Did the market pop or did the market not?
And the market popping and the market going down first registers in the futures in Chicago. So, they get the directional signal from Chicago and New Jersey. It says get out of the market. If you want to know what happened in the Flash Crash — my guess is ... it's never been well explained — my guess is that's how it starts. It does start in the futures market and then the next thing is all the people who are supposedly the intermediaries in the stock market just pull out.
TOM GARDNER:
I don't want to digress, because I like the thread here, but [if that's the case], is it possible that these players, whether they're good or bad actors ... should they be building their systems closer to the Chicago futures? Shouldn't they be getting the closest possible read there ...
MICHAEL LEWIS:
They do ...
TOM GARDNER:
... rather than in New Jersey, or they're doing both?
MICHAEL LEWIS:
Both.
TOM GARDNER:
Okay.
MICHAEL LEWIS:
Yes, they're doing both. And this line gets the signal in the fastest possible way from the Chicago Exchange to the New Jersey Exchange.
There's several great things about this story, because [Spivey] does it completely in secret. He doesn't tell anyone.
TOM GARDNER:
It's also great that he's doing it in secret and he doesn't really fully know why he's doing it.
MICHAEL LEWIS:
You know why? He thinks he knows why and he thinks he knows the market. He thinks there are 400 people out there who will pay, he's guessing, $10 million a pop to be on the line. But they're guessing. I mean, there's this wonderful business school case study that someone will do about this one day.
So, they start to go out into the market to tell high-frequency traders that if they want the fastest line, he's got it. Just flip it on and wait. You better pay for it or you're going to be [the] last to know whether the market moved. And the high-frequency traders, when he goes to see them, they're like, "Who the hell are you? What did you do just do? Ten million dollars? Are you out of your mind? We have basically a costless line already from Verizon." Nobody knows how valuable it is. They really want to throw him out of the office. But then they realize he's right. We've got to have it. But it isn't 400 of them. It's 27. It's not that many.
TOM GARDNER:
In a funny way, they also begin to resent him ...
MICHAEL LEWIS:
They hate him. They all hate him. They all hate him.
TOM GARDNER:
They're like, "My system is working. Now I'm going to have to pay $10 million and now the game is on to go faster and faster to beat the other firms."
MICHAEL LEWIS:
Right. They hate him and he loves it that they hate him. He doesn't care. He's like the salesman who doesn't [care] what his customers think about him. And he says this to me — that it was kind of fun to see how angry they got. One of the customers, when they walk in, gets angry, calms down, says, "Let us think about it," and then comes back and says, "Can you double the price?" They wanted to price everybody else off the line.
The banks' response is riveting. He goes into the banks. The banks are trying at that point in their lives — I think they think they're going to compete in high-frequency trading. That turns out not to be so, I think. But he goes into Credit Suisse and he says, "For $10 million, you can be on the line, but you can't let your customers use it. You can't let anybody else use it. It would just be your own proprietary trading." To which they say, "Screw you. You're trying to screw our customers. We won't do that. You want us to trade against our customers at a faster speed than the customers. Are you crazy? We're not going to do that."
He goes to Goldman Sachs and they say, "Ship it in. We'll take it."
TOM GARDNER:
And I also like the Morgan Stanley ...
MICHAEL LEWIS:
And he goes to Morgan Stanley and they say, "Could you change the language, because we want to do it ..."
TOM GARDNER:
In case they're called out ...
MICHAEL LEWIS:
Yes, in case they're called out. So, the optics aren't good, but he starts to develop the first picture of what this market looks like. No one knows this market. No one knows who these high-frequency traders are. He's finding their names in obscure SEC documents, calling them up out of the blue and saying, "You don't know this, but you have to meet with me." So, the book opens with this project ...
TOM GARDNER:
In a funny way, Dan Spivey is similar to Brad and [Ronin 00:14:51] in that when they went to present what they were developing, they were, "It's Moneyball." They were laughed out of the executive suite at every baseball team stadium. It's very funny. My brother David initially wanted to go into baseball. He thought there was no path for him having read Bill James so early on.
MICHAEL LEWIS:
Right ...
TOM GARDNER:
I don't know when Bill James first started writing — maybe in the early eighties or something — but David's there reading Bill James in the late eighties, really wanting to go into baseball and felt he would never have the ability to do it, so he went into investing. It was a meritocracy where, "Hey. People can laugh at me. They can say that my strategy doesn't work, but the merit will out."
MICHAEL LEWIS:
I have the results.
TOM GARDNER:
"We'll see what the results are." And so you have these characters who are stepping into the executive suite and convention and being initially laughed at before they explain [why they're doing what they're doing] and what it will mean.
MICHAEL LEWIS:
Here's also how it's very similar to Moneyball. The Oakland A's basically, with their actions, say to the rest of baseball, "You don't know how to value baseball players and you don't understand the value of baseball strategy, because we found inefficiencies in them and we are exploiting them. That's how we're succeeding." The book describes that process and in the bargain, embarrasses everybody who's not doing it their way and creates this uproar and this anger.
Brad Katsuyama and IEX come out and say, "We have created the only fair exchange. We're investors actually on an equal footing and there aren't people exploiting each other just in the structure of the exchange, thereby embarrassing and humiliating and shaming the 13 public stock exchanges and 46 dark pools that are out there." Everybody's involved in the stock market and creating a very similar sort of uproar. This book feels, in the experience of publishing it, very similar to Moneyball.
TOM GARDNER:
There are so many other things I want to cover and I know we have limited time but Dan Spivey — there's almost a little Moneyball in that. He's seeing something that others aren't seeing ...
MICHAEL LEWIS:
It's an unbelievable act of entrepreneurial nerve to say, "I'm going to lay a straight line from Chicago. I'm going to dig this tunnel ..."
TOM GARDNER:
I'm going to blast through the Allegheny Mountains ...
MICHAEL LEWIS:
"I'm going to blast through the Allegheny Mountains and I'm going to do it completely in stealth. No one's going to know and I'm going to spring it on a market I don't even know."
TOM GARDNER:
But then what it creates is bad actions. That use of the technology — that great new insight into active entrepreneurialism — leads to something that you certainly, I think, from the tone of the book, don't favor and Brad then [crosstalk 00:17:33] ...
MICHAEL LEWIS:
I have a thing I've got to square in my head and it's this. I think Spivey's entrepreneurial act was incredible. It's like this is what makes America great — that someone's willing to go do that. And at the same time, the use to which this thing is put is not great. But I would say this — that the high-frequency traders were always going to have the fastest line. They were going to be doing this. I don't think he increased the take that high-frequency traders have in the market. He just taxed them. It's almost a pure tax. So, in a way, it was kind of charming. He was bleeding the profits of high-frequency traders. It's like someone who sneaks onto the pirate ship and steals the pirate's stolen gold. That's what it feels like.
TOM GARDNER:
I think a lot of people — myself included — initially thought high-frequency trading was profitable because of speed and that was it, but they had some ...
MICHAEL LEWIS:
Why would speed be valuable all by itself?
TOM GARDNER:
Well, I was going to combine it with that they had their beliefs about where the market was going based on their fundamental research.
MICHAEL LEWIS:
Ha!
TOM GARDNER:
Right?
MICHAEL LEWIS:
Ha, ha!
TOM GARDNER:
I'm a Fool. I don't feel [crosstalk 00:18:46].
MICHAEL LEWIS:
That's very sweet. No, no ...
TOM GARDNER:
This is why this book was so valuable to me, Michael ...
MICHAEL LEWIS:
It's very sweet.
TOM GARDNER:
I didn't know what the high-frequency trader advantage was. They have speed. They're there first, but what if they're wrong?
MICHAEL LEWIS:
So, a couple of [things]. One is their obsession is with speed — with microsecond advantages. And two, the fact that what we know of them, they never experience a day of trading losses. That every day is profitable. A thousand days of no trading losses.
TOM GARDNER:
Mathematically impossible unless ...
MICHAEL LEWIS:
Unless you're basically gaming the market. You can't be taking market risk. You can't be making judgments about stocks. No matter how good you are as a money manager, you will have losses. You will have stocks that go down some days, right?
TOM GARDNER:
Of course.
MICHAEL LEWIS:
Of course. So, they're doing something different.
TOM GARDNER:
This is why this book was so valuable to me. And what they're doing is ... Explain dark pools and what is happening with the various firms ...
MICHAEL LEWIS:
One of the things the book tries to do, through the journey of Brad Katsuyama, is divine the different predatory strategies. I don't pretend to have gotten them all. He finds four big ones.
I'll give you an example of the one that's easiest to get your mind around — the first one he discovers. He's sitting at his trading desk in Southern Manhattan in 2008. Previously, before this, he starts to know something is wrong. When he would look at his trading screens, he'd see however many stock markets there were at the time. He'd look across them and he'd say, "Well, altogether, in all the markets, there's 20,000 shares of Microsoft offered at $25 a share, and if I want to buy 20,000 ..." He hits a button. "I'll buy 20,000." He gets them at $25. He would just get them.
One day he wakes up and he hits the button, and he only gets a couple of thousand. Everything else disappears, and Microsoft stock goes up and he realizes that from there on in, every time he hits a button to buy or sell, the market knows what he's trying to do and runs out in front of him and either jacks the price up or sends it down depending on what he's buying or selling. It takes him a year and half to figure out what is happening in this particular ...
TOM GARDNER:
By the way. How much do you think it's moving up? Let's say twenty-five ...
MICHAEL LEWIS:
Pennies.
TOM GARDNER:
Pennies.
MICHAEL LEWIS:
Pennies.
TOM GARDNER:
He can only buy at $25.01 ...
MICHAEL LEWIS:
But over the course of a year at his trading desk ...
TOM GARDNER:
Of course. Yes ...
MICHAEL LEWIS:
... it's tens of millions of dollars. So, it takes an incredible act of detective ingenuity for him to figure out what actually is happening. And what actually is happening is one of the HFT strategies is the buy signal from his desk goes up the side of the West Side Highway in fiber optics, goes out the Lincoln Tunnel in the fiber optics that are on the side of the Lincoln Tunnel and arrives first at the BATS Stock Exchange which is planted right on the other side of the Lincoln Tunnel. I don't know why it was built there, but it's interesting that it was built there.
The other exchanges are further away. It takes his buy signal longer to get to those exchanges. On the BATS Exchange, high-frequency traders are making small markets in Microsoft to divine the intentions of brokers who are sending in orders. They divine his intention to buy Microsoft and they race him and beat him to the other exchanges, buy up the Microsoft, and then sell it back to him at a high price. That's what happens in that case. And every time he ...
TOM GARDNER:
It's parasitic ...
MICHAEL LEWIS:
It's parasitic. No matter what exchange he landed in first, they would beat him to the other exchanges to get whatever stock was there. So the fragmentation of the market created this opportunity for people to race back and forth between the markets.
The dark pools add even more fragmentation. One way to generalize what is happening is that it's sort of like there's 60 places now where you can buy and sell the stock of Apple ...
TOM GARDNER:
For large investors who don't want the market to know what investment they're making. So, they send their order into a dark pool.
MICHAEL LEWIS:
Which ends up not being a dark pool ...
TOM GARDNER:
By the way, we put a couple of flashlights in the dark pool, and they've give them bathing suits.
MICHAEL LEWIS:
That's exactly right. So they're giving flashlights to high-frequency traders in the dark pool. They've giving them special access — sold them access to the dark pool. Then what they do is the way the big banks can deroute the orders ... It's like they want their order to be executed in their dark pool, so they do everything possible to prevent it from being executed outside the dark pool. They horde the orders. They keep big orders that might cross away from each other. This system of intermediation has evolved to prevent buyers and sellers from coming together too easily, because otherwise you don't need the intermediary.
TOM GARDNER:
In some of your interviews I've read online, some people are saying, "Well, this is just great. I don't know why Michael Lewis is raising an alarm here. This is creating a tremendous amount of liquidity in the market." It's allowing investors to be down, penny to penny, rather than back in the day, in 1989, when I was buying shares, it was like you could buy it at $35.125 to $35.875. We're talking pennies, so we're out of fractions. We're into decimals.
MICHAEL LEWIS:
So, people are saying this. Let me see how I can explain this. So, technology has brought wonderful gains to many industries. When I was living in London [at] 24 years old, it cost me like $2.00 a minute to make a phone call to my parents. It now costs me pennies a minute. That's because of gains in technology. Now, imagine if some gremlin in the middle of the telephone system, in the process of that declining price, instead of letting it go down ...
TOM GARDNER:
Wedges his way in ...
MICHAEL LEWIS:
Wedges his way in and charges me ten cents a minute or a nickel or a minute. I'd say, "Wow. The phone system is still so much better. Why do I have to deal with the gremlin?"
TOM GARDNER:
And they were the first ones to go out publicly and say, "We're creating ..."
MICHAEL LEWIS:
They were creating phone calls ...
TOM GARDNER:
Voice, sound and a lower-priced technology.
MICHAEL LEWIS:
Let me give you another explanation to couple with that explanation. If you take any market — take the stock market. If the government waved a wand over it and said, "So, you now have to be front-run. Here's the government entity that will front-run ..."
TOM GARDNER:
Scalpers, ...
MICHAEL LEWIS:
Scalpers, We'll front-run every trade. What is the effect on this market? It will double the volume in the market, because every trade gets front-run. So, all of a sudden the Scalpers, creates twice the volume. And if you think liquidity is volume — yes, you increase liquidity. And you can start to say, "You can't get rid of Scalpers, because otherwise the market will be half the size." That's what's happened.
You have to define liquidity. What is liquidity? It's the ability to turn your stock into cash. They're not there to do that. They're not there taking the risk. They go home every night without positions.
TOM GARDNER:
Without them — technology and decimalization — the spreads would be narrower.
MICHAEL LEWIS:
That's true. The actual spread would be narrower. I mean, the stated spread is often a penny. It's tiny. But it's an illusion. The minute you go to act on that spread, it widens with any volume.
TOM GARDNER:
So, what has this changed for you in your active day trading?
MICHAEL LEWIS:
I don't ...
TOM GARDNER:
Well, that's my question. What impact does this have on your approach to investment at Motley Fool?
MICHAEL LEWIS:
Can I just tell what my reaction was? So, my reaction was, first, unbelievable story that this has happened and that these guys wouldn't figure it out. That was my first reaction. But how it affects me personally, as an individual investor. I am the most passive investor there is. I take very little interest in it. I don't trade. I hold long term. And so, the scalping side of things matters very little to me. I'm not losing that much money.
However, this is a systemwide tax on investment capital. I don't know what it is — it's $20 billion or $30 billion or whatever it is a year — but it's a significant sum of money. [And] that's bad for the economy. Productive enterprise pays more for capital because of this. Now, that, in a way is trivial compared to the instability caused in the system by the complexity required by high-frequency traders and demanded of the exchanges by high-frequency traders.
So, what is the instability? What do flash crashes and Nasdaq outages and all this lead to? It leads to mistrust in the investment public. [Why] is there a decline of individual American investment in the stock market during one of the greatest bull markets in history? It's because people don't trust it. I mean, there is understandable mistrust of this market. It's an unstable market. So, what's the cost of the mistrust? You tell me.
TOM GARDNER:
Well, here's a [crosstalk 00:27:07]. I don't want to put you in the position of being incredibly selfish, but I'm going to for the fun of it. Doesn't all of that actually benefit you as a passive long-term investor? I don't want to make it all about each of us as an individual — but if so much of the financial machinery and the people that are behind it ... which are becoming fewer and fewer as the machines take over — is focused on trying to slice down the time and the frequency that they can activate trades and the information they can get to just nibble and be a parasite on every transaction, there's so much attention there. And if the rest of the marketplace is therefore distrustful, doesn't that increase or offer greater long-term opportunity for a long-term, passive investor like you?
MICHAEL LEWIS:
I have to think about that one. I think that my benefit ...
TOM GARDNER:
I'm not saying it's a good thing ...
MICHAEL LEWIS:
My basic reaction is probably not, because what I'm thinking is I'm a long-term passive investor. What am I actually doing as a long-term passive investor? I'm making an investment in the future profits of American corporations — or the corporations in my portfolio — and those future profits are going to be badly affected by an unstable market. If they're operating in an unstable market, it's just not good.
But if I was a long-term stock picker ... If fewer people want to be in the marketplace, maybe it creates a bargain or two for me. I don't know. I just don't know.
TOM GARDNER:
But the overall instability and loss of trust to the market system ...
MICHAEL LEWIS:
Can I add one more thing? As a cost?
TOM GARDNER:
Sure.
MICHAEL LEWIS:
And I don't think it's trivial. If you create an industry on Wall Street that sucks in the best and the brightest — whose job is basically to game the system and scalp investors — and you create that as a model for success in this country, and that's what kids who graduate from Princeton and Harvard and Yale think is successful ... what is the effect of that instead of doing something actually useful?
TOM GARDNER:
I love the description in the book of — I think it's John Schwall. Is his first name John?
MICHAEL LEWIS:
Yes.
TOM GARDNER:
And he's assembling the LinkedIn networks to understand what's happening with high-frequency trading businesses because none of the executives will go on record and they'll fire anyone if they speak to the media — but so many of the software developers in technology are going onto LinkedIn and posting what they do. He's able to connect those networks, read what they're doing and he comes to the conclusion that all of these presumably very bright developers don't have any idea what they're doing.
MICHAEL LEWIS:
That's right.
TOM GARDNER:
They're building the whole technology platform. They have no idea how it's being used. It's being used to parasitically nibble off of trades across the market.
MICHAEL LEWIS:
Right. That's right. It's amazing. And the people at IEX found this over and over — that the technologists tended ... not always — but tended to be so narrow, so specialized that they didn't have a sense of how their work fit into the overall picture. That's a real misuse of talent resources. That's disturbing.
TOM GARDNER:
I have a potential solution. I'd like to have you shoot it down. I can't shoot it down in my mind right now, but I'm sure it can be.
MICHAEL LEWIS:
Maybe you can't shoot it down because it's your solution and you really don't want to.
TOM GARDNER:
I'm so egotistical ...
MICHAEL LEWIS:
I'll try.
TOM GARDNER:
So, here's what it is. Why don't we apply capital gains tax rates tied to the length of your holding period? We do in a very macro, long way ...
MICHAEL LEWIS:
You're really saying if it's a millisecond ...
TOM GARDNER:
Yes. It's 98% capital gains tax. And basically if it's 10 years, it's 0% capital gains.
MICHAEL LEWIS:
Here's the thing. I mean, this is going to sound crazy coming from my mouth right now. But I have no doubt that there's some useful high-frequency trading. And if you start mucking around in the markets that way, I think what we need is more transparency about what's going on. I think there are other ways to solve the problem. I don't know what the consequences of that are.
TOM GARDNER:
It seems so [00:30:55] to me that everyone now needs to be in New York. I love the firm. I can't remember in the brilliant story that you've told here the firm that feels like it's fine to be in Kansas. And then they're waking up to the reality that ...
MICHAEL LEWIS:
Well, you probably remember. There's a time that people were saying that the great thing about now — that technology means it doesn't matter where you are.
TOM GARDNER:
But if everyone needs to converge closer and closer right in the center of New York City and New York City has like the highest tax rates, why don't we tax that high-frequency trading because they really have to be in New York?
MICHAEL LEWIS:
Where they have to be is in New Jersey ...
TOM GARDNER:
Have to be in New Jersey ...
MICHAEL LEWIS:
... which is even worse. They have to have their machines next to the stock exchange. That's the thing. Wall Street is no longer Wall Street. It's in New Jersey. How that happened, I don't know.
TOM GARDNER:
Michael, what do you think, broadly, is happening with technology like algorithms? Robots? Does this interest you or do you just happen to have gotten deeply into the story because it's in the world of finance which you have spent so much of your life ...
MICHAEL LEWIS:
I'm probably not as interested as I should be, but you can't help but notice that the technologist is displacing the trader on Wall Street. That that's what's been happening. Machines have replaced people — so the people who control the machines are the people who have increasing power — the people who at least understand the machines.
TOM GARDNER:
And the Russian technologist who's in jail, rightly or wrongly, now ...
MICHAEL LEWIS:
They let him out, but yes ...
TOM GARDNER:
Oh, they let him out ...
MICHAEL LEWIS:
His conviction was overturned after he spent a year in jail.
TOM GARDNER:
Okay. But those technologists — you're saying — they are the future of Wall Street. Like Pixar is the future of Hollywood, in some way. I mean, technology that may be a backroom-basement tool ... that has been used by investment firms ... is becoming much more front and center and ultimately will be the leader of those firms.
MICHAEL LEWIS:
I think one of the reasons the high-frequency trading industry — the shadowy, very small firm industry — has flourished is that the big banks did not confer enough status on the technologist who could create high-frequency trading platforms, and so they went and did it outside of a bank. They don't respect the technologist. I think that's probably changing, but slowly.
I mean, the geekification of Wall Street started when I was there. All of a sudden in the Salomon Brothers' trading pool, the guy who used to be the guy who ran the thing was big and hairy and an ape-like kind of thing. He got replaced by these weeny, MIT guys who had no hair anywhere.
TOM GARDNER:
Does this cause you to be a long-term optimist about the markets and market stability and do you believe that the book has the potential to have a major impact? I mean, I presume that's part of the reason you've spent probably a very intense period, given how recently this happened, to actually sit down and write this book. Are you an optimist that transparency will win and that the market will be more stable for investors?
MICHAEL LEWIS:
I think it's going to be a war. I really think that it's going to be an ugly, long war. And I think Brad Katsuyama is Frodo Baggins in Lord of the Rings. He has antagonized Mordor, and the Orcs are rising on Wall Street. And on the other side, he's got this fellowship with the ring thing with investors — big investors who are supporting him. The war is between, ultimately, big investors who manage little people's money and the system that is exploiting the money.
I don't know where it ends up. I don't actually know where it ends up. I do think it's not going to just go away quietly. The book's not going to be published and then people are going to forget about it because they've got all these investigations going on. And I do think also that if the world changes, it won't be because of the book.
IEX could be the lever. You create this fair exchange — and it's really a fair exchange — and you're committed to restoring trust in the financial markets. What you do is you give people a choice. And so, all of a sudden, it's not one dark pool versus another or one exchange is sold out to HFT versus another exchange that's sold out to HFT. You actually have a fair place that's operating in the interest of investors that you force a choice onto the world that hasn't existed before. And that's very seditious.
TOM GARDNER:
Very. An opportunity to have a purely transparent place.
MICHAEL LEWIS:
Yes. There's no reason it can't be. Actually, I think they're going to win. I don't know how, but I do. I can imagine several paths to change. I mean, I can tell you what I think the most likely is. The most likely is one of the public exchanges — possibly the New York Stock Exchange — says this thing is turning fast. The old business model of deriving our revenues from high-frequency traders is going to collapse. Let's buy IEX and make them the New York Stock Exchange.
TOM GARDNER:
Because we get the reputational win. A huge reputational win.
MICHAEL LEWIS:
Yes. So, Goldman Sachs has been the first mover in the banks to get behind IEX and no one else has followed ...
TOM GARDNER:
I love that part of the reason that could be true is because they realize they can't catch up technologically ...
MICHAEL LEWIS:
That's right. That's right.
TOM GARDNER:
So, that's your point. "Let's play the reputational side."
MICHAEL LEWIS:
Let's play the reputational side.
TOM GARDNER:
Let's win with what we've got.
MICHAEL LEWIS:
There's no reason one of the exchanges won't do the same thing and the natural one to do it is the New York Stock Exchange.
TOM GARDNER:
So, in that scenario, you are our J.R.R. Tolkien. We hope you're safe in the eye of this ...
MICHAEL LEWIS:
I thought I was Gandalf.
TOM GARDNER:
Okay, you're Gandalf. I love that. You're such a youthful Gandalf.
MICHAEL LEWIS:
Okay. I'll be one of the humans. One of those guys. I'll be Viggo.
TOM GARDNER:
Okay, perfect. You're Viggo. I know you're not going to share this with us. This is the final question and I'm getting from Mac, our producer, that you have to go. You've got a variety of interviews here in New York, so thank you for spending time with us. The Federal Communications Commission License No. 1215095. I Googled it. I need to dig deeper.
MICHAEL LEWIS:
You do.
TOM GARDNER:
There's a clue. Has someone figured the mystery of the final page of your book out?
MICHAEL LEWIS:
Not someone who's going to put it in print, but an investor got to the bottom of it very quickly.
TOM GARDNER:
Okay, got it. So, do you have any additional clue or hint for us, or no ... we're on our own. There's enough there.
MICHAEL LEWIS:
There's enough there.
TOM GARDNER:
That investor did it.
MICHAEL LEWIS:
You can figure out whose it is.
TOM GARDNER:
The puzzle at the end of this great book and we're going to figure it out together in theMotley Fool One community. Why not. Michael, thank you.
MICHAEL LEWIS:
Thank you.
