Take it to the limit: ASIC's new approach in a fast-moving world

After consulting more, it now thinks upper and lower limits on buy and sell quotes are a better idea, and it's right: it's never a good idea to totally shut down trade in a stock or, in extremis, a market.

In its new report ASIC has also come up with a sensible approach to the growth of so-called "dark pools", markets that match buyer and seller behind closed doors. The convention, backed by ASIC's market integrity regime, will be that dark pools can be used only if they offer a price edge a "meaningful price improvement": they cannot, in other words, be used as a secret share reservoir, robbing the open markets of volume and pricing information.

The regulator wants software filters across the market to minimise the risk of order errors that, in a computerised world, can breed like sheep they would refuse to execute incorrectly configured quotes, for example, and shut down rogue trades if they occurred and it's going to at least consider whether Australia should encourage market-makers specialist firms that stand in the market to buy or sell a particular share, in return for offsetting concessions: lower trading fees, perhaps, or enhanced powers to short stocks as well as buy them.

Market-makers are common overseas, but much rarer here. They could be an important source of liquidity for less frequently traded shares on the ASX all of them except the big four banks, BHP Billiton, Rio Tinto and Telstra, arguably.

The simple, sobering fact, however, is that ASIC is reshaping the system without knowing precisely how it will behave as so-called high-frequency trading (HFT) takes over. HFT is expanding faster than the ability of regulators and market players to fully understand it.

The Australian Securities Exchange estimated in February last year that computerised trading triggered by pre-set parameters, or algorithms, accounted for between 30 and 40 per cent of the Australian sharemarket's turnover.

High-frequency trades that are completed in milliseconds are a subset of algorithmic trades, and the ASX estimated in February 2010 that they accounted for between 3 per cent and 4 per cent of turnover. ASIC's estimate is that they now account for at least 15 per cent, and as much as 25 per cent.

That's an astonishing rate of growth. And it will continue as the Chi-X share trading platform opens for business at the end of this month, as the dark pools continue to expand, and as the trading system continues to modernise.

The benchmark is overseas. High-frequency trading accounted for 56 per cent of equity turnover in the United States last year, up from 21 per cent in 2005. It accounted for 38 per cent of turnover in Europe, up from just 9 per cent in 2007.

It's possible that HFT may be even more dominant here. Australians don't often acknowledge, let alone brag about it, but the Australian economy is a modern conveyance. Our sharemarket is one of the most highly automated in the world, and it is tailor-made for HFT now that the ASX's monopoly is ending. Overseas, HFT is essentially a wholesale market phenomenon. Our system is so well connected that the entire market, including retail investors, will be HFT's catchment.

But it's not clear yet what changes HFT will produce. Talk to retail brokers and many will tell you that HFT is jerking buy and sell quotes around, on a logic that is impossible to understand. Talk to the HFT traders, and they will tell you the opposite.

GETCO, one of the world's biggest HFT traders alongside groups including Citadel Investment Group and Jump Trading, specialises in market-making, for example. It invests its own money with the aim of capturing as much trading in a share as possible, and pocketing the spread the gap between the buy quote and the sell quote.

To do that it needs to get itself to the top of the queues of buyers and sellers that are compiled by the trading systems, and to do that it has to beat the sell quotes and buy quotes that are already posted. It's impossible for this to work if GETCO doesn't narrow the buy-sell quote on the stock it is working on, by offering to sell shares for less than competing sellers, and offering to pay more than competing buyers. And that puts GETCO on the side of the angels: its activity results in shares costing less for any given volume. GETCO got its ASX trading licence in May. It's already got about 1.5 per cent of the trade, and it's growing fast.

HFT is also used in arbitraging strategies that look to exploit minute differences in quotes for the same share or equity product on different platforms, or different time zones. This too should close down price gaps rather than widen them.

But a third strategy, so-called directional HFT trading, is more of a punt a purchase or sale in anticipation of a price movement, basically. There is more objective risk in directional trades, and partly because the mix of HFT strategies is impossible to predict, the markets and the regulators haven't yet reached a consensus about how risky HFT is for the system as it expands.

Many HFT traders use prime broking platforms offered by the big investment banks to execute their trades, for example.

But one of the biggest prime brokers, Goldman Sachs, does not offer prime broking services to HFT traders yet. It doesn't because it isn't sure what the counterparty risk is. And if Goldman isn't sure, I doubt anyone is.

mmaiden@theage.com.au