Tearing away the HFT tentacles

This market isn't the only one increasingly concerned about the growing significance of high-frequency, algorithm-driven trading in securities markets. In Europe and the US regulators are trying to come to grips with the implications of the increasingly automated trading for their markets and debating whether they actually need to do something about it.

The Australian Securities and Investment Commission has already flagged some action to regulate the dark pools and execution that have emerged as institutions have responded to the growth of high-frequency trading by taking their transactions out of the 'lit' markets. And there has been some discussion about imposing transaction costs on the multitude of unfulfilled orders that HFT traders use to probe the market for information.

In Europe regulators are considering similar measures, including the imposition of unexecuted order to trade ratios, circuit breakers, minimum periods for which orders have to stay in the market and the like. In the US, where HFT now dominates trading on equity markets, the debate as to whether HFT benefits markets or damages them is strong but unresolved.

Earlier this month the chief economist of the Commodity Futures Trading Commission, Andrei Kirilenko, produced the draft of a study he conducted with academics from Princeton and University of Washington which looked at HFT activity in a future contract – the "e-mini S&P 500" – on the Chicago Mercantile Exchange using actual firm data over two years.

The conclusions were interesting. The researchers found that HFT trading is highly profitable – in August 2010 the HFT traders made profits of more than $US23 million – and while there is risk involved the returns relative to risk are unusually high.

More significantly, they concluded that HFTs generate their profits from all other market participants and that the most profitable HFTs are those that are the most aggressive in initiating trades and have the fastest systems. They also concluded that the most successful HFTs were liquidity takers rather than liquidity providers.

Institutions have increasingly appreciated that HFTs were profiting from their traders at their expense and have shifted their transactions flows into dark pools. Retail investors don't have that option, although some investment banks/brokers are now bundling retail orders for dark execution.

The Kirilenko study found the HFTs made average profits from every future contract traded with retail investors that ranged from $US3.49 per transaction to $US5.05 (the less aggressive HFTs actually made the higher profits while the aggressive traders made more money from larger investors and market makers).

In aggregate, the aggressive HFTs earned about $US45,267 a day in gross trading profits and the HFTs overall earned aggregate gross profits of $23.6 million in August 2010, or an annualised rate of $US280 million.

If the HFTs are making large excess returns relative to the risk, and taking liquidity from the other market participants rather than adding to it, and profiting from traditional institutional and retail investors, one has to question why they are allowed the information and execution advantages they are granted by co-locating their technology platforms next to those of securities exchanges to gain their microseconds of competitive edge.

While the Kirilenko study was confined to a single contract on a futures exchange, because it is very heavily traded by a wide range of investors in would appear reasonable to accept that the broad findings, or at least their direction, would be applicable to trading in other securities and other markets.

If HFTs add little or nothing to the real functions of capital markets – providing forums for raising and distributing capital and pooling liquidity to enable that to occur efficiently – but profit at the expense of other market participants and undermine the efficiency of their activity, the regulators could eventually be expected to at least level the playing field and deny them those milliseconds of advantage, particularly as algorithmic trading malfunctions have already produced a number of market meltdowns.

One suspects that it may be easier to do that in this market, where HFT activity is still a relatively modest, albeit growing, proportion of market activity than in markets like the US where it dominates. ASIC's actions next year will determine the long-term character of our markets, particularly the equity markets.