High-frequency trading rewriting the rule book
When we thought about changing the market structure, we didn't think of them [retail investors]. ASX chief Elmer Funke Kupper I just think [high-frequency trading] is badly corrupting the whole system. ASX shareholder You wouldn't be hearing about any of this stuff if volumes were higher. It's all crap. Trader
But the practice is fuelling concerns about market fragmentation and the integrity of the system, writes Gareth Hutchens. The spectre of ultra-fast trading has stalked the nation's sharemarket this month.First, at the Australian Securities Exchange's annual meeting, where board members were peppered with anxious questions about high-speed or high-frequency trading - called HFT.Then came the bizarre share price spikes on Thursday morning last week, when a handful of blue-chip stocks shot up, inexplicably, before just as strangely dropping back down, in the seconds before the market opened. The irregular price movements sent whispers hurtling through the market: were high-frequency traders involved?The two events raised another question: Could this be what the ASX chief executive, Elmer Funke Kupper, had been warning about?As the sharemarket splinters beyond a dozen exchanges and alternative trading venues, and as high-speed traders exploit the subsequent and ever-growing arbitrage opportunities, are markets becoming disorderly, causing investors to lose faith in the system itself?Not everyone thinks so. Some sections of the financial industry are privately seething that Funke Kupper and others have been whipping up hysteria about high-speed trading. In the bars of Sydney's financial district, the topic is waved away with scorn. "It's just become a scapegoat," is the refrain.Over the past few years high-frequency trading was biggest new thing to hit sharemarkets and, in the minds of the big super funds, the most disruptive.On any given day, this lightning-quick, computer-driven form of trading accounts for 30 per cent of all of the business transacted on the nation's sharemarket.But critics say high frequency has contributed to the hair-raising flash crashes and computer hiccups.Since Funke Kupper became the ASX chief in October last year, he has warned of the consequences of allowing high-speed traders to flourish with the arrival of multiple trading venues. He could do little to stop Chi-X Australia, the country's first alternative stock exchange which began operating late last year, because he hadn't yet joined the ASX.But he's fighting to stop other parts of the ASX business being opened to competition, such as clearing and settlement services.Ignoring for the moment that his argument gets a kick from commercial self-interest - he's got revenue streams to protect - Funke Kupper's genuine concern, he says, has to do with the potential damage that could be done to the country's equity market as we tinker with it needlessly. And he's not alone with his concerns. Some traders, fund managers, brokers and executives feel the same way.Gone are the days of the single stock exchange, when most trades took place on the same open market. In Australia today, there are now at least 18 different places where one can trade BHP Billiton shares.There are two main exchanges, the ASX and its rival Chi-X, with a possible third exchange - the Asia-Pacific Stock Exchange - hoping to begin operating next year, pending approval from Parliament.There's a large handful of trading venues where one can conduct off-market trades, such as traditional over-the-counter type trades (that have for decades been done privately away from the main exchange).And then there are the large broking houses, such as UBS and Citi, that have begun offering their own trading areas - called "dark pools" - where orders are matched by electronic algorithms, with no human intervention, and then reported to the main exchange after a trade has been made.(There's an argument within the industry about what a "dark pool" actually is. Both the Australian Securities and Investments Commission and the ASX have said that most trades that take place away from the main exchange are basically "dark".)But the large broking houses use a different and more specific definition that reduces the number of official dark pools to five. These belong to UBS, Citi, Credit Suisse, Liquidnet and ASX's Centrepoint).Funke Kupper believes that this fragmentation is a bad thing: the more the market splinters, he says, the more liquidity will get sucked from the main exchange into smaller off-market trading areas, making it harder and more costly for companies to raise capital. And in an emergency, that could be particularly worrisome.The near-feverish concern about high-frequency trading is intimately linked to this issue of market fragmentation.High-speed traders (firms such as Getco, Virtu, and Optiver) use ultra-fast computer technology to buy and sell shares in the blink of an eye, often thousands per second.Think of what it's like to read a company's financial report. A high-speed algorithm will have scanned and absorbed the entire report, and then executed its trades, by the time it takes you to finish the first sentence.High-speed traders thrive when they can jump between different exchanges to take advantage of tiny differences in price.So the more a market fragments, the greater the opportunity for profit, and the greater the reason to expand.Carole Comerton-Forde, of ANU's College of Business and Economics, says Australia has become more attractive for HFT in recent years, for two reasons.First, the ASX upgraded its trading technology in November 2010, allowing trading capacity to exceed 5 million trades and 500 million order book changes per day.It also launched its high-speed distribution network (ASX Net) and improved its co-location facilities (ASX Liquidity Centre).Second, Chi-X opened its doors last year.Since then, high-speed traders have proliferated.According to the corporate regulator, HFT now accounts for about 30 per cent of equity market turnover, up from just 3 to 4 per cent in February 2010.And that's a figure that has begun to worry investors.As one shareholder put it at the ASX's annual meeting: "I just think [HFT] is badly corrupting the whole system ... on Little Street where I'm from, it's certainly eroding confidence [in the market]."The annual Fix Conference 2012 was held in Sydney this month. It's where the upper ranks of the financial class - merchant bankers, high-frequency traders, and their globetrotting PR teams - came together to talk about the latest developments in electronic trading.The keynote speaker was Nick Leeson, the infamous "rogue trader" of the early 1990s who brought Britain's oldest merchant bank, Barings, crashing to the ground in 1995, from the port of Singapore.Leeson provided an unusually candid "bio" for the conference program: "In December 1995 a court in Singapore sentenced [Nick] to six and a half years in prison. Lisa his wife got a job as an air hostess to be able to visit him regularly. At first, their marriage survived the strain of being apart, but what Lisa could not abide were his revelations of his infidelity with Geisha girls and she divorced him."The conference had over 1000 attendees. Technology companies set up stands to flog the latest in trading technology.These are the guys who design the trading systems that can handle the ultra high-speed algorithms that have been scaring brokers and fund managers.They talk about trading speeds in nanoseconds (one-billionth of a second) and how microwave technology can beam information through the air in a faster and more direct way than copper cables. The technology start-up Zeptonics, which specialises in speeding up the network infrastructure within exchanges and co-location facilities, had a display there.The company's principal of hardware, Charles Thomas, later explained why microwave technology was appealing to traders."You find a lot of the traders ... if you can get the fastest connection between exchanges, you open up the opportunity to beat everyone else in arbitrage and other sorts of transactions," he said."[So] if you can get a line of sight microwave link, then that's got two advantages. Not only is the data travelling faster over the distance but it can actually be shorter, you know, point to point, rather than running along existing cabling conduits which creates a sort of zig-zag path."He said the technology was already being used in the US.After the conference, attendees kicked on at the Sydney Hilton's Marble Bar, into the small hours of Wednesday morning.A few rounds in and talk turned to the hysteria being whipped by the ASX and the media. They said there was nothing to be afraid of, that technology would keep advancing like it always has, and that we would all benefit from it.As they see it, high-frequency trading has become a scapegoat, an excuse used by brokers to explain why the sharemarket is still a disappointment more than four years after the financial crisis.As one trader put it: "You wouldn't be hearing about any of this stuff if volumes were higher. It's all crap."The choice of metaphor is an interesting one. The term "scapegoating" refers to the ancient and barbaric ritual where one's "sins" were placed on a goat before it was led it into the desert and hurled off a cliff.In this corner of the financial world, there's an idea that those who are complaining the loudest about high-frequency trading are the ones who've been caught on the hop by the technology, or they're the ones with the clients who are becoming angrier about their inability to make money in the post-global financial crisis sharemarket.Or maybe they just don't understand the new world.But whatever the reason, they've thrown their sins on to the new technology and pushed it out into the public realm.But that's not how the other side sees it.The chairman of the Australian Securities and Investments Commission, Greg Medcraft, says this issue has "the attention of regulators all over the world", and that some bankers have expressed real concerns about it to him."While some say high-frequency trading provides liquidity, I know some very senior bankers that privately describe it as providing only 'phantom liquidity'," he told the FINSIA conference this month."ASIC needs to keep pace with these rapid changes in technology to ensure markets are fair and efficient."If high-speed trading is causing real problems, the scapegoating metaphor might not be a perfect fit.Funke Kupper says we need to stop Australia's equity market fragmenting further.He says the situation in the US is "out of control" with more than 10 exchanges and over 50 alternative trading venues, and that Australia should avoid going down that path.But the co-head of equities at UBS, Gary Head, says Australia is not a fragmented market.He says if one looks at where trades take place in Australia, about 71 per cent of trades are matched on the ASX, while 4 per cent are matched on its rival, Chi-X. Dark pools account for only 5 per cent, while broker crossings account for the remaining 20 per cent."The ASX does 95 per cent of exchange-traded flow. That's a definition of a non-fragmented market," he said.A recent paper from independent research broker ITG showed that, despite concerns that dark trading has reached levels that pose risks for market quality, more trading is being done "on the [main exchange] today than there was two yearsago, and far more than there was20 years ago".To draw those conclusions, ITG relied on the ASX's own data.This could support evidence that high-frequency trading's peak may have already passed. Globally, profits for high-speed firms have been declining for the past few years, according to US company Rosenblatt Securities, and the industry is beginning to consolidate.But that does not mean that Australia's equity market has not fragmented at all in recent years.The global company Fidessa has been tracking Australia's level of market fragmentation since Chi-X began operating.Its website shows what proportion of an individual stock is traded on the main exchange, off-market, and in dark pools.Last week, just over 14 per cent of all Telstra shares traded were traded in a dark pool. For Qantas shares, that number was 7.4 per cent.The Industry Super Network's director of regulatory policy, Zachary May, has become a well-known voice in the debate.An American who now lives in Australia, May spent years working in the US for the equivalent of ASIC, the Securities and Exchange Commission.Two months ago, ISN - which represents industry super funds - called for a moratorium on allhigh-speed trading in Australia's financial markets to give regulators time to wrap their heads around it."A moratorium would allow technological and market developments to proceed only after the risks have been carefully studied by ASIC," he wrote at the time.Two weeks ago he was a co-signatory to a letter sent to ASIC by a group of super funds, representing more than $1 trillion, which called for reform of Australia's market at the level of the stock exchange.As he explains it, big firms with the most money are able to see market information before anyone else, given the speeds with which they operate. They then act upon that information, buying and selling shares before the normal retail investor. He says the fact that the ASX facilitates this means the market is inherently unfair."Market fairness involves the dissemination of information by market operators that results in a level playing field ... this is different from the provision of 'non-discriminatory access' to special information services which necessarily results in information asymmetry and a two-tiered market," he says.But Comerton-Forde says there's nothing wrong with the advance of technology, as long as people who wish to pay for it can use it."Each individual investor has to make a decision on whether it's worth investing in that technology to get that advantage," she said."I don't really see that as much of an issue, as long as the data that's being made available is consistent and available to everyone that wants to pay for it."There's no question that high-frequency trading has changed the way some market participants behave. David Hobart, from hedge fund Blue Sky Apeiron, trades mostly futures and foreign exchange. He says he had his first major brush with high-frequency trading two years ago."You'd get these really quick, really large spike moves ... and you'd think, 'Oh, some guy just did a fat finger order', but it would drive the market up 200 points on a market that would have an average daily range of 30 points or something ... and come straight back within a minute, and anyone that had stop orders left would just get rogered," he said."That happened to me on the Singapore exchange ... so you just pull your orders out."Ross Smyth-Kirk, the chairman of gold producer Kingsgate Consolidated, says he does not think the equity market is orderly any more, because high-frequency trading exacerbates share price movements, whether up or down. "It's a total distortion of the market. It distorts the market completely, no matter how they want to paint it," he said."The market's supposed to be about supply and demand but it's no longer about that. It's about what some machine does in a flick of a second. There are academic apologists all over the place saying it increases liquidity, but it doesn't increase it at all. It's the same false argument that's used for shorting."ASIC has established two taskforces to consider if the current regulatory framework is still appropriate: one on high frequency trading, the other on dark pools.Consultation papers have been released. New rules for dark pools will apply from mid-2013, while new rules and guidance on automated trading will apply in early 2014.Some of the changes they proposed to make include introducing "kill switches" to be used in the event of a US-style flash crash, and introducing some kind of circuit breaker in the event of unusual volatility to prevent trades from occurring and to reset the market.It's also in the middle of a tender process for a multimillion-dollar system upgrade that will allow it to keep a faster eye on this stuff.Funke Kupper reflects on the recent annual meeting."Why did I think our AGM was so good? Because for the first time we heard from the people who actually are the investors," he said."The reason we find ourselves in ... [this] position [with two exchanges] .. is that when we thought about changing the market structure, we didn't think of them."It was a conversation .. between regulators, exchanges, and banks. "[And] we're still talking to ourselves. We're not thinking about the end investor."STOCKS AT RISKAustralian stocks most vulnerable to high frequency trading across multiple venues1 Goodman Fielder2 REA Group3 Reckon Ltd4 Australand Prop5 Charter Hall Retail6 Super Retail7 Base Resources8 Astro JapanProperty Group9 Kingsates Consolidated10 Mirvac Group
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