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GRC Professional : GRC Spring 2012
28 GRC Professional • Spring 2012 Q&A What are your views on the current controversy around high frequency trading and dark pools? ASX is concer ned about the impact on investor confidence of changes to Australia's market structure and continues to be in dialogue with ASIC. That said, at times the debate on high frequency trading (HFT) is too emotive and in danger of overlooking the real issues that need to be addressed. The highly charged assertion from some prominent financial journalists and commentators that all HFT is "legalised front- running" is not correct and the calls for it to be prohibited as a consequence are an over-reaction. HFT describes a whole raft of different trading technologies and strategies. Some HFT technology is deployed by genuine market makers and also by traders doing nothing more than seeking to profit by frequent buying and selling near the spread. Market makers and these types of traders provide genuine liquidity to the market and that is a good thing for the market. Some HFT technology is deployed by brokers to achieve a particular execution strategy effectively -- for example, ensuring that a client wanting to transact a large order at the volume weighted average price for a day is participating in the market throughout the day at appropriate prices and volumes. The type of HFT that seems to be causing the most agitation is the so-called "hunter" or "sniffer" algorithms, that seek to identif y hidden large buy or sell orders and interpose themselves in between to generate a profit. I would make three obser vations about these. First, these are a small sub-set of HFT. What they do is not front running in any proper sense of that term. Front running describes a situation where a trader who knows about a potentially market moving order, or the imminent relea se of potentially market moving research, jumps in front of the order or research and trades with a view to profiting from the market movement. In most cases this is illegal. These algorithms don't know anything; they are just making an educated guess. Secondly, for as long as we have had exchanges, we have had smart traders who try to identify emerging supply or demand and interpose themselves to make a profit. Back in the days of trading floors, traders used their eyes, ears and noses to spot these opportunities. Now they are using technology and they are getting much better at it as a consequence. Thirdly, the real issue here is that these types of algorithms are making it more competitive for fund managers and other institutional shareholders to secure volume at the prices they want. This is causing some to abandon the lit m arkets and move into da rk pools, where they have less competition from HFT. And this is at the core of the problem that needs to be addressed and where the debate has got off the rails. If you allow orders of any size, without thresholds, to be transacted in dark pools, it will remove volume out of the lit markets, widening the spreads in those markets and adversely affecting their critical price discovery function. This is a bad outcome, especially when conducted in venues that a ren't regulated, a nd serves to undermine the quality of the lit, public markets. It is also an outcome that can be easily prevented -- through the introduction of an appropriate minimum order size before trades are allowed to be executed away from lit markets. This is what ASX advocates. The other fix is to ensure that the economics of trading in markets do not unduly favour or promote HFT, or any particular stakeholder group for that matter. Maker taker pricing -- where high frequency traders actually get paid fees by an exchange to put orders into the market -- has contributed to many of the problematic issues we see in American markets. We must continue to avoid in Australia allowing any exchange to offer pricing incentives of this type that distort trading behaviours and favour the interests of HFT over more traditional traders. ••• The type of HFT that seems to be causing the most agitation is the so- called 'hunter' or 'sniffer' algorithms, that seek to identify hidden large buy or sell orders and interpose themselves in between to generate a profit.
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