Opinion is divided over whether high-frequency trading is a good or a bad thing for the sharemarket, 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 known as HFT.
Then came the bizarre share price spikes on the morning of October 18, when a handful of blue-chip stocks shot up, inexplicably, before just as strangely dropping back in the seconds before the market opened. The irregular price movements sent whispers through the market: were high-frequency traders involved?
The two events raised another question: Could this be what ASX chief executive Elmer Funke Kupper has been warning of?
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 actually becoming disorderly, causing investors to lose faith in the system?
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 the biggest new thing 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 business transacted on the sharemarket. But critics say high-frequency trading has contributed to the hair-raising flash crashes and computer hiccups.
Since Funke Kupper became the ASX chief executive 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 its 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 concern, he says, has to do with the potential damage that could be done to the equity market as we tinker with it. 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. 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 Chi-X, with a possible third exchange the Asia-Pacific Stock Exchange hoping to begin operating next year.
There's a large handful of 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 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 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.
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.
Professor 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 a 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 ASIC, HFT now accounts for about 30 per cent of equity market turnover, up from just 3 to 4 per cent in February 2010.
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.
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 6 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."
More than 1000 people attended the conference. Technology companies set up stands to flog the latest in trading technology.
Technology start-up Zeptonics, which specialises in speeding up network infrastructure within exchanges and co-location facilities, had a display.
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 this technology was already being used in the US.
After the conference, attendees kicked on at the Sydney Hilton's Marble Bar. A few rounds in and talk turned to the controversy over high-frequency trading . They said there was nothing to be afraid of, that technology would keep advancing like it always has, and that we would all benefit.
As they see it, HFT 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 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 HFT are the ones who've been caught on the hop by the technology, or the ones with the clients who are becoming angrier about their inability to make money in the post-GFC sharemarket. Or maybe they just don't understand the new world.
But whatever the reason, they've thrown their sins onto the new technology and pushed it out into the public realm. But that's not how the other side sees it.
ASIC chairman Greg Medcraft says this issue has "the attention of regulators all over the world", and that some bankers have expressed to him real concerns about it.
"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 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 more than 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 about 71 per cent of trades in Australia 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 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 years ago, and far more than there was 20 years ago".
To draw those conclusions, ITG relied on ASX's own data. This could support evidence that HFT's peak may have already passed. Globally, profits for high-speed firms have been declining for the past few years, according to US firm 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.
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 it equivalent of ASIC, the Securities and Exchange Commission.
Two months ago, ISN which represents industry super funds called for a moratorium on all high-speed trading in Australia 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 Professor 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 HFT 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 HFT about 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.
Ross Smyth-Kirk, the chairman of Kingsgate Consolidated, says he does not think the equity market is orderly any more, because HFTs exacerbate 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.
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 proposed changes 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.
Sitting in his office, ASX chief Funke Kupper reflected on the recent AGM.
"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.
STOCKS AT RISK
Australian stocks most vulnerable to high-frequency trading across multiple venues
1 Goodman Fielder
2 REA Group
3 Reckon Ltd
4 Australand Prop
5 Charter Hall Retail
6 Super Retail
7 Base Resources
8 Astro Japan
10 Mirvac Group