Book: Flash Boys: A Wall Street Revolt

A cliche I’ve heard many times is “Wall Street Always Wins.” The first week of 2016 in the public markets has been an entertaining reminder of this.

In 1998, when I started ending up with lots of shares in public Internet companies, I came up with a formulaic approach for any public equities that are distributed to me (either from our funds or other VC funds). The approach was mathematic, dispassionate, and easy for me to execute. Over the past 18 years this strategy served me well.

In 2002, I decided not to own any public company stocks except for companies that I directly invested in as private companies. I sold whatever remaining public company shares I still had post Internet bubble and took an entirely different approach to the public markets.

While I have still have plenty of public equity, it is through either index funds, equity fund managers that I have a long term relationship with, or a few companies that I invested in when they were private companies. And, for the last category (the shares I own personally), I still use the long-term formulaic approach I came up with in 1998.

I’m a big believer in the Bogle school of thought about owning the market, rather than trading stocks. As a result, I don’t have to pay attention to the public markets on a daily basis. Or a weekly basis. Or an monthly, quarterly, or annual basis. Or basically, at all. That lets me focus all of my mental energy on what I like and what I think I’m good at (which is not being a stock picker or trader.)

The first finance course I took at MIT was 15.401: Finance Theory I and was taught by Stewart Myers. I remember the cover of the textbook, fondly called Brealey and Myers, what the Capital Asset Pricing Model is, and a few other things. Even though my future business partner Dave Jilk told me that he enjoyed the finance classes he had taken, I didn’t, and after taking 15.402 (which was required for my masters degree), I was done with corporate finance after taking the final exam.

Except – not really – since a big part of my job is corporate finance, just for startups and fast growing companies. However, unlike the evolution of the 15.4xx finance classes, and the extreme amount of financial engineering and financial innovations (both good, bad, and questionable) that came out of MIT research and MIT professors, most of the math involved for a venture capitalist can be done in one’s head, as long as you are decent at arithmetic.

But, for some reason, I occasionally like reading about Wall Street and corporate finance. Some of it is akin to watching the inevitable train wreck that surfaces in books like The Big Short. Some of it is to try to understand human motivation and behavior in a sphere that I don’t encounter often. And some of it is just to learn something that, in some parallel universe, I might be participating in.

Flash Boys was a good capstone to the last week of wallowing in the global financial crisis of 2008, which I began by watching the movie The Big Short. Once again, Michael Lewis took a hard topic and made it accessible, fun, interesting, and character heavy. After reading the book and then poking around IEX, the alternative trading system at the center of the story, I got a fun bonus by discovering that Spark Capital and Bain Capital Ventures are both investors in IEX.

I’m probably done for a while reading about Wall Street. But, once again, after reading Flash Boys, the cliche “Wall Street Always Wins” rings true in my brain.

  • Coincidentally, Andrew Parker mentioned their investment in IEX and Flash Boys on this week’s interview:

    Happy B Day Brad!

  • Matt Kruza

    Good article brad. The danger is main street is starting to see much of the tech world as the finance industry…. troubling trend. And there are plenty of leaders (both CEO’s and VC’s) who give that some legs. Obviously I don’t think you fall in that category, but I think the overall attitude toward tech does not really have the public support it used to. Interesting implications for both entrepreneurs, VCs, employees, public policy and the general public. Each can be analyzed on their own, but just felt like an apt reference since your post talks about the view of finance.
    Side note: much of this I think directly relates to how much “finance” vs innovation in VC game now. The mega rounds, uber big VCs, public funds and even some PE getting in which led to the unicorn craze is part of this. That may all start to fade perhaps

  • Like the sentiment in The Big Short. The danger of the Big Short is this: the blame is laid entirely on the banks. The reality is that without government as a backstop, the banks wouldn’t have been able to create the house of cards they created. It was basically impossible to short CDO’s unless you had the balance sheet to be a counterparty.

    I certainly think that the structure of Wall Street, and LaSalle Street in Chicago is not optimal. There are inherent inefficiencies that are built in and codified via regulation. Someday it will be fixed, but that doesn’t guarantee we won’t have bear markets.

    The current regulatory estate the policymakers and bureaucrats have created make us no “safer” today than we were in 2007-especially given the costs they put on the system.

    Brad is correct. For the average individual, follow Bogle’s strategy. It’s based on Eugene Fama’s efficient market hypothesis. People that can consistently beat the market either have some sort of artificial edge, or they are statistical outliers. It’s possible to use options to earn a higher return-but it’s almost impossible to do at scale.

    • My takeaway from The Big Short was not that the banks were to blame. Rather the issue was one of moral hazard. Individuals ability to create gain for themselves in the short term while passing long term risk and consequences to another entity.

      If there was one party to blame, there’s an argument for the ratings agencies. IMO there’s no problem w/ very risky, sub-prime derivatives, so long as they are rated as such. If they were rated appropriately, demand-side would’ve been far less, so supply would never have been created.

    • The reality for me, despite the fact I’m a progressive (not a dem or republican), is it is Bill Clinton who is to blame for not vetoing the bill that gutted Glass-Steagall .

      Bill Clinton claims that isnt true. But the repeal was specifically done in order to “enhance the stability of our financial services system” by permitting financial firms to “diversify their product offerings and thus their sources of revenue” and make financial firms “better equipped to compete in global financial markets.”[1]

      It did exactly this….except it did its job Way WAY too effectively.
      It made them so well equipped they were able to gut the combined wealth of the middle class.

      Bill just doesn’t want to admit he could have stopped all this madness with a well timed veto pen on the 99 Gramm-Leach-Bliley Bill.

      • True story: In 2000 I was in a small group meeting with Senator Phil Gramm. One of us asked, “Are you concentrating too much risk into too few hands?” Gramm replied that he and Treasury Sec Rubin didn’t think so. I think there are plenty of things we can do without bringing back Glass-Steagall. It is extremely clear to me that markets are not nearly the same as they once were. Electronic markets have more volume, but less marginal liquidity. (Try to get out of a big position and you will see what I mean)

        The breakdown of the public marketplace is why I started to blog in 2010. Dodd-Frank was a horrible law that did nothing to help Main St. or to make it easier for capital to flow through the system.

  • TyDanco

    Flash Boys. like all of Michael Lewis’s stories, was a great read. I’m uncomfortably close on this one–I came up on Wall St in the same class (1983) as Michael, and we actually had one shared account…who told me that Michael Lewis was the best salesman he had covering him.

    More to the point, later in life my company was acquired by a PE firm with many fintech investments, and I met several of the protagonists in the book. Their basic trait was that they were all competitive as hell. So I understood all that coming in. What froze me, however, was the episode where the young guys in the SEC assigned to regulating the various types of (essentially illegitimate) orders at the heart of high frequency trading didn’t want to bust the HFT traders…because they all planned on taking a high paid job on the Street after they put in their 2-3 years at the SEC.

    I too have all of my public investments in low cost index funds, and take it as a cost of doing business that those big whales will get constantly nibbled by the sharks. And there is an interesting coda to the biggest shark, Goldman, in the immediate aftermath of the book, once their PR shine had been acquired. Then it was back to business.

  • “Power tends to corrupt, and absolute power corrupts absolutely.
    The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks.”

    – John Emerich Edward Dalberg-Acton, 1st Baron Acton, KCVO, DL —known as Sir John Dalberg-Acton, 8th Baronet from 1837 to 1869 and usually referred to simply as Lord Acton—was an English Catholic historian, politician, and writer. Wikipedia

    • Rosey

      Lord Acton perhaps rephrased Sir William Pitt, “Unlimited power corrupts the possessor”

  • John Belo

    I finished reading it about a month ago. It completely changed the way I think about equity markets. Definitely worth a read.

  • Jason Lim

    One of my key takeaways from Flash Boys was the paradoxical use of technology to actually slow down processes as in the case of IEX making sure that each buy/sell order had the same latency to the exchanges to prevent front-running.

    I wonder where else technology will be used to counter technology. The most likely ones for me are search engines and social networks.

  • Ha! B&M CAPM (light blue softback) sits gathering dust a couple of feet from me.

    The ideas of market efficiency , NPV for decisions and following indexes because any established trend is soon broken also gather dust in my mind – but are shaken off regularly when someone tells me they can beat the market.

    Perhaps the biggest win for me was the simplification of decisions and a deeper understanding of how to put value on apriori information.

    Much of Entrepreneurial thinking can be reduced to the questions –
    What dont I know ?, How much is it worth and what will it cost to find out ?

    Get these right and decisions get easy fast – even to know that you cannot find an answer is a great way of preventing time lost spinning wheels that will get you nowhere.