Rush hour

Regulators run behind market players as high frequency and dividend washing test the regulators.

Summary: ASIC and the Tax Office are taking measured but separate steps to stamp out two common practices on the sharemarket – high frequency trading and dividend washing. It’s a rush to plug the loopholes.
Key take-out: While ASIC is aiming to slow down high frequency trading, the ATO is closing the lid on the practice of washing dividend franking credits.
Key beneficiaries: General investors. Category: Shares.

Local regulators are rushing to plug holes in the tax system as new technology opens pathways to quick profits.

While some investors are still bruised from Australian Taxation Office threats over “dividend washing” last month, high frequency traders have been hit by a warning from the Australian Securities Investment Commission that it will slow down trades on the Australian Securities Exchange (ASX) in a bid to halt HFT.

The market watchdog plans on introducing clamps on high-speed computer trades unless HFT is stopped. These clamps, which halt trades for half a second before letting them resume, hope to remove the HFT speed advantage over other traders and therefore render the practice moot.

The threat comes after US financial journalist Michael Lewis released his new book, Flash Boys, on the topic in which he says the US market is rigged, with the HFT profits coming at the expense of the rest of the market, and that there is currently only one fair exchange called the IEX.

While the IEX is not yet a public stock exchange (it’s currently registered as an Alternative Trading System), its popularity is growing. The exchange resists HFT techniques by having longer cable lengths and reducing the number of complex orders.

HFT uses algorithms and super-fast computers to rapidly trade small amounts of securities, capturing tiny profits in price fluctuations between buyers and sellers.

The practice is estimated to cost investors as much as $2 billion a year in Australia, according to Industry Super Australia. In its submission to the Murray Services Inquiry, the super fund said HFT creates an uneven playing field by skimming the profits of larger trades between buyers and sellers.

Concerns have been raised that it’s particularly damaging to retail investors because they trade larger parcels of shares, which are easier for HFT traders to detect. Institutions, meanwhile, have combatted HFT by transforming their trades into a larger number of smaller parcels.

The action by ASIC seems a reversal of its stance on HFT, when it reported in March last year that public concerns  appear to be overstated and can be attributed to the increasing use of trading technology by investors generally.

Dividend washing crackdown

Meanwhile, the ATO is moving ahead with its dividend washing crackdown.

Dividend washing is where investors sell their stock on the ex-dividend date, then buy the same amount of stock back off foreign investors in a special secondary market during the two-day cum-dividend period that entitles them to double the franking credits. This is because Australian tax franking credits attached to dividends are of no use to foreign investors.

The practice only works on blue-chip stocks such as the banks and Telstra because the ASX only sets up a special market for these stocks. The ASX originally established this secondary market decades ago to facilitate the delivery of shares against options that were exercised cum-dividend, but the market increasingly became used for dividend washing.

Last week the ATO sent out thousands of letters to sophisticated investors, brokers and fund managers, telling them to declare their excess claiming of franking credits as far back as 2010 or face heavy penalties.

As Eureka Report warned subscribers back in January in Dividend washing dries up, the new laws effectively stamp out the practice by cancelling out the second lot of franking credits investors can get.

“The Tax Office gets two benefits from issuing the letters: the self-compliance aspect prior to the law arriving, and the law gets fabulous publicity so that it’s widely known that it’s coming in,” says David Pring, tax services partner at Deloitte.

Tim Hogben, executive general manager of operations at the ASX, told Eureka Report that the ASX was aware of the secondary market being used for dividend washing and said it was a means for foreign holders to access the value of franking credits.

Hogben says the ASX has been working closely with the ATO since Treasury released a discussion paper on the topic in June last year. Since that paper, he says there has been a notable decline in the use and turnover of special markets, though the ASX does not monitor dividend washing.

“Looking at the drop-off in value and volume traded since the discussion paper was put out there, it was a fairly large proportion of the special market trading,” he says.

Hogben also stressed that dividend washing can occur outside these special markets, such as through the use of different companies and by trading different classes of shares. The ASX is in discussion with Treasury about these methods.

Pring’s main concern back in January was that the ATO was going after taxpayers who, for the most part, had no idea that managers and brokers were engaging in the practice on their behalf, and that it would target them retrospectively.

“What’s happened is that now the letters have been received, and investors are asking brokers and fund managers questions,” he says.

Indeed, investors are irate about the retrospective application of the law. It will apply from July 1, 2013, but could go back four years for sophisticated investors and two years for investors with simpler affairs because the ATO can chase tax returns in the amendment phase.

It does not appear to be an empty threat either; the ATO says it can use data-matching techniques to identify taxpayers where there has been a sale and repurchase of the shares in the two-day window.

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