High-Frequency Trading - A Workers’ Capital Briefing

September 2012

High-Frequency Trading A Workers’ Capital Briefing

High Frequency Trading: A Workers’ Capital Briefing

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About the ACTU The Australian Council of Trade Unions (ACTU) is the nation’s peak body for organised labour, representing

Australian workers and their families. Nearly two million workers are members of the 46 unions affiliated to

the ACTU.

The Working Australia Papers The Working Australia Papers are an initiative of the ACTU to give working people a stronger voice in the

development of social and economic policy. Previous Working Australia Papers have addressed a broad range

of issues, from taxation policy to productivity.

Working Australia Paper 6/2012

D No. 6/2012

Australian Council of Trade Unions Level 6, 365 Queen Street Melbourne VIC 3000 www.actu.org.au

http://www.actu.org.au/


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Introduction In August 2012 The Australian Securities & Investments Commission (ASIC) issued a consultation paper seeking

views on its draft market integrity rules and guidance on automated trading1. A high profile and increasingly

important form of automated trading is ‘high-frequency trading’ (HFT): a set of practices that utilises speed to

generate additional returns to HFT firms and their clients. In recent years there has been growing concern that

HFT is serving to exacerbate the speculative, short-term and volatile nature of financial markets. ASIC’s

consultation is, in part, a response to such concerns.

Australian industry and not-for-profit funds are major participants in global capital markets. Via the world’s

major trading exchanges they invest billions in equities, bonds, derivatives and foreign exchange. But unlike

some other participants, super funds have little or no choice but to remain in these markets for the long-term.

Our super funds therefore have a strong interest in financial markets that are regulated to be transparent,

secure and fair. Such markets are more likely to deliver stable and reliable returns over many years – rather

than short-term speculative gains in the space of a few days, hours or seconds.

The purpose of this ACTU paper is to highlight some of the risks that HFT may present to super funds as long-

term investors in global financial markets. Those who specialise in HFT earn billions in profit every year, not

from long-term productive investment in jobs and communities, but from being able to trade faster than their

competitors. For this ‘skill’ they are paid large fees and commissions. In the context of the global pensions

industry, payments for such short-term unproductive trading represent a growing leakage from the

investment chain that connects workers’ contributions to the sources of long-term return that will ultimately

help to fund their retirement.

The issues raised by HFT therefore deserve close attention by unions and super funds. This paper is intended

to serve as a brief introduction to HFT and why regulatory reform is necessary. After a brief explanation of

what HFT is and how it can generate profits, the paper critically discusses the arguments commonly made in

support of such trading. These arguments are found to be flawed. The paper therefore ends by outlining some

reforms that would help to counter the risks HFT now presents to financial markets and those long-term

investors who have come to rely on them, and proposes some immediate steps that super funds in Australia

should take.

TIM LYONS ACTU Assistant Secretary

1 ASIC (2012) Australian market structure: draft market integrity rules and guidance on automated trading, Consultation

Paper 184


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What is High-Frequency Trading?

Within the next year a new fibre-optic cable, costing $300 million, will be laid across the floor of the Atlantic

Ocean between New York and London. The purpose of the new cable is not to facilitate increased telecoms or

internet traffic. It will not be available for use by the public or by any government. It is a private venture with

one aim: to reduce the amount of time it takes trading firms to buy and sell financial instruments. At present

the fastest cable between Europe and North America allows trades to be communicated in 64.8 milliseconds.

The new cable, when it begins to operate in 2013, will allow those few who can afford to purchase access to

communicate a buy or sell order in 59.6 milliseconds2.

Since 2005 over twenty new data centres have been built in the US state of New Jersey, close to the computer

‘trading engines’ that power the New York Stock Exchange3. These centres have been built to house servers

owned by financial institutions across the world. By being physically closer to the computers that process NYSE

trades these institutions can reduce the amount of time it takes to buy and sell by milliseconds.

But for some even the latest fibre-optic technology is too slow. Cables often have to be laid around buildings

and other structures – increasing their length and therefore slowing the flow of data. Therefore some trading

firms have begun to invest in building chains of microwave dishes that can fire data-signals to each other

across distances in straight lines. In the context of communicating trades between Chicago and New York fibre-

optic cables can only manage a speed of 6.55 milliseconds. Microwave dishes can cover the same distance in

4.25 milliseconds. It is estimated that this difference could be worth $1,350 a day to a trader wishing to profit

from price differences for the same securities on the two exchanges4.

What is occurring is a technological ‘arms-race’. In the world of HFT saving milliseconds can mean millions in

additional profit. The race is on to find newer, faster ways of trading across time and space. In the words of

Andrew Bach, head of network services at NYSE Euronext:

‘The speed-of-light limitation is getting annoying’5

2 ‘Stock trading is about to get 5.2 milliseconds faster’, Businessweek, 29.03.12

3 ‘Server farms hurt by glut’, Wall Street Journal, 13.06.11

4 ‘Networks built on milliseconds’, Wall Street Journal, 30.05.12

5 ‘Light is not fast enough for high speed stock trading’, New Scientist, 01.10.11


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Source: Wall Street Journal, 30.05.12


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HFT has its origins in the introduction of real-time quotation systems to financial markets during the 1980s and

the use of algorithms to automate trading within pre-determined price, volume and time parameters. Over the

past thirty years trading in highly liquid instruments such as derivatives, equities, foreign exchange and bonds

has become increasingly driven by computer programmes designed by mathematicians and physicists,

requiring little or no human intervention. HFT utilises the latest developments in computing,

telecommunications and quantitative modelling to reduce trading ‘latency’ (the time needed to execute an

order), generating profit by exploiting the comparative slowness of other market participants. The graphic

below illustrates how this can work.

Source: The New York Times, 24.07.09

This example illustrates one common form of HFT. An investor submits an order to a trading venue for shares

in company XYZ. HFT traders are able to detect the order milliseconds before others. Sometimes, as in the

above graphic, certain traders are given advance notice of an incoming order by around 0.03 seconds (these

are called ‘flash orders’). Knowing that an order is coming they buy all available shares in XYZ. The order then

hits the market. The HFT traders can then sell the shares they bought milliseconds before for a higher price.

Within a fraction of a second HFT traders have bought-low and sold-high – without any human intervention

and with negligible risk. Repeated many times a day, sometimes in connection with large volume transactions,

this can generate significant profit. It has been estimated that HFT firms made profits of nearly $13 billion in

2009 and 20106.

6 ‘High Frequency Trading’, The New York Times, 10.11.11


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HFT has become an increasingly significant feature of global financial trading. Approximately 60 per cent of

equity trading in the US, and 40 per cent of equity trading in Europe, is the result of high-frequency trades. In

the UK the figure may be as high as 77 per cent7. In Australia around only 10 per cent of ASX trading is

attributed to HFT activity. This is expected to grow8. The graphs below illustrate the increase in algorithmic

trading, much of it driven by HFT techniques, since 2004.

Source: The Economist, 25.02.12

In addition to developments in computing and telecommunications HFT has been encouraged by a number of

recent changes in financial regulation. In particular, as part of its broader drive to deregulate markets, the

European Union adopted the Markets in Financial Instruments Directive in 2004. Despite strong opposition

from some member states the Directive abolished the ‘concentration rule’. This rule had allowed member

states to require that trading in financial instruments be conducted only via a regulated exchange. The rule

served to limit the extent to which such transactions could be channelled through non-regulated venues or

taken completely off-market. The EU concluded that this rule limited competition resulting in high transaction

costs. These costs inhibited trading and so compromised liquidity, particularly in secondary securities markets.

This placed European venues at a competitive disadvantage to other trading centres.

However, one consequence of rule abolition has been an increase in opportunities for inter-exchange pricing

arbitrage. Such a trading landscape lends itself to HFT. This regulatory change helps to explain why the

majority of specialist HFT firms have been established within the last ten years.

7 tabbgroup.com, 18.01.11

8 ‘High frequency trading is cuckoo’, Business Spectator, 11.04.12


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The 2010 ‘flash crash’

HFT became an issue for regulators in May 2010 when the Dow Jones Industrial Average suddenly fell by

nearly 9 per cent in the space of a few minutes – the largest intraday fall in the history of the index. Most the

fall was reversed within 20 minutes. The fall had been triggered by a large mutual fund entering the market to

sell an unusually large number of futures contracts. Buyers included HFT firms. However, because HFT

algorithms are typically designed to avoid holding positions for long the HFT traders began selling the contracts

again within minutes. The combined impact of the original sale and the high-frequency reselling drove futures

prices down leading to equivalent sales in equities markets to offset the falling value of the derivatives. The

spiral of selling continued for several minutes until the sharp plunge in prices triggered an automatic 5-second

pause in futures trading after which demand-side interest recovered and prices began to stabilise and rise.

An investigation into the May 2010 ‘flash crash’ by the US Securities and Exchange Commission and the

Commodity Futures Trading Commission concluded that while HFT did not initially trigger the crash it

nevertheless exacerbated the massive swings in trading activity and prices. It took intervention by non-HFT

agents to prevent markets falling further than they did.

Problems of High-Frequency Trading

Since the ‘flash crash’ in 2010 regulators and parts of the business media have taken an increasing interest in

HFT and the risks it may pose to the stability and integrity of financial markets. The public debate has become

increasingly polarised between those who view HFT as making a valuable contribution to increasing the cost

and price efficiency of global finance, and those who see it as increasing systemic risk while making little or no

contribution to directing financial capital into productive long-term investments.

Advocates commonly make the following arguments in support of HFT and why further regulation is

unnecessary:

a) HFT helps to generate liquidity. HFT agents compete to buy incoming offers to trading venues and so

provide an important source of demand and market-depth. They therefore play a role akin to ‘designated

market makers’: registered market participants whose role is to offer firm buy/sell quotes on a range of

securities in order to maintain broader market liquidity.


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b) HFT reduces the cost of trading. By injecting demand into markets at low-risk HFT agents contribute to

tightening spreads.

c) HFT makes markets more efficient. Aggressive trading across venues helps to minimise or eliminate price

discrepancies between related financial instruments.

The notion that HFT generates liquidity, lower costs and market efficiencies has become the shared common

sense of the HFT industry, many regulators and exponents of ‘efficient markets theory’. However, there are

important weaknesses in the pro-HFT case including in relation to market integrity and fairness.

Firstly, as discussed above, HFT agents are able to create and cancel orders in milliseconds. The average HFT

latency is 3 milliseconds. The liquidity they provide therefore tends to be a ‘thin’ and volatile form of demand

that involves a highly selective buying of securities that are then re-sold within fractions of a second. Liquidity-

making gives way to liquidity-taking before most other market participants are able to buy/sell at prices that

resemble real levels of supply/demand and real long-term investment values. Instead, and in contrast to

‘designated market makers’, HFT agents utilise speed to generate information asymmetries that result in many

institutional investors, such as pension funds, paying more for securities simply because they are too slow to

pay less. In the view of a European asset manager who gave evidence to the UK government’s inquiry into

computerised trading:

‘Although HFT may contribute to tighter spreads in the lit markets, and potentially higher volumes,

most of the added liquidity is artificial, in that large institutional orders cannot interact with it to any

great benefit. High trading volume does not necessarily mean greater market liquidity for institutions.’9

Secondly, the tight spreads generated by HFT tend to be of limited value to the broader market. They are often

of limited depth, meaning that they relate only to small trading volumes which, once exhausted, are rapidly

replaced by wider-spreads as a result of automatic algorithmic re-pricing. Further, HFT spreads are usually on

offer for millisecond durations which means they are only of use to other HFT agents. Finally, tight spreads on

particular trades do not necessarily mean lower aggregate trading costs. Evidence from asset managers to the

UK government inquiry illustrates this point:

‘Lately spreads, correlation and volatility have remained high whereas liquidity is limited (we would

argue that much of the liquidity supposedly added by HFTs is not of any use to institutional investors

9 Government Office for Science (2011) End-user Perspectives on Computerised Trading, p. 41


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and therefore is not really liquidity at all). This combination leads to an increase in overall trading

costs.’

‘Overall there has been a marginal increase in the cost of trading…Some direct costs, such as

commission rates and head count, have decreased as a result of alternative trading venues being used,

and greater efficiency in the methods of trading. Other direct costs, such as technology spend have

increased as the market has become more fragmented. Indirect costs, such as market impact and

opportunity costs, have risen largely because of the increased volatility in markets.’

‘Increased IT costs and the IT team have offset the savings on commissions and spreads.’10

Thirdly, HFT may contribute to levelling prices across venues. However, this is a ‘solution’ to a problem that

regulators, via the deregulation of trading exchanges, have contributed to creating. It is therefore a problem

that could be alleviated by means other than HFT. Nor is it clear how levelling prices in 3 milliseconds rather

than 1 second benefits long-term institutional investors and other non-HFT market participants.

In addition to questioning the arguments made for HFT some argue it can be used deliberately to manipulate

markets and price formation to the advantage of those with the fastest technology and most advanced

algorithms. This helps to explain the massive investments made by many HFT firms in recent years in co-

locating to major exchange servers, laying new fibre-optic cables and hiring the most able mathematicians and

physicists. Examples of manipulative strategies that some HFT firms are suspected of using include:

a) Quote stuffing: the practice of placing a large number of quotes in the market for the purpose of slowing

down the processing of orders by an exchange or the activity of other traders. In both cases the causing of

delays will benefit the fastest HFT agents who will able to buy/sell at prices that reflect a lag in price-

formation.

b) Momentum ignition: the practice of buying/selling in sufficient volume to ‘ignite’ a generalised rise/fall in

prices for a security that the HFT agent can then exploit.

c) Spoofing: the practice of issuing waves of false orders at different prices for a security already held by an

HFT agent to give the misleading impression to the wider market that demand is greater than it really is.

Once orders for the security start to flow-in from other agents the lower prices initially fed into the market

10 ibid, p. 45


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are withdrawn so that the security is eventually sold for a price higher than would have been the case

before the ‘spoofing’ was initiated.

However, because of the speed and complexity of HFT market abuse it is often difficult to prove. Nevertheless,

many of those who gave evidence to the UK government inquiry believe that market manipulation often takes

place:

‘We try to avoid venues that allow these types of strategies but it is very difficult to find evidence that

market abuse has occurred. These strategies should be banned.’

‘According to the FSA quote stuffing does not take place in Europe but if 95 per cent of orders are

cancelled before being executed then you would think an element of that represented orders which

were never meant to be executed.’

‘Quote stuffing happened on the day of the Flash Crash. There was a single exchange that was the

source of these quote stuffing events and there was possibly only a single participant. What happened

was that a single stock would get 5000 quotes in a second, and then they were all cancelled instantly.

We definitely see this as market abuse and it could get worse.’11

More important than particular instances of market abuse is the systemic risk and instability that HFT

contributes to generating – and the inability of regulators to keep pace with new developments and the new

abusive strategies they make possible:

‘The biggest risks are to financial stability, especially when computers are entrusted to perform tasks

quicker than human common sense can dictate. Unless distinction is made between certain types of

computer-programmed trading, and curbs are placed on the more opportunistic types, the next ten

years will see an increase in instability of markets, further loss of confidence and an erosion of market

integrity.’

‘There is no way that the current regulatory authorities have the expertise or capabilities to detect or

enforce market abuse.’12

11 ibid, pp. 71-72

12 ibid, pp. 74-76


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These risks and instabilities are exacerbated by ‘Direct Access Trading’, where non-members of a trading

venue can participate directly in the market using the electronic systems and algorithms of a member

institution. Such participants are less likely to understand and comply with market rules, and may not fully

comprehend the nature and implications of the systems and algorithms they are given access to. This is likely

to disrupt markets and lower confidence in their quality and integrity.

A further consequence of HFT has been an increase in ‘dark trading’. In contrast to ‘lit trading’ where

buying/selling takes place on exchanges that impose strict obligations in relation to pre and post-trade

transparency, ‘dark trading’ in so-called ‘dark pools’ involves conducting transactions in private venues where

prices and volumes need not be publically disclosed. This form of trading has become increasingly popular in

recent years partly because many market agents have lost confidence in the capacity of public exchanges

where HFT is common to offer a fair and stable trading environment. However, while conducting certain

transactions away from lit exchanges may make sense for particular buyers, sellers and brokers, it comprises

broader public transparency and price formation. It therefore risks making financial markets and capital

allocation less rather than more effective.

HFT or Socially-Useful Financial Markets?

The primary role of financial markets should be to generate and allocate capital for the purpose of facilitating

long-term investment in productive and sustainable economic activities that help meet the needs of workers,

citizens, consumers and communities. This requires a financial system whose regulatory structure and system

of incentives operates to discourage short-term, unproductive speculation and related abuses. The Global

Financial Crisis demonstrated that too many of the world’s financial institutions had become pre-occupied

with securing short-term speculative gains, generating massive systemic risks and instabilities that have since

cost millions of jobs and the destruction of public services in many countries. Unfortunately, despite the

events of recent years it is far from clear that the lessons of this experience are being learnt.

A financial system that helps to deliver good jobs, steady growth and a sustainable environment is one that is,

at the very least, transparent, accessible, stable and free from abuse. All participants must be able to enter

and participate in markets on a fair and equal basis. In the absence of such conditions prices are more likely to

deviate sharply from fundamental asset values, leading to speculation, volatility and market manipulation.

There is strong reason to believe that many contemporary forms of HFT act to encourage speculative

behaviour across the financial system.


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Recommendations for Reform

There are a number of reforms that regulators and policymakers must consider implementing. These include

the following:

1. Impose a moratorium on HFT until regulators have completed a detailed assessment of the role it plays

our financial system and the costs/benefits it generates for system-users.

2. Impose a minimum resting time of 1 second for trades. This would help to promote genuine liquidity and

radically reduce opportunities for abuses such as ‘spoofing’. The onus should be placed on the HFT

industry to make a social utility case for being allowed to trade in milliseconds.

3. Outlaw ‘flash orders’. Trading venues should not be allowed to offer advance notice of incoming orders to

any market participant, including HFT firms. The practice encourages a ‘two-tier’ market that

disadvantages the large majority of participants who cannot co-locate or buy access to the fastest fibre-

optic cables.

4. Mandate fees on those who cancel orders above a certain order/trade ratio (such as 3:1). Regulation must

ensure that such fees fall on those responsible for implementing the cancellations and who seek to benefit

from them, rather than being passed-on to other parties.

5. Mandate a clear and consistent system of circuit-breakers within and between all trading venues. By

suspending trading when market indicators breach certain pre-set limits circuit-breakers would help to

minimise contagion-risk and stem volatility.

6. Regulators should aim to bring all trading venues under a uniform set of regulations that promote

consistent pre and post-trade transparency and equality of market access. Encouraging more competition

between greater numbers of exchanges is a recipe for instability, market abuse and the weak policing of

behaviour.

7. Outlaw ‘Direct Access Trading’. Only those who fully understand market rules and the technologies at their

disposal should be allowed to participate directly in financial markets.

8. Impose an appropriate set of charges on HFT traders to pay for the additional costs incurred by

government and regulators resulting from the increased regulation and policing of HFT behaviour.


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Next Steps for Australian Super Funds

There is reason to believe that HFT represents a risk to long-term capital market participants such as Australian

industry and not-for-profit super funds. But the extent of that risk, and the associated costs to members, is

presently unknown. It is therefore important that funds, individually and collectively, take the following steps:

a) Each fund board should recognise HFT as an investment risk. The fund should commission a report

from its investment team or consultants that details how and to what extent HFT is built into their

current portfolio, and what costs/benefits HFT delivers to members. This cost/benefit analysis should

include an assessment of systemic risks in addition to fund-level risk. In light of this analysis the fund

should then consider the extent to which portfolio reliance on HFT should be reduced.

b) Via their collective bodies and associations funds should call for and support further detailed analysis

and policy development in relation to measuring collective HFT risk and what steps Australian regulators

should take to mitigate it.

Documents

High-Frequency Trading - A Workers’ Capital Briefing