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Flash Boys is a book written by Michael Lewis that covers in great detail the history and mechanics of the highly lucrative and legal process of High Frequency Trading (HFC). In short, stock market traders take advantage of the digital aspect of the stock market to make micro-second trades (buy and sell) to profit off your trade. A over-simplified analogy is a marathon where one opponent built a straight path from start to finish and only he could run on it (oh and he also found a way to gaurantee he's the first one out the gate)! Below are some of my notes from the Flash Boys, but rest assured the book goes into much deeper detail:
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Ronan's history in the telecom industry (MCI, Qwest, Level 3) gave him the technological background on communications.
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Latency is the time between when a signal is sent and received and can be affected by the hardware, the fiber optic cable, and the code. And the length of the fiber optic cable effects latency. Ronan figured out that if he moved the office from Kansas City to Nutley, New Jersey, latency went 43 milliseconds to 3.8 milliseconds. It gets to the point where customers are interested in where their hardware is location in the building, as customers were willing to pay to relocate their hardware closer to the pipe that exited the building (all for a shorter route) to gain an advantage over others in the same building. Stock exchanges then realized they could charge millions for customers to be located inside the stock market. Ronan soon became the expert in proximity, aka "co-location".
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Customers soon began asking about data switch speeds (and it went from 150 microseconds to 1.2 microsecond per trade). The type of glass that most efficiently conveyed light signals through fiber optic cable became important.
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Brad Katsuyama at RBC then offered him a finance job on the trading floor at a pay cut to his previous job, and without knowing the basics of trading. Brad and Ronan collaborated to figure out fundamentals of HFC and built out their own network of fiber network to exchanges that they could then control timing to the various exchanges. They then went out to explain the details to over 500 professional stock investors, who collectively controlled many trillions of dollars. They were pissed that their Wall Street Firms had failed to protect them, but very few transferred services to RBC. But after a few "flash crashes", RBC began gaining influence as more brokers picked up on what was happening. RBC soon raced to the top of list that banks used to determine their ranking with peers. Brad Katsuyama found he was an expert in a field that required honest change.
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RBC (Brad and upper management) met with the SEC's Division of Trading and Markets staff to discuss what they found from Thor. The staff members were divide on supporting HFT and supporting RBC. Afterwards, RBC conducted a study that showed since 2007, 200 SEC staffers had left their government jobs to work for HFT firms and firms that lobbied Washington.
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In 2005, 25% of trades are by HFT firms. By 2008, 65% of trades are by HFT firms.
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Flash Boys then delves into the story of Sergey Aleynikov, an educated Russians who immigrated to America, and eventually ended up working for Goldman Sachs with a starting salary of $270,000. His job was to improve Goldman Sachs HFT algorithms. He had band aid fix their huge system, and by the time he left, was placed under arrest by the FBI (tipped off by Goldman Sachs) for stealing computer code. After a signed confession, and sentenced to 8 years in federal prison.
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As Brad got investor money to build his own exchange, he hired a team of talented engineers and salespeople. The engineers had to decode the various types of orders and figure out how they benefited HFT. Other than common orders like limit or market order, there were other kinds like 'Post-Only, Hide Not Slide'. Their goal was to eliminate any advantage that HFT were exploiting. What Brad created was IEX, essentially a Dark Pool, but with all rules exposed and fair. Even before IEX opened for the first time, large investors began to discredit IEX by saying they were owned by HFT. When IEX launched, they would need 40-50 million shares a day to cover costs. On the first day, they traded 586,000 shares. Their first full week was 12 million. It wasn't until Goldman Sachs began trading that they hit huge volume, and it was fair (midpoint).