High-frequency trading: are you in the dark?
Australia has fewer opportunities for electronic front-running.
High-frequency trading and dark pool liquidity have been two of the most topical market structure issues globally in recent years. During this time, there have been enormous advances in technology within our markets. At the same time, the venues on which trading occurs have also experienced significant developments. Exchange markets have expanded their dark trading facilities while market participant-operated crossing systems have continued to evolve. In article, we explore what you need to know about high-frequency trading and dark pools.
What is high-frequency trading and dark pool liquidity?
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.
Dark pools are essentially private off-market exchanges that enable large or institutional investors to buy or sell large positions without disclosing their intentions to the market. This helps to protect the anonymity of the investor and limit adverse price movement prior to execution. Dark pools offer the opportunity to control dealing costs by avoiding exchange fees and offering the opportunity to price at the mid-point of the bid/ask spread rather than paying the full spread. This directly reduces the cost of transacting. An added benefit of dark pools is access to liquidity unavailable on public exchanges; this is what’s known as ‘dark pool liquidity’.
What controversy surrounds high-frequency trading and dark pools?
Dark pools can offer price, cost, and liquidity advantages to the institutional funds that ultimately benefit the retail investors who own these funds. Since dark pools do not disclose trade details until after the execution is transacted, a pricing disparity can result between the private exchanges and the public exchanges. While a lack of transparency is part of the appeal of dark pools, this can also make these exchanges vulnerable to potential conflicts of interest by their owners and other predatory trading practices. This can occur if a broker’s proprietary traders trade against dark pool clients or if the broker sells special access to the dark pool to high-frequency trading (HFT) firms.
Controversy around high-frequency trading 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.
How much is it costing investors?
Recently, Australian Securities and Investment Commission (ASIC) released a review of high-frequency trading and dark liquidity which estimates that high-frequency trading firms earned revenues of between $110 million and $180 million in the 12-months to March 2015. They put the material cost imposed by high-frequency trading firms on the broader market at 70 cents to $1.10 per $10,000 dollars of trading.
Should investors be concerned?
According to ASIC, high-frequency trading in share markets has remained reasonably steady in Australia at around 27% of total share market turnover. This is comparable to levels in Canada, the European Union and Japan. However, it is more concentrated (with 30% fewer high-frequency traders) and high-frequency traders are most active in mid-tier securities and futures. While there is evidence to suggest that investors in offshore markets can be significantly disadvantaged by this practice, the latest ASIC review concluded that this is not a concern in Australia.
Brokers in Australia are governed by wider best execution strategies such as the ASIC ‘market integrity rules’ so the opportunities for ‘electronic front-running’ are much less in the domestic market.
What are we doing to protect clients against predatory trading practices?
A number of techniques can be employed to avoid the toxic liquidity of 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 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 on a daily basis to ensure we are meeting our desired goals.
AMP Capital was also 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. 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.
Negative sentiment about high-frequency trading appears to have improved as market users have become better informed and equipped to operate in an electronic and high-speed environment.
About the author
Joe Kassel has over 23 years' experience trading in institutional financial markets both in Australia and globally. He joined AMP Capital in 2009, taking responsibility for global Toshin Fund trading and led the creation of the global dealing capability for AMP Capital's REIT and listed infrastructure joint venture with Brookfield.