Fighting Wall Street Predators with Game Theory

Punishing the financial defectors

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By David Sloan Wilson

The newest Wall Street bestseller by Michael Lewis, Flash Boys, chronicles the unlikely emergence of fairness in the corrupt world of high-frequency trading (HFT). It’s a gripping and enlightening read for anyone who doesn’t already know the story, but it becomes especially enlightening when viewed through the lens of evolutionary game theory (EGT).

The EGT story is simpler than the HFT story. It consists of only four actors, who reflect combinations of two binary strategies: whether to cooperate or defect in a social interaction, and whether to punish or ignore defections by others. These actors interact with each other in a social environment defined by the parameters of the game.

In one classic version of the game, each player is given an endowment, which they can keep or contribute to a common fund. The fund is multiplied and distributed equally to the players. This is a social environment that rewards defection, since players that don’t contribute get the highest returns. When actual people play the game, most start off moderately generous, but as soon as they realize that they are being exploited by others, they withhold their own contributions. Cooperation goes down the drain, leaving only defection and the lack of social benefits.  There is no way to punish defectors in this version of the game, so the punish vs. ignore option is inoperative. The only way to punish defectors is to withhold one’s own cooperation; that is, to become a defector oneself.

The punishment option can be added to the game by allowing players to contribute to the first common fund, where it is multiplied and distributed as before, or to a second fund, where it is multiplied and used to punish defectors by deducting from their payoffs.  When this version of the game is played by real people, if enough players are motivated to punish defectors, then cooperators earn the highest payoffs and everyone ends up cooperating. But there are still financial losers in this game and they are the punishers. Since they must pay to punish, they place themselves at a disadvantage compared to cooperators who don’t punish. The problem of free-riding hasn’t gone away, but merely relocated from the provision of the public good to its protection.

A lot depends on the multiplier of the punishment fund. If it is high, then a little goes a long way toward punishing defectors. If it is low, then punishment can only be levied at a substantial personal cost. A lot also depends on the number of members playing the game who are willing to punish. If they are many, then the per capita cost of punishment becomes low. If they are few, then the per capita cost becomes prohibitive. Acting like the Lone Ranger can get you killed.

Against this background, the world of high-frequency trading can be seen as an enormously complex game that the defectors have won.  According to Lewis, the parameters of the game were established by a set of rules called the Regulation National Market System (Reg NMS) that was passed by the U.S. Securities and Exchange Commission (SEC) in 2005 and enacted in 2007.  Reg NMS was intended to correct trading abuses and required brokers to find the best market prices for the investors that they represented. This required a mechanism for comparing prices across stock markets. The system created by the SEC became known as the Securities Information Processor (SIP) and was slow by computational standards. High-frequency traders could exploit this weakness by building faster processors, allowing them to preview the market and trade on what they had seen.

The result was an arms race for processing speed of mind-boggling proportions. Flash Boys begins with the story of a fiber optics cable that was built to connect a data center in Chicago to a stock exchange in New Jersey at a cost of tens of millions of dollars, just so information could be transmitted a few milliseconds faster than existing communication channels. Like the fastest running cheetah, this tiny difference in speed enabled the owners of the cable to charge banks and investment companies millions of dollars to gain an edge over their rivals without producing any social benefits whatsoever. This was just part of a feeding frenzy in which the high-frequency traders were the predators and the average investor was the prey.

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The heroes of Flash Boys are a small group of people who discovered the injustice of high-frequency trading and were morally offended by it. In game theoretic terms, they were cooperators who were inclined to punish. But the game they were playing was wickedly stacked against them. They were few in number. The cost of attempting to punish would be severe. And it wasn’t clear how to punish, even if one decided to make the sacrifice. The world of HFT was like the first version of the game described above, in which the only way to protect oneself is to join the defectors.

Not everyone who inhabits the world of HFT is morally corrupt, but the moral landscape is nevertheless bleak. Some inhabitants are predators and proud of it. Some know what is taking place but don’t see how it can be stopped. Some enjoy the money and the technological challenges without thinking or caring about the societal consequences. Some are misled by free market ideology to think that the system is actually good.  Here is how Lewis describes the moral landscape of HFT through the eyes of one of the book’s characters, Don Bollerman.

Don wasn’t shocked or even all that disturbed by what had happened, or, if he was, he disguised his feelings. The facts of  Wall Street life were inherently brutal, in his view. There was nothing he couldn’t imagine someone on Wall Street doing. He was fully aware that the high-frequency traders were preying on investors, and that the exchanges and brokers were being paid to help them to do it. He refused to feel morally outraged or self-righteous about any of it. “I would ask the question, ‘On the savannah, are the hyenas and the vultures the bad guys?’ “ he said.   “We have a boom in carcasses on the savannah.  So what? It’s not their fault. The opportunity is there.”  To Don’s way of thinking, you were never going to change human nature—though you might alter the environment in which it expressed itself.

Not everyone is this morally apathetic, even on Wall Street. Laboratory studies show that people who punish in game theory experiments are morally indignant and take pleasure in seeking revenge. Some of the characters in Flash Boys bring these scientific results to life, such as John Schwall, who felt this way about high-frequency trading.

“It really just pissed me off,” he said. “That people set out this way to make money from everyone else’s retirement account. I knew who was being screwed, people like my mom and pop, and I became hell-bent on figuring out who was doing the screwing.”

What causes some people to become morally active in this way?  In an interview on National Public Radio’s “Fresh Air”, Lewis commented on the fact that most of the heroes in his book are Canadian, immigrants to America from other countries, or the children of recent immigrants. John Schwall is an American, but his father and other men in his family are firefighters. The common denominator might be a sense of good old-fashioned decency that makes the world of HFT particularly offensive. The 9/11 attack on the World Trade Center and the 2008 economic crash also seem to figure in the moral awakening of the men who decided to fight the system, no matter how great the odds.

Punishment is necessary to maintain cooperation, but it is not sufficient. In addition, the rules of the game must be structured to protect against exploitation and to lower the cost of acting in the capacity of a punisher as much as possible. The main achievement chronicled in Flash Boys is the creation of a new stock market (called Investors Exchange, or IEX) with fairness baked into it, unlike all the other stock markets. For the first time, investors have an opportunity to trade in an environment that is remarkably well protected against predators. This is the real-world analog of exchanging the first game described at the beginning of this essay for the second game.

One of the major themes of Flash Boys concerns the need for simplicity and transparency. Predators need cover to ambush their prey and part of the complexity of financial markets is cover invented by the predators. Theories of financial markets also provide a kind of cover when they portray current market processes as good for society. It doesn’t matter whether this cover was invented to conceal predatory activities or merely has that effect. Either way, EGT reveals predatory activities for what they are and provides a guide for the construction of social environments that actually benefit the common good.

At the present moment, a competition among games is taking place—a fair stock market vs. stock markets that favor predatory activities in myriad forms.  If the fair stock market prevails, the impact on societal welfare could be huge.

2016 March 1

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