ASIC on the hop as super-fast trading, dark pools and market makers change the game

After consulting more, it now thinks upper and lower limits on buy and sell quotes are a better idea, and it's right: it's never a good idea to totally shut down trade.

In its new report ASIC has also come up with a sensible approach to the growth of so-called "dark pools," markets that match buyer and seller behind closed doors.

The convention, backed by ASIC's market integrity regime, will be that dark pools can be used only if they offer a price edge, a "meaningful price improvement". They cannot, in other words, be used as a secret share reservoir, robbing open markets of volume and pricing information.

The regulator wants software filters across the market to minimise the risk of order errors that in a computerised world can breed like sheep. The filters would refuse to execute incorrectly configured quotes, and shut down rogue trades.

And it's going to consider whether Australia should encourage market makers, specialist firms that stand in the market to buy or sell shares, in return for offsetting concessions. These might be lower trading fees, perhaps, or enhanced powers to short stocks as well as buy them.

Market makers are common overseas, but rarer here. They could be an important source of liquidity for less frequently traded shares - all except, perhaps, the big four banks, BHP, Rio Tinto and Telstra.

The sobering fact, however, is that ASIC is reshaping the system without knowing precisely how it will behave as so-called high frequency trading (HFT) takes over. HFT is expanding faster than the ability of regulators and market players to fully understand it.

The ASX estimated in February last year that computerised trading triggered by pre-set parameters, or algorithms, accounted for between 30 and 40 per cent of the turnover.

High frequency trades that are completed in milliseconds are a sub-set of algorithmic, and the ASX estimated in February 2010 that it accounted for between 3 per cent and 4 per cent of turnover.

ASIC's estimate is that HFT now accounts for at least 15 per cent, and as much as 25 per cent, of turnover.

Growth will continue as the Chi-X share-trading platform opens for business this month, as the dark pools continue to expand and as the trading system modernises.

The benchmark is overseas. HFT accounted for 56 per cent of equity turnover in the US last year, up from 21 per cent in 2005. It accounted for 38 per cent of turnover in Europe, up from 9 per cent in 2007.

It's possible that HFT could be even more dominant here. Australians don't often acknowledge let alone brag about it, but the Australian economy is a modern conveyance. Our sharemarket is one of the most highly automated in the world, and is tailor-made for HFT now that the ASX's monopoly is ending.

Overseas, HFT is essentially a wholesale market phenomenon. Our system is so well connected the entire market, including retail investors, will be HFT's catchment.

It's not clear yet what changes HFT will produce. Talk to retail brokers and many will tell you that HFT trading is jerking buy and sell quotes around, on a logic that is impossible to understand. Talk to HFT traders, and they will tell you the opposite.

GETCO, one of the world's biggest HFT traders, specialises in market making. It invests its own money with the aim of capturing as much trading in a share as possible, and pocketing the spread - the gap between the buy and sell quotes.

To do that it needs to get itself to the top of the queues of buyers and sellers, and to do that it has to beat the quotes already posted.

It's impossible for this to work if GETCO doesn't narrow the buy-sell quote, by offering to sell shares for less than competing sellers, and for more than competing buyers.

And that puts GETCO on the side of the angels: its activity results in shares costing less for any given volume. GETCO was awarded an ASX licence in May. It has about 1.5 per cent of the trade, and it's growing fast.

HFT is also used in arbitraging strategies that looks to exploit minute differences in quotes for the same share on different platforms, or different time zones. This, too, should close down price gaps.

A third strategy, directional HFT trading, is more of a punt, a purchase or sale in anticipation of a price movement, basically. There is more objective risk in directional trades, and partly because the mix of HFT strategies is impossible to predict, the markets and regulators have not yet reached a consensus about how risky HFT is for the system as it expands.

Many HFT traders use prime broking platforms offered by the big investment banks to execute their trades. But one of the biggest prime brokers, Goldman Sachs, does not offer prime broking services to HFT traders yet. It doesn't because it isn't sure what the counterparty risk is. And if Goldman isn't sure, I doubt anyone is.