Michael Lewis, a master of making heroes and villains out of the everyday players in the financial markets, launched his book Flash Boys: A Wall Street Revolt with his customary blaze of publicity earlier this month.
It attempts to explain how high frequency traders (HFTs) and dark pools – two separate but interlinked phenomena – are changing the way markets operate, and how this is disadvantaging regular retail investors.
The practices he talks about are alive and well in Australia, too. Perhaps not to the extent they occur in the US, due to the much larger number of exchanges and overall volume there, but they do happen here.
High frequency trading is the practice of firms putting orders, or messages to amend or cancel an order, in at times many times faster than the speed it takes to blink your eyes. Somebody who can do that at a microsecond (one millionth of a second) faster than you, or anybody else, has the opportunity to exploit your position.
By observing and placing countless messages, orders and amendments a day – the majority of which do not go through to execution – HFT traders are able to work out the direction of trades by people, usually mums and dads, but also institutional investors. They can then push up the price of stock a retail trader might be trying to buy – by going in and buying it at a cheaper price and then on-selling it to you at the higher price – all in a fraction of a blink of an eye.
In such a scenario, your physical location matters. You will get a time advantage from being in the same facility that an exchange has it servers.
Zachary May, director of policy at Industry Super Australia puts it like this: “The ASX can respond to an order in a colocation facility faster than light can travel from Sydney to Perth,” he says.
And that means if you are an investor in Perth, there is no way you can beat the high frequency traders located in Sydney, and especially not those collocated with the exchange.
HFT traders do influence prices and outcomes for investors. A US research paper – The Trading Profits of High Frequency Traders [pdf], by Matthew Baron, Princeton University, Jonathan Brogaard, Foster School of Business, University of Washington and Andrei Kirilenko, Commodity Futures Trading Commission (CFTC) – found that HFTs make on average $0.25 per trade. “This equates to $18,799 per day for each HFT in the August 2010 E-mini S&P 500 contract alone,” the paper said.
There has yet to be any major analysis in Australia of how often retail or institutional traders come off better, or worse, when they engage with high frequency traders. To do such an analysis you would have to have information on who is on both sides of a trade, which is usually confidential, and currently only available to the Australian Securities and Investments Commission. ASIC has not released comprehensive analysis of this audit trail data information. And ASIC would not answer direct questions to why it does not analyse, or release analysis of, this data. A spokesperson repeated the results of existing studies, specifically Report 331 Dark Liquidity and High Frequency Trading [pdf], and said that “in reality”, existing rules were sufficient to deal with the use of trading technology.
“ASIC’s study into high frequency trading in the Australian markets found no fundamental deterioration of market quality, or systematic abuse that threatens the integrity of our market. Rather, we found the Australian market, which is less fragmented than the US, to be one of high quality and integrity,” the spokesperson said in a written response to questions from Business Insider.
But profiting is neither abuse nor manipulation. If it consistently happens to one side, over another, due to some sort of advantage, it is just unfair.
Dark pools are not the villains
Dark pools are essentially off-market pools of liquidity but as Trent Hayes, head of investment trading and execution at the $75 billion AustralianSuper notes, they have been given a very unfortunate name.
He suggests they would be better off being calling liquidity pools.
Dark pools were designed to enable investors with large trades to find and trade with other large orders in the same stock.
This enables both the buyer and seller to trade a large order at the market price.
Hayes says a well-managed dark pool offers less risk of information leakage, which can occur when a large order is sliced into many small orders and executed on the lit (public) market.
To ensure the market remains informed of the transactions in a stock, trades in dark pools are reported to an exchange as they occur.
If AustralianSuper goes to market with a large buy trade in BHP, for example, they are at risk of information leakage. If the market works out a large order is being traded, the price could be bid up, making it harder for AustralianSuper – which is the retirement funds of millions of Australians – to get the best price.
Being in charge of executing equity trades for a part of AustralianSuper’s assets, some of which are now managed in house, Hayes has used dark pools before.
“From my point yes I have [used dark pools]. But that being said, I think you still need to be careful about who could be on the other side of it,” Hayes says.
And knowing who might be in the dark pool is key. That onus is currently on the investor who is looking to trade, but operators of large dark pools are listening to clients and are asking some participants to leave, if that’s what other clients are demanding.
Hayes says many of the brokers are now starting to control their dark pools and may offer two, one for internal matching and one that is open to other brokers, so users can try and control who they are interacting with.
“There has been a bit of pressure from the clients about who they are wiling to match,” Hayes says.
The “meaningful price improvement” rule, introduced by ASIC in May last year, meant that traders in dark pools had to trade at prices at the midpoint between the buy and sell spread or no greater than one tick up or down.
A further rule of enhanced data for supervision introduced in October last year means that operators must now collect additional data on orders and trades and on whether participants are acting as a principal or agent.
ISA’s May says that while investor protection in dark pools is important, it often becomes a distraction and an issue that people raise when they are trying to take attention off high frequency trading.
He says a dark pool, prior to the introduction of the meaningful price improvement rule, was a place many traders went to try to get away from high frequency traders, as long as they were fairly confident of who was in the dark pool with them.
In France a high frequency trading tax has been introduced. This tax kicks in on messages to trade, rather than actual trades, if the message to trade ratio is too high. In France this is defined as messages above a cancellation or modification rate of 80 per cent.
The Financial Services Council in its submission to ASIC mentioned a similar proposal back in early 2013 on options for amending the ASIC market supervision cost recovery arrangements.
Another solution could be introducing a system that could slow down the high frequency traders, which is exactly what the heroes of the Michael Lewis book – the former Royal Bank of Canada traders, who started up their own exchange IEX – did when they built “Thor”. That was a tool that built delays into the stock exchange orders so they could all arrive at an exchange at the exact same time.
May says that over a year ago, ISA proposed the use of electronic call auctions in Australia, which would have a similar effect to Thor. Electronic call auctions were also included in its submission to the ongoing Financial System Inquiry.
IEX was established on the same philosophy as “Thor”. A similar exchange would work just as well in Australia but setting up a new exchange is a time consuming process.
It took years for Chi-X to go through the right hoops to be able to set up here, although one might hope that an exchange that promised a fair outcome for all, even if it did compete with the incumbent, would be granted a bit more leeway.
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