High-speed cyber-trade brings risks

It is bad timing for Chi-X, which was recently granted an in-principle agreement to set up a trading platform in competition with the Australian Securities Exchange. Those fearful of the rise of cyber-trading will use the screw-up on Wall Street on Thursday, when the market crashed 1000 points in milliseconds, to lobby the federal government hard to delay that decision.

The reason? The expectation is that once Chi-X sets up, there will be an explosion in the size of ultra-fast systems and sophisticated computer programs to generate, send and carry out orders all in split seconds. If Australia's regulator and systems aren't ready to cope with this, a similar catastrophe could happen here, leaving the Rudd Government's head on the chopping block.

Last week's violent swings, which triggered millions of margin calls as some shares crashed more than 60 per cent, prompted US President Barack Obama to say regulators were "evaluating this closely with a concern for protecting investors and preventing this from happening again". A House subcommittee set a hearing for tomorrow to investigate. Regulators and governments around the world will await the fallout.

There are already concerns in the Australian market that the government acted too quickly in announcing an in-principle agreement before ensuring that all the right systems were in place and that the regulator ASIC would properly be able to monitor the markets. Some fear the government is obsessed with Australia becoming a financial hub for Asia, and will do anything to make sure that happens, even at the expense of the retail investor. Its reversal of the High Court decision on the Sons of Gwalia case to prevent shareholder class actions against insolvent companies went against the High Court, ASIC and its own adviser, the Corporations and Markets Advisory Committee.

The main winners from this decision will be foreign hedge funds, vulture funds and investment banks that buy distressed debt from companies that have made unsecured borrowings, at 10 or 20? in the dollar. The change in legislation if it gets through the Senate will enable these foreign investors to more safely buy cheap distressed debt without having to worry about local investors coming out to claim their losses against the company. In addition, banks that lend unsecured to Australian companies do not want to share the company's assets with defrauded investors if the company becomes insolvent.

Interestingly, it is these same players who will be the big winners in the government's decision to introduce competition to the ASX by allowing the likes of Chi-X and others to set up trading platforms to compete on price and speed of trade execution.

Right now, an estimated 20 per cent of local trading is classified as short-term trades, including short selling, derivatives playing, dark pool trading and high frequency trading. In the US and Europe, with multiple exchanges, short-term trading now accounts for between 50 and 65 per cent of all trades, making a mockery of the traditional buy-and-hold investors.

On Thursday night the US equity market was down 3 per cent on fears of a debt crisis in the eurozone. It was then reported there was a trading error to the low side. This caused algorithmic traders and black box trading systems to aggressively sell the market, and arbitrage against different exchanges, all of which exaggerated the share price declines. At one stage the market was down around 10 per cent. It finished the day down 3.2 per cent.

Days later it is still unclear what caused that volatility. This speaks volumes about how complex the world of trading has become.

Despite the relatively small amount of cyber-trading in Australia, high-frequency trading was in full force last week after the federal government released its controversial proposal to slug a 40 per cent resources tax on miners.

This caused an enormous amount of "rumourtrage", with reports that certain companies would shelve plans. Between the rumors and denials, millions of shares were traded and billons of dollars wiped from the market. While many lost money, some high-frequency traders made a bucketload tracking the rumours.

Reports had Rio Tinto shelving billions of dollars of projects due to the proposed mining tax, only to have the company put out an ASX statement that no decision had been made.

In a case of stating the facts to the media, but not the market, Cape Lambert executive chairman Tony Sages stated that the company was shelving plans. On May 6 the company issued a change in directors' notice, which reveals Sage took advantage of the weakened share price and picked up 1 million shares at $399,627. A week ago the same parcel would have cost him almost $500,000.

It will be interesting to see if ASIC puts two and two together and gives its Project Mint rumourtrage taskforce a rev up, particularly given the recently promoted Belinda Gibson saying in March that the mere existence of the program had caused a tightening up of behaviour in the market when it came to spreading rumours that could affect prices.

Regulators often don't really understand what is going on - in terms of the intricacies of what the players are actually doing and how they are using a new product or a new technology - until something painful happens to make them aware. Rumoutrage and high frequency trading make for a potent combination.