“There is no fire like passion, there is no shark like hatred, there is no snare like folly, there is no torrent like greed.”
― Siddharta Gautama (c. 563 BCE or 480 BCE - c. 483 BCE or 400 BCE)
“When the stock market crashed, Franklin Roosevelt got on the television and didn't just talk about the princes of greed. He said, 'Look, here's what happened.”
― Joe Biden (1942-)
“Let us wage a moral and political war against the billionaires and corporate leaders, on Wall Street and elsewhere, whose policies and greed are destroying the middle class of America.”
― Bernie Sanders (1941-)
Michael Lewis’s book Flashboys: Cracking the Money Code is a piercing study of Wall Street’s virtually limitless greed, and the willingness of investment and trading insiders to enrich themselves at the expense of others—including their own or others’ clients. It reminds me of the story of the stockbroker, taking a couple of important clients to his yacht club for dinner. Looking out through the big bay windows at the beautiful boats bobbing gently at anchor, the broker points expansively to the largest, a gleaming white 140-footer with glittering letters on the bow, the True Purpose. “That’s my yacht”, he says. To which one of the clients replies, after a suitable pause to register how impressed he is: “Which are the client’s yachts?”
It’s an aphoristic, evocative reminder of who makes all the money. The ones with the most power, and knowledge.
Lewis painstakingly traces the rise of high frequency trading, in which stock buying and selling takes place inside black boxes in large security-minded buildings using computer algorithms to create profits for the companies with the fastest and smartest computer code. The companies doing this argue that this activity, intensifying greatly over the last decade or so, shortens trading times and creates huge amounts of liquidity in stocks for the benefit of everyone—traders and investors alike. So the clients—those putting up the money in exchange for shares in a company—are supposed to get the best price, with their trade settled very quickly.
According to Lewis, however, it does neither. Or rather, these are not the chief purpose. The real goal is to stand between buyers and sellers, and profit from the spread between the two. So if Apple stock is trading at between US$143.50 and US$143.60, and some clients want to put in huge orders for them because they think the price will go up because a new iPhone, iPad or Apple watch is to be announced, the computer is set up to make gains by running ahead of the clients’ trade. High frequency trading companies do this within the multiple stock exchanges available to operate in, or within the large banks’ “dark pools”—their own internal trading spaces.
Although the average trade in the US stock market is not large in dollar terms, and the profit from any one transaction tiny, the overall profits from front-running are enormous. Billions of dollars are made from this activity. If hundreds of millions of stocks are traded, and the pace-setter makes just a fragment of dollar value from each transaction, they get rich. And this, according to Lewis, means that investors, small and large alike, are being cream-skimmed, a fraction of a cent at a time.
My own interest in this book is not so much in the efficiency or inefficiency of financial markets, or the business models which are designed by big companies to cash in over the unwitting little person, or the obsession with computer speeds (now measured in the smallest slivers of microseconds). I am even less drawn to Lewis’s depictions of the computer programmers—a disproportionate number of whom are Russian immigrants who, through sheer mathematical prowess and applied ingenuity, write the code that is used to exploit the markets and take advantage of the smallest chinks in financial systems to make the megabucks.
I marvel, instead, in this being a tale of human behavior in complex settings. In complex systems, everyone to some extent is a prisoner of the system itself—meaning, that no-one really understands the whole picture (that’s a marker of complexity, after all), and behavior that’s not at all predictable emerges and adapts over time, dynamically.
Complex systems are everywhere. Think the economy, forest ecosystems prone to bushfires, and military operations. They share common features, such as having multiple agents with dynamic behaviors, exhibiting path dependence (their history helps determine their current circumstances), and non-linearity (their progress does not proceed in straight lines).
They are inherently unpredictable. People in complex systems aim to survive and thrive, protect their interests, and optimize their position vis à vis others.
The hallmark of unfolding events under complexity is that they proceed in non-linear fashion; things happen in complex systems that have never happened before. People in complex systems have considerable degrees of freedom to self-organize; they don’t necessarily wait for someone in charge to tell them what to do. Despite having agency, people herd—that is, they mimic successful behaviors in others; but sometimes that becomes a stampede.
That’s when order can quickly become chaos. The economy goes into freefall, as it did everywhere in March 2020; the bushfire becomes uncontrolled and uncontrollable even for experienced firefighters, as it did in Australia’s Black Summer of 2019-2020; the Taliban slice through the Afghani forces inside three months, May-August 2021. That’s what can happen in all systems, not just the stock market. All systems are not far from the edge of chaos, occupying the liminal space between order and disorder.
In Lewis’s story, the high frequency companies exhibit all the behavioral features of those under pressure in a complex adaptive system. They self-organize, compete though mimicry and strive to out-perform others, either adapting, or dying. The successful ones have made a killing; the unsuccessful ones are out of business. Wall Street as a whole has flourished since the Global Financial Crisis of 2008 and then again during the second quarter of 2020 as it was realized that the pandemic would not last forever. Both times, the markets bounced back from the darkest days when everyone thought it was Armageddon. But at what cost to the little guy, and all the clients?
Now others are reacting against this enrichment of the few. Not just Lewis, by his exposé. A group of poachers-turned-gamekeepers led by some of Lewis’s heroes, Brad Katsuyama, a Canadian, and Ronan Ryan, and Irish-American, started a new stock exchange, IEX, without the features of the existing exchanges, which the high frequency players had learned to game. Now, banks and other companies could break the cycle of exploitation if they wished, and place clients’ stock orders in an environment of benefit to the client not the group making the market on their behalf. But at this point it only has 2.4% of the market for trading.
Anyone with an inkling of competitive behavior in complex environments knows that the defensive routines of the players profiting from the existing system will kick in every time. They have lots to protect—their livelihoods, large profits, proprietary trading systems and the prestige, status and power they hold. There is also the shame and even disgrace of being exposed as an exploiter, even a cheat and a fraud—if it comes to that. These are powerful incentives to fight against reform and maintain the status quo. That always happens in complex systems. The present players, who have plenty of sunk costs and have learned to do well by exploiting the benefits of the current circumstances, will repel all newcomers and fight any threats to their incumbency.
No-one knows how this will end up. Remember, complex systems are non-linear, and unpredictable, especially in the medium term. Regulators have yet to show their final hand. The public, who are the clients, trying to invest or trade shares on an even playing field, do not really understand what’s been going on. And for an individual, who misses a small bit of one cent per share?
But change will occur and when it does it is likely to be dramatic. Complexity theorists know this as a phase transition, where the system moves from one state to another very swiftly, even in the face of strong defensive routines by existing players who disproportionally benefit.
My advice? Watch this space. It is hard to see how it can be allowed that traders with the fastest computers continue to make obscene profits, taking money like candy from a baby, which in this case is you and me. It should be the case that everyone who buys stocks and shares is on a level playing field. But resistance to change from those who are benefiting from the current system is usually amongst the strongest of human behaviors.
And the lesson for other complex systems? While systems change and adapt all the time, planned, orchestrated, deliberate change is hard. The economy continues to go through booms and busts despite all the sophisticated knowledge of policymakers and academics about how they work. Bushfires ravage the west coast of the US, Australia, Europe, Latin America and Africa every summer, despite much deeper, research-based understanding of forests and their management. Hostilities, from the Peloponnesian War through the Crusades of the Middle Ages, to the World Wars of the 19th century and the Afghanistan war in this, are inherently unpredictable and the outcomes unclear except in hindsight—and it has proven hard to change the way wars are waged and even how we get into them in the first place, with such regularity.
I usually try to land on an upbeat note. But when dealing with entrenched behaviors in complex ecosystems, there’s no ready fix, no magic bullet. But know this, profoundly: pressure will eventually build, and the system will find a new equilibrium after passing, often very rapidly, through a phase transition marked by critical inflection points, often manifesting as a symmetry-breaking process. Or more prosaically, shit happens when you least expect it.
Kauffman, Stuart (1995). At Home in the Universe: The Search for the Laws of Self-Organization and Complexity. New York: Oxford University Press.
Lewin, Roger (1999). Complexity: Life at the Edge of Chaos. Chicago: University of Chicago Press.
Lewis, Michael (2014). Flashboys: Cracking the Money Code. New York: Penguin.