Flash War!


Earlier in 2014 Flash Boys woke up many with its allegations of rigged portions of the stock market. It did not awaken many of you, of course, because you trade daily and have been abreast of market structure issues for years. You already have known about THOR, Spread Networks, order-cancellation on different exchanges, dark pool leakage, and such. What Lewis did was examine a complex topic, envision a story – complete with heroes and anti-heroes – and tell it in an easy-to-understand way for the average investor at home.


Speaking from experience, what Lewis did is not easy to do; we tried with Broken Markets, which did not sell as well as Flash Boys. We at Themis are not journalists. To our knowledge, neither is Michael Lewis. None of us work at Reuters or Bloomberg. No… Lewis is an author, and a story teller, and he does it extremely well. He tells a compelling true story (90% anyways) through the eyes of Brad Katsuyama, and makes you feel what Brad felt. It became a best seller, which prompted regulators to assure us that they are on the case (at least at first), and prompted a large backlash from the “status quo” in the industry. Stock Exchanges like BATS went publicly bananas in their outrage over the story’s insinuations. Brokers who route orders – perhaps not always responsibly – also were upset at Lewis for causing the world to focus on their complex practices. And of course… HFTs have spoken out aggressively. Modern Markets went on the attack. They hired Bart Chilton to repeatedly claim markets are not rigged, and that costs are the very bestest ever. A blog appeared titled Lewis Fiction, which pointed out inaccuracies in Flash Boys, and MMI tweeted every update of the blog right on cue .


We believe the author of the Lewis Fiction blog is the same Peter Kovac who has written the Flash Boys: Not So Fast kindle book that MMI spammed all of your inboxes with a few weeks ago, and whom you may have seen on CNBC and Bloomberg last week. We read Kovac’s book, and in this morning’s note want to share some of our thoughts.


Our Thoughts on Flash Boys: Not So Fast


Let’s start off by saying Kovac is smart. He is a Princeton grad, a software engineer, Madison Tyler (bought by Virtu) alum, and he is very, very well spoken. You should read his book. He makes his arguments eloquently, is an excellent writer, and is obviously passionate about the markets as his perspective has allowed him to perceive them. I may be generalizing, but he appears to be from the generation of young traders resentful of Old Wall Street, who genuinely believe that through coding and programming, they have disrupted the stock markets; I am also willing to bet that Tradebot / BATS’s Dave Cummings is a hero to many in this group. Through this lens, Kovac is appalled that there are some who find their disruptions harmful to investors. This passion is prevalent in Kovac’s e-book.


While I chronicled many inaccuracies in Kovac’s book, in the same way that he scrutinized Lewis’s book, I’ll just share some of them here. For example:


–          Kovac claims that a decade ago stocks were traded on only two exchanges, executed by only one or two designated market makers, submitted by a handful of brokers? This is wrong, and contradicts actual market history, while it may fit with the perspective of someone who started trading in markets in 2003. There were hundreds of brokers who submitted orders – from firms like Montgomery, Instinet, Piper, GS, MS, ML, Themis, ITG, Bloomberg, BNY and hundreds of NYSE floor brokers.  There were also numerous ECNs, exchanges, and trading venues where trading took place voluminously – not just two.

–          Kovac claims that ” In the last decade Wall Street was upended through two important transformations to this system: computerization and competition.” This is also wrong. These changes began over 20 years ago, which is significant because “computerization and competition” began well before Kovac’s post 2003 time frame.

–          Kovac claims that HFTs have dramatically reduced trading costs for investors over the last decade. Again this is debatable, and is the subject matter of so many of our notes to you. By the time Kovac joined Madison Tyler in 2003, spreads had already compressed nearly 80% due to decimalization and electronic market direct access – not due to high frequency trading, which can be argued to have taken off post 2003.

–          Kovac claims HFTs narrowed the spread in MSFT. He claims a decade ago it used to be six pennies, and today it is just one penny. He is wrong here. Microsoft traded with 32nds and 64th spreads on Instinet pre decimalization (1.5-3 cents), and 1 penny spreads immediately upon decimalization – well before “the rise of HFT”.

–          Also, trading costs for most institutional investors DOES NOT EQUATE to the bid-ask spread, although the spread might be a good proxy for an E*TRADE retail trader moving in and out of a hundred shares, or an index fund that tends to rebalance with small order sizes.

–          Kovac chastises Lewis for quoting academic Adam Clark-Joseph’s Exploratory Trading (a paper we highlighted for you years ago) without apparently reading it. A commenter on Amazon debunks Kovac better than we ever could:


There are other confusions in the Introduction. Kovac mentions an academic paper by Adam Clark-Joseph called “Exploratory Trading,” and with apparent sarcasm suggests that while Michael Lewis referenced the paper Lewis couldn’t have read it. Kovac includes this quote from the paper, about how HFT firms make money: “One possibility is that HFTs merely react to public information faster than everyone else…A second possibility is that HFTs simply front-run coming demand when they can predict future aggressive orders. However, I find neither of these hypotheses to be consistent with the data.”

Kovac then writes, “In other words, this research, cited by Lewis himself near the conclusion of his book, contradicts everything he has said about front-running in the prior two hundred pages.” Kovac suggests this is some kind of “Aha!” moment. See, he seems to say, there’s no front-running and Lewis’s own sources say so.

Your guess is as good as mine on this, but Kovac seems to be the one who apparently didn’t read the research. Go to the next paragraph in Clark-Joseph’s paper: “[T]he private information about price-impact generated by an HFT’s small aggressive orders enables that HFT to trade ahead of predictable demand [that is, front-run demand] at only those times when it is profitable to do so (i.e., when price-impact is large).”

So the paper says HFTs don’t front-run demand in every instance, but they do front-run when they believe it’s profitable to do it. The paper says the very opposite of what Kovac implies it does, and is powerful research evidence supporting “Flash Boys.” If there’s any remaining doubt about what Clark-Joseph really means, the next-to-last sentence of his paper is “Finally, since HFTs appear to trade ahead of predictable demand innovations…HFTs could have a destabilizing influence on prices if suitable positive-feedback mechanisms exist.” Why Kovac quotes research that concludes high frequency trading firm’s front-run demand and can destabilize markets, and why he seems oblivious he’s done it, is another great mystery.



There are many inaccuracies, and I could go on and numb you; I probably already have. Let me just add a few more problems I have with Kovac’s book:


–          Kovac takes issue with Front-running from a legal standpoint (How could HFTs front-run? They have no customers!) This is not Lewis’s point.

–          Kovac claims HFTs cannot see your order coming, which means he is either ignorant or feigning ignorance about dark pool IOIs, blind pings, ELP conditional orders, ELP rebating to broker routers, etc.

–          Kovac tries to debunk latency arbitrage when he goes into a long and correct analysis of what the SIP is and what it’s used for. “You can look at the SIP; you can’t trade off the SIP.” Kovac is wrong. While HFTs and others do trade fast using direct feeds, some automatically sweep through slow, hidden resting-flow that is pegged to slower data feeds like the SIP. For example many dark pools price their hidden bids and offers off the slower SIP. Ironically so does Direct Edge.

–          He defends order types like Hide Not Slide, and says they do not cut the line. He should read Haim Bodek’s book.

–          He repeatedly belittles the expertise and “marketing spin” generated by Brad Katsuyama and Ronan Ryan, and IEX in general. This implies that the rest of the market currently trading on IEX is foolish for being duped. I guess this includes Virtu.

–          Kovac says that if HFTs were doing bad things, FINRA and the SEC would have caught them, and because they have not, there must be nothing bad going on. Kofac should know better, He knows the regulators are playing catch up with their sureveillance ability. They have come a long way, though! Just this year we have seen  enforcement actions from the SEC,  CFTC and CME – enforcement actions against so many HFT firms, who vary from small to large (Panther, Athena, Tower-Latour).


For all the bad I have outlined above, Kovac correctly talks about the problems of using the SIP, and correctly defends electronic market making.  Firms like Virtu don’t lose money often because they trade what they know, simply, and the law of large numbers works to their advantage. We agree with him here. Liquidity provision has changed with market evolution. Today’s dominant participants on the public exchanges (and dark pools for that matter) operate differently than the participants of fifteen years ago. This is neither good nor bad – it just requires understanding. We agree.


Kovac writes well. I am glad I read the book. While his book, and Lewis’s book, and Dark Pools, and Broken Markets all have their issues, they all raise important issues  from unique perspectives. And the truth – whatever that may be – lies in between all of them.