Head of Equities Dealing and Exposure Management
High-frequency trading - a highly technical and marginally understood practice - has been receiving lots of media attention lately. We explain what it is and what it means for Australian investors.
What is high-frequency trading and why the hype?
High-frequency trading (HFT) involves the use of powerful computers and complex algorithms to rapidly trade securities. High-frequency traders move in and out of short-term positions aiming to capture sometimes just a fraction of a cent in profit on every trade. This will quickly add up with an incredibly high volume of trades. Typically, traders with faster execution speeds will be more profitable than traders with slower execution speeds.
Controversy around high-frequency trading has mounted following the publication of the book Flash Boys by financial journalist Michael Lewis. In the book, Lewis claims high-frequency traders - using powerful computer algorithms and high-speed cable networks plugged directly into exchanges’ computer systems - have rigged the market at the expense of ordinary investors.
Are investors being ripped off?
There is evidence to suggest that investors in offshore markets are being taken advantage of by this practice although reviews last year by the Australian Securities and Investments Commission (ASIC) and the Financial Services Council both concluded that this is not a concern in Australia.
We also believe this to be true. Australia’s market is vastly less fragmented and complex than other similarly advanced markets. That is, less than 20 per cent of trades in Australia are executed via HFT compared to 55 per cent in the US. This means opportunities for ‘electronic front-running’ are much less in the domestic market. In addition, brokers in Australian are governed by wider best execution strategies such as the ‘market integrity rules’ introduced by ASIC last year.
Risk to the integrity and stability of markets
If left unchecked, high-frequency trading can pose dangers to the financial system and the integrity and stability of share markets. For example, the ‘Flash Crash’ on May 6, 20101 which was, in part, attributed to high-frequency liquidity providers rapidly withdrawing from the market.
Several countries have proposed put curbs on high-frequency trading due to concerns about volatility as well as introduced requirements for markets to halt trading under certain circumstances to allow for the return of equilibrium.
How much is this costing regular investors?
In terms of the cost for regular investors, there were claims by Industry Super Australia that high-frequency traders cost large investors around $2 billion a year. Unfortunately, because HFT is difficult to define and impossible to quantify, there is no agreed-upon estimate about the profits of high-frequency trading firms. According to institutional brokerage Rosenblatt Securities, the revenues of these HFT firms have been rapidly declining since their peak at around $5 billion in 2009.
Response by regulators
Early responses by regulators were to impose fees on order-to-trade ratios above a threshold (still permitting HFT activity but taxing it). The focus now seems to be moving more towards introducing clamps on super-fast computer trades to reduce their speed.
At AMP Capital, we had already been handling our clients’ orders with market structure firmly in mind long before this issue broke. In fact, we were one of the earliest promoters of and adapters to IEX, a more equitable trading platform where investors can trade without being subject to unnecessary intermediation or predatory strategies.
To protect our clients’ interests, we insist on a range of anti-gaming measures to randomise our dealing activity and avoid being detected by high-frequency-trading firms. When directing our clients’ orders to dark pools (which are exchange-like venues where orders are not displayed, we are conscious of using minimum acceptable quantities (MAQs) to stipulate dealing in sizes that are too large for an HFT firm’s risk horizon. Additionally, we monitor and measure ourselves through the use of transaction cost analysis (TCA) on a daily basis to ensure we are meeting our desired goals. The measures we have in place have been carefully implemented to avoid adverse prices for our clients. We are committed to working diligently to protecting our clients’ interests in ensuring that they receive the best execution.
My view is the market is rapidly catching up with what has been going on and the playing field is levelling very quickly as evidenced by the declining market share and profits of high frequency trading. The recent spotlight on high-frequency trading has become a catalyst for a broader discussion about market structure to ensure that long-term investors are receiving a fair stake.
1 The ‘Flash Crash’, was a United States stock market crash on Thursday May 6, 2010 in which the Dow Jones Industrial Average dropped about 1,000 points (approximately 9%) only to recover those losses within minutes. It was one of the most turbulent days of trading in the history of the Dow Jones Industrial Average.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.