KGB: ASX's Elmer Funke Kupper
ASX chief executive Elmer Funke Kupper explains the risks posed by proliferation of high frequency trading, and why the ASX can't 'cut the pipes' between exchange and high frequency trading computers.
– What risks are posed by the proliferation of dark pool and high frequency trading.
– Why the ASX can't 'cut the pipes' that link the exchange and high frequency trading computers.
– Why regulation of financial exchanges in Australia is superior to that seen in the United States.
– Why the ASX supports competition among exchanges, such as that presented by the introduction of CHI-X.
– What is driving the lack of interest in equities from retail investors around the world.
Alan Kohler: Well Elmer, it feels like we’re a bit in transition at the moment: dark pools are growing, high frequency trading seems to be growing. The first question is, is that right? Is high frequency trading still growing and if so where is it going to stop? Where does it get to in terms of a proportion of stock exchange trading, both here and around the world?
Elmer Funke Kupper: We’ve seen both grow in Australia and if we look at other markets like the United States, you get a bit of a sense of how big this can become. So here in Australia high frequency trading is perhaps 15 to 25 per cent of the market, in the US it can be 70 per cent on any given day. Dark execution is about 25 per cent of the market, as high as 40. So, I think overseas markets give us a bit of a guide of how badly this can end.
AK: You use the word badly.
EFK: Well, I think I use the word badly because markets are all about confidence and when the market structure changes and the unintended consequences of that start to shake people’s confidence in what the market is there for, I think we take an enormous risk against which we don’t see a lot of benefits – and it’s the reason that we’ve said [that] in Australia we’re still okay. Right, there’s a lot of noise in the press about it, but we’re actually still okay. What we’ve said is we’ve got to make sure we stay okay and that we put some very simple measures in place that put a box around it and allow us to have confidence that what we see on the stock exchange today on the ASX is real and is of very high quality.
Stephen Bartholomeusz: What are those risks, Elmer? What are the bad things that happen as a result of growth in dark pools and high frequency trading?
EFK: Well , the most obvious one is the flash crash that we’ve seen where algorithmic trading taking place away from the exchange, away from the oversight of regulators that we are subject to go haywire and start to distort market movements. We’ve seen that a couple of years ago on the New York Stock Exchange. We’ve seen it most recently with a company called Knight Capital in the United States where an algorithm went haywire, 140 stocks started to misbehave and in fact Knight Capital went under; it lost $US400 million in the process.
But what it does is retail investors look at that and say, that is a place I don’t want to be. And I think that’s a very dangerous place to go. When it comes to dark pools, we know from academic research that the more liquidity you take away from the one place that everybody gets together, the more damage you do to price discovery and the spreads in that market. And it becomes a circular argument, I mean people say dark pools can give people price improvement, but of course the more goes to dark pools, the bigger the spreads in the normal market, the easier it becomes to prove the dark pools are okay and you’re in this circular argument and you end up with a lit market that is the last place people want to trade in because they’re trying to create a little bit of margin along the way.
AK: In fact it’s just going to be computers trading with each other. The stock exchange becomes computers trading with each other; human beings trade somewhere else.
EFK: Well, that’s an extreme version of it and in some ways that’s what we’ve seen in places like the United States. That’s not the case in Australia. But I’ve been talking to my shareholders over the last couple of days, and they’re all fund managers in their own right, and they’re telling us quite consistently that under the current market structure they find it harder to execute than they did under the previous market structure. And this is one of the points we’ve been making quite strongly and that is when regulators and governments think about changing the market structure, they should think about the end customer, the retail investor and the fund manager, and they should think about the net benefit to the economy. So, the fact that the ASX lowered its fees – there’s no debate about that, we’ve done that – doesn’t mean the economy is better off because once you start to play with the quality of what we do in the country you take enormous risks and it is never worth it as it turns out.
Robert Gottliebsen: Elmer, this is far more serious than what you’re saying. What we’ve got looking at here is a totally immoral practice where a series of inside traders learn what’s happening in the market... As an ordinary retail investor, either for a fund or for themselves, as their orders come on, these guys slip in and get a better price – either the in or the out. It’s totally immoral, it’s wrong and it does the stock market no credit to Australia and you can see when you have immoral practices like that what can happen overseas. Now, I think there’s only solution, there’s only one moral solution and that is that the high frequency pipes should be cut and we have proper trading. And unless you do cut them, you will have dark pools.
EFK: Well, that’s an extreme and almost medieval solution...
RG: No, no, no. It’s the correct solution. It’s the moral solution. It’s the right solution.
EFK: No , so, I don’t debate with you. I mean the thing we have to remember here is that high frequency traders come in many different guises, right, so people who use speed to transact can provide real liquidity to the market if they are a market maker for example. A market maker who is obliged to post prices and post trades in the market place, that other people can trade against, and does not withdraw them but deploys technology to post those trades, that’s perfectly right – that’s real liquidity. Someone who is in and out of the market at very high speeds, but does not add capital to the market, but trades effective on his own account – some people call it front running – is a much more dangerous practice. The technology these guys deploy is almost identical. One is fine and the other isn’t. And so, what we need to do is rather than cut the pipes, which I think is not going to happen...
EFK: ...is make sure that – I understand your opinion, but I don’t think that that’s where we’ll go – is to make sure that the economic incentives of the behaviour are more aligned with the market place and it’s important to think about that because if we look at the contrasts between the United States and Australia, one of the reasons we are in a better place is that the regulators here are not allowing some of the practices that are allowed in the United States and economic incentives are a bit more aligned with the market. Not enough yet – we need to continue to tighten it – but it’s a lot better than in the United States and we need to continue to work on that.
RG: I think that we now have in Australia a situation where people are losing faith in the equity market, as they’re doing in the States too, and the first thing that you have to do is to make sure that they get a free and fair access to the market as they used to have and they no longer have and the reason we’ve got dark pools is because of high frequency trading. The way to stop dark pools, which I can see the problem with them, is to stop high frequency trading.
RG: Should we change the regulator so we get a tougher regulation to stop it, if you can't do it?
EFK: I think we’re blessed with very strong regulators here who actually have a very deep understanding of this. But one of the things you have to recognise here is that we’ve changed the market structure and I think if we’d thought about it a little bit longer, two or three years ago, we may not have done that. But we’ve done it; it’s not going to go away. So, we now have to deal with the consequences of that and it’s a very important point right now.
RG: And how did we change the market structure? Where did we go wrong?
EFK: Well, we allowed fragmentation to proliferate, both with the introduction of another exchange... and I’m not saying competition is bad by the way, what I’m saying is the consequences of fragmentation and the trading models that that allows to create can be damaging unless you manage it well. So, unfortunately whenever you change these structures, there are unintended consequences.
AK: But Elmer, the fragmentation you talk about here, but more especially in the US, allows high frequency arbitrage, right? I would have thought there’s nothing wrong with that? The problem of front running, which Bob is on about, surely is not caused, not brought about, by the introduction of another exchange?
EFK: And Alan, this is exactly the point. The technology that’s deployed is actually very similar, so how do you differentiate one from the other.
AK: No. But the front running is not caused, the bad high frequency trading is not caused, by fragmentation. You seem to be, you’re melding it all together and saying the problem is fragmentation. Actually, it’s not. It’s allowing front running computers.
EFK: Yeah. So, I don’t confuse... There’s a connection between the two because fund managers tell us they’re going 'dark' because they don’t want to be in a place where they run into high frequency traders that front run. So, high frequency traders, the solution there is to manage their economic incentives much better so that front running becomes an expensive thing to do for them and there are relatively straightforward ways we can do it. We’ve already started it in Australia, so I think ASIC has done a good job on that and I know they’re continuing to look at that. Fragmentation is a different problem, although there is a link of course with the fund managers. So, the reason I’m not quite with you if you deal with high frequency traders, you deal with fragmentation. One of the reasons there’s fragmentation is something we call internalisation. So, this is retail brokers matching trades within their own engines as opposed to passing them through the exchange; nothing to do with high frequency traders.
AK: Well, what’s it got to do with?
EFK: Well, it’s basically brokers being able and allowed to match trades, even small trades, within their own broking engines rather than send them ....
SB: It’s still not new, though, is it, Elmer? Remember the ASX has had dark executions forever.
EFK: It’s not new, but it’s growing. And the technology that’s available to the big retail brokers around the world allows them to become smarter and smarter and faster and faster at internalising as well. So, the technology that we’re talking about is a natural development being deployed for a variety of strategies. Some of those are fine. As you both know people who are just smarter market makers than others from management who deploy algorithms sometimes themselves and some of the behaviour is unhelpful; internalisation, front running and so forth. What we need to do is put in place measures that allow that to happen and then put a box around the other one. And I don’t think it’s difficult. Our submission to regulators when it comes to fragmentation is very simple, very straightforward and it will deal with 80 to 90 per cent of the problem. High frequency traders is a tougher nut to crack. Cutting the pipes is not the answer.
SB: Pricing might be.
EFK: Pricing is.
RG: Or pricing the pipes?
EFK: No , well, we’re pricing pipes already, but pricing the transaction. So, one of the reasons we are better off in Australia – you know, it’s highly technical, but it matters – in the United States the regulatory charges to a high frequency trader are based on trades, not orders but trades. A high frequency trader has a very high order-to-trade ratio because they’re in the market all the time, so their order-to-trade ratio is perhaps a 150:1 whereas for you and me it’s eight:one. In Australia, ASIC charges users based on trades and orders, so if you proliferate orders in Australia, you pay for that. In the United States you don’t. See, in the United States it’s free to put orders in the market even if you have no real intention of executing them all. In Australia there’s a charge. The next step is to say, well is there another way we can tighten it up? For example, charging for messages? Anything that creates the frequency. If you start doing that, the profitability of the algorithms goes down and the proliferation of them reduces as well. And my instinct is absence of a smarter idea, which I haven’t heard yet, that’s the way to go and I think ASIC gets it.
SB: In relation to the dark pools, the answer is also regulation, isn’t it?
SB: That you’ve got these kind of quasi exchanges which are unregulated and we’ve got the two exchanges which are, so why don’t we just regulate the dark pools?
EFK: Well, you could argue that... Well, why don’t we just say if a retail broker internalises trades ‘in the dark’, just oversee them the way you oversee an exchange, you know. It’s an unpleasant experience perhaps for them, but you can do it. The problem of course is it doesn’t solve fragmentation because you still fragmented the market and research from people like Alex Frino from the University of Sydney has shown us the more you fragment, the more the bid-offer spread spread goes up, the more expensive it becomes for everyone to trade. So, the best market place, the most efficient market place, is the place where everybody gets together because that’s what the finance market tells us and we believe that’s true.
AK: You just want your monopoly back.
RG: Can I just put two points to you? Firstly, as a rough guess, how much do the high frequency traders contribute to the profit of the New York exchange? Would it be half their profit? Three quarters?
EFK: I honestly don’t know the answer to that to be honest.
RG: Well, what is it in Australia?
EFK: Well, I’ve been asked this question before. It’s hard to quantify, but if you take our trading revenue – it’s about $35 million, $36 million – high frequency traders are 15 to 25 per cent of the market, call it 20 per cent, call it $7 million in our case, revenues not profits, revenues. And then on clearing it might be a similar number.
AK: What about technical services?
EFK: There are some technical services, but our technical services business services the equities market and derivatives market and it serves all our clients. I think if you look at the $45 million dollars of revenue we get out of technical services, a modest part of that is high frequency trading clients in the way you describe them.
AK: Are you charging them enough rent?
EFK: I think they would say so, yes. I think we don’t. This is an important point. We are the lead exchange. We have to have reasonable commercial terms. We can’t discriminate for people who trade within the rules of the country.
RG: It seems to me that the fund managers, the representatives if you like of the retail traders, are saying to you unless you clean your act up, we’re not going to deal with you. That’s what they’ve said in New York. That’s the same view. So, pretty well they control the shots.
RG: If they demand the pipes be cut, you’ll have to cut them and it’s as simple as that. If they’re prepared to accept that the regulations work, that’s fine. So, dark pools are essential now because, and the bigger they get the better because your system is not good enough. The people who operate the dark pools should be saying to you: stock exchange, do it this way or we’ll not deal with you. That’s what they’re doing in New York and that’s what they should do here.
EFK: I understand what you’re saying. Unfortunately, the logic goes the wrong way around there.
EFK: Because the math says that fragmentation...
RG: You’re the one that’s doing the wrong thing. You have got the wrong... You’ve put these things in.
EFK: Well, actually...
RG: And it’s not them who’s wrong, it’s you.
EFK: Okay. Let’s start at the beginning. We didn’t ask for a change in market structure that’s created all this. In fact the people that operate the dark pools have. I mean that’s the truth. And so, we have groups of people here who say, on the one hand we want competition and we want to foster high frequency trading and some of their own proprietary trades are high frequency. On the other hand, they say, here’s a dark pool for you the fund manager to deal with. So, you know, they’re playing both sides. We have over the last six months been very active as an exchange to bring fund managers into the debate and we’re delighted they’re involved and I wish they had been involved two or three years ago because we may not find ourselves in this position.
So, what I’ve explained to anybody willing to listen including regulators is that the fact that fund managers do not put submissions into a formal review process does not mean they’re not relevant. I think we have an obligation to reach out to the end consumer and the end consumer is not the ASX, it’s not the investment bank or the broking community, it’s the fund manager and the retail investor. And I think in this particular scenario we have not reached out to them before we made a change in market structure. Had we done it, we might have made a different decision. I can’t change that. It wasn’t my choice. But now we have to deal with the consequences. And the proposals that we put forward deal with the consequences. They’re unpleasant – I don’t disagree with anything you’ve just said – but the question is what do we now do recognising we can’t turn back time as far as we would like? There are other markets in the world who have said we don’t want to go here at all.
AK: You mean to fragmentation?
EFK: They don’t want to be here. Why? Because we don’t think it’s worth it.
AK: So, are you prepared to say that – on camera – that you think the stock exchange is a natural monopoly and should stay... and should be a monopoly, like a road from somewhere or the NBN is a monopoly. The government’s decided that it’s okay to have a natural monopoly there. Is that what you are really, at bottom, is that what you’re saying?
EFK: No. I wouldn’t say that because if I look at the introduction of CHI-X – they are a competitor. They’re going to be around. They’ll gain market share. They’re a lit market just like we are. I think all of that is fine. But with the introduction of CHI-X we’ve amplified a set of structure changes that have bad consequences. We need to manage that. If we put a box around it, as we’ve suggested, we will manage it much better than we do today. If CHI-X can thrive in that environment, good luck to them. That’s what competition is about. But that level of competition can never come at the expense of market quality and investor confidence because then we’ve lost the point of what a market is there for. A market is there for capital formation, investment, risk transfer and so we need to put a box around it and then we need to let ASX and CHI-X compete. I’ve got no problem with that. But we have to do it.
RG: Would you say that if that doesn’t work and the funds are still not happy, then my solution is to cut the pipes?
EFK: Well, my... Yeah, maybe it is. I think it’s a hard decision to make.
RG: Is there a chance? If you can fix it and the fund managers believe it’s a fair market, then that’s fine, but if you can’t, then I tell you what to do.
EFK: And so you should. But remember if we cut the pipes, we’re back to your solution which is there one exchange in this country. I mean it’s a consequence of doing it and so that will be a very deliberate space trade-off by regulators to, say...
AK: Oh, are you saying that CHI-X can’t exist without high frequency trading?
EFK: I suspect that model is more dependent on it than our model. In fact multiple exchanges really to some degree depend on that kind of model. The next stop in this...
AK: So, that’s an interesting statement. I mean so are you saying that the stock exchange competition actually relies on high frequency trading in order to have competition?
EFK: It’s a circular argument, right, so if you look at the United States where there’s a stock exchange called BATS – it’s like CHI-X, in fact in Europe it owns CHI-X – if we look at the economics of that exchange, you know, end to end from listings all the way through to trade execution, it is completely driven by the economics of high frequency traders. In fact the largest high frequency trader firm is a shareholder in the exchange and extracts enormous rents from the business model, so you know... I think if we step back a couple of years and people said well this idea of market structure and competition is good because the fees will be lower and we will bring new clients to the market, we’ll bring new liquidity to the market. That was a reason to do it. I think those reasons have proven to be untrue. The reason of new liquidity, and there are no new clients. And therefore the reduction of the ASX fees is still true. We’ve innovated. We built new data centres. We’ve done a number of good things that come from competition. But the unintended consequences of it I think are quite severe and we need to now manage them and we don’t have a lot of time. But we can do it. I’m not as pessimistic as your because I think the pessimism is partially driven by the noise in the media rather than the reality and I think we have to deal with the reality and the noise will go away.
SB: Elmer, you might have to deal with a new reality. There’s another discussion underway about structural change to your industry and this is clear in the settlement. If the ASX have not been clear and the settlement were to be broken as CHI-X is arguing it should be, what impact does that have on you? What impact does it have on the market?
EFK: Well, I’d say this is the next stop on the train journey to structural change that we may come to regret one day. So, the question is should the clearing business be opened up for competition or not and is that a good thing? And very wise people are looking at that question. I think in Australia there’s a bias to open these things up as there was with equities trading. Our submission... We make about $45 million a year in revenues out of equities clearing, so that’s the number that would be impacted by that. We have asked the question as we have in equities trading, so if you read our submission to the Government, it says literally we welcome competition provided there is a net benefit to the country. And that is a P&L benefit to the country and a balance sheet benefit. And if I just come back to equities trading and just answer the question that way... If you look at the P&L of the country, we’ve cut our trading fees by seventeen million, $17 million , not a lot at national common level. More for us, not a lot for Australia. The implementation cost of the new market structure with all the complications and regulations was materially more than $17 million.
And in fact if you go around the broking community, many people would say they are worse off under this model. So, from a P&L perspective I’m not sure Australia is better off. We certainly aren’t. Now, you look at the balance sheet of the country and we’re now having big discussions about high frequency trading, about dark pools and the quality of the market. That’s the balance sheet of the country. That’s our long term future. So, I’m not sure that’s been good either. So, I’m talking about the same question. That $45 million might come down. What are the costs of implementation and what are the risks we take with financial stability? Because remember a clearing house assumes the credit risk of our financial markets. It’s a very important function. Investors rely on it to make sure their trades get executed.
So, the question is do we fragment that or if part of it goes overseas, do we understand what we’re doing with financial stability? If the answer is we can implement it cheaply and we know what we’re doing with our financial stability, then the answer is bring in competition. All that we have noted is that no other country in the world has gone down that path. Europe has competition between clearing houses because it tried to create a single market out of all these countries. No other market has it. America has got a single clearing house. Canada, single clearing house, Brazil, Singapore, Hong Kong, Australia. So, our view is make sure that you have that equation right and if you’re sure, bring it on. I mean we’re not going to argue with the benefits of competition provided there’s a benefit for Australia.
RG: Just one final question on a slightly different subject. Globally, people say we’re looking at the death of equities; that it will take the equity market, not just in Australia, globally, 10 years to reattract retail investors on the sort of scale you might expect. And part of the reason it’s going to take such a long time is that they’ve lost confidence in the actual market system. Would you agree with that?
EFK: No, I don't. I think in America there might be a little bit to that, but think Facebook. Facebook I think has been very damaging in America because it... there was such a broad retail participation in it by the very nature of the company that that has been very unhelpful I think in America. I think here we don’t have that problem. If you look at the reduction in equities trading around the world, it’s pretty similar across markets whether there’s competition or fragmentation or not. So, markets like Singapore and Hong Kong are in the same boat as we are; are in the same boat as Canada is or Europe, so... The data suggests that it is about the world economy and it’s about people’s personal balance sheet and confidence rather than confidence in the market structure per se. But I do agree with you that it can take quite some time to come back because I think it’s shaken pretty hard and Europe needs to work itself out, American needs to... That takes a long time, so it could be years. I hope it’s not, but I can’t control it.
AK: It’s been great talking to you, Elmer. Thanks very much.
EFK: Thanks very much.
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