Getting the jump on high-frequency trading

What is effectively a legalised insider trading network is creeping into Australia, but before our banks get used to it, it's worth looking closely at the repercussions already being felt on the US stock market.

The legalised "insider trading" network, which now dominates share trading in Australian and American stock exchanges, has been caught dangerously extending its activities in New York. And the precedent is likely to apply in Australia.

I may be an optimist but I hope that the latest discovery of the activities of the "legal insiders” will be the first step in halting small American and Australian investors being ripped off by the big investment banks who are given exclusive entrance to legalised "insider trading".

Investment banks rely on stock markets to make their money yet their legal insider trading practices and the corporate governance requirements that came out of the Enron and other US crashes is substantially reducing the supply of new American listings. American companies now prefer to stay private. In the US the Facebook fiasco and in Australia the Myer share offer pricing is also making investors wary of floats where investment banks are involved, although in Australia the mining boom has masked the lower American listings trend.

The latest episode in legalised insider trading is revealed in the New York Times. The New York Stock Exchange (and the ASX) will vigorously dispute that they are fostering legalised insider trading. They call it high-frequency trading. In essence the big investment banks and others pay the New York, Australian and other stock exchanges big money to get a pipe directly into the trading system. Via this pipe they can detect big buying or selling orders as they arrive, enabling them to jump in first and make a killing by making the buyers pay more or the sellers get a lower price.

As Alan Kohler explained (High-frequency trading is cuckoo, April 11), there are six of these pipes into the Australian trading floor. There are many more in New York and from the New York Times report it would seem that some of those using these pipes are widening their sources of insider information from simple market trends to advanced knowledge of events.

In New York the market can move by large amounts after the CPI and other economic data is released. Prior to the release of the CPI the big news agencies are locked up so that when the data is released they have available immediate commentary interpreting the results. It’s a good system if not corrupted.

But this system appears to have been corrupted in the US on two fronts. First there has been leaking from the lockup and this is being addressed by tighter computer rules and systems. But the second corruption is harder to fix. Some of those in the lockup are reporting direct to those investment banks with a pipe. The investment banks therefore have the information just a little before anyone else. With their pipe direct into the exchange that’s all they need to make a killing.

A small media group has been banned from the lockup for doing this but wherever there is big money others will emerge and, now they see the rewards, the owners of these legalised insider trading pipes will seek to extend their advantage to other events affecting markets.

We have seen investment banks playing havoc in the US via sub-prime; in Europe via government bond raisings and now we are seeing further activities that reflect their profits at all costs mentality. Once these banks were important contributors to the capital raising system.

They still serve that function but some have added ruthless trading techniques to that activity.

Having a pipe into stock exchange trading so you can act faster than anyone else might be legal but it should be stopped. The stock exchanges are hooked on the money they raise from the investment banks and will not do it. The global regulators have it in the too hard basket and, at least in the US, the two major parties are dependent on the investment banks for their funding.

But the combination of the governance rules and the investment banks' bad market practices is slowly killing the goose. It will take time but eventually someone will wake up in New York and then we will follow. Or is it possible we could wake up first?

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