Australian financial markets are suffering due to high-frequency trading, says a recent research report from the University of Sydney Business School. Lecturers at the university, Dr Amy Kwan and Dr Richard Philip, found in their study that a high-speed system (ITCH) introduced by the ASX in 2012 has driven up the cost of transactions performed by investors of the ordinary kind by high-frequency investors.
High-frequency investing – known as front running – is described as ‘predatory’ in High-frequency trading and dark pools: a toxic effect on market evolution?, with these traders gaining their advantages using speed at the expense of slower institutional investors and retail traders.
The advantage stems from information gained not widely available to all investors, that these wily traders utilise to win. The change in market structure, to allow high-frequency trading, has been called ‘one of the most significant changes to market structure in recent years’ by the researchers, with attempts by regulators at levelling the playing field have not been fast or broadly successful.
The banking sector looks upon high-frequency trading favourably, with academic reports pointing to it being a good thing for markets, however that isn’t all there is to the story.
The trades are carried out via expensive electronic platforms using algorithms to execute trades in nanoseconds via a pre-programmed piece of software. The ITCH direct data-feed interface allows fast traders to benefit by increasing the speed at which investors can access market information – up to seven times ordinary protocol speed. The researchers say that high-frequency traders can now queue-jump non-high-frequency trading order flow, and this increases costs for regular investors because ITCH costs money to implement. Less orders are successfully executed against incoming market orders, with this being attributed to strategic order placement strategies implemented by high-frequency traders.
The long-term impact on high-frequency trading may have a negative outcome as the markets evolve, with ‘abuses’ appearing in the form of private dark pools used by traders to possibly broker trades against their own clients. A dark pool is usually operated by an investment bank and broker-dealer company, and facilitates trades in equities outside of the usual channels, and have the added veil of allowing anonymous trading without the usual scrutiny applied to public exchanges.
Covert trading is allowed since limit orders being submitted in dark pools can buy or sell earlier than displayed orders on lit exchanges, so long as the price is in existing regulations. Normally a trade would take place when buy orders match sell orders, prioritising orders on a ‘first-in, best-dressed basis’. Dark pools mean traders can completely bypass queues on public exchanges.
The rise of grey markets (a version of a dark pool) is also an area of concern, say the researchers, with information withheld from certain clients, while being offered to others. Kwan and Philip suggest that this ‘toxic’ trading practice may discourage investors and borrowers in future, and are positive about ASIC’s plans to help to curb unfairness in the marketplace. ASIC implemented an integrated fee model in 2012, and a price-improvement rule to minimise queue jumping, among other initiatives.
High-frequency trading, Kwan and Philip say, operates within legal boundaries, but market evolution may be disturbed, including the development of conflicts of interest when participating in dark pools and grey markets.