ASIC Market Supervision Update Issue 45
High-frequency trading: The Australian story
In recent years, issues around high-frequency trading have generated a great deal of media attention and concern among investors and consumers. There was, and remains, concern regarding developments in our market and overseas, about the possible impacts of high-frequency trading, including the suggestion that it undermines market confidence. In 2012, ASIC established a taskforce to look at these concerns. The taskforce analysed data and market behaviour, and where appropriate took action, including changes to the regulatory framework, and publically reported on its findings.
In recent weeks, there has been significant media attention about high-frequency trading in the United States, citing horror stories around its apparent influence on Australian markets. Much of the hype has centred on recent publication of the US book Flash Boys by Michael Lewis. The book's author claims that high-frequency trading firms and their fast computers have effectively 'rigged' the US stock markets, and in doing so have made billions of dollars by leaping in front of investors. While many local media outlets have been quick to try and draw parallels with the Australian market, any suggestion that high-frequency trading is pervasive in Australia, is simply not supported by the evidence.
While the United States and Australian markets do share some characteristics (more than one market trading the same securities; co-location and data feeds with different speeds) there are a number of factors that make the situation in Australia very different. Not only is the proportion of the Australian market that is high-frequency trades considerably smaller, but unlike the United States, ASIC has actively discouraged maker-taker pricing rebates, has banned payment for order flow, and has taken a principles-based approach to market selection for execution (i.e. there is no Regulation National Market System).
Flash Boys also suggests that there is a problem in the United States with unnecessary intermediation and limited transparency via dark pools that is to the detriment of investors. ASIC has not and will not tolerate this type of behaviour in the Australian market. In 2012 and 2013, ASIC introduced new market integrity rules to ensure there is transparency on the rules of engagement in dark pools.
While some local media commentators have suggested that ASIC is doing little in regard to HFT, the truth is in fact quite different. ASIC's lack of hysteria regarding high-frequency trading should not be mistaken for complacency. ASIC has actively engaged with the evolution in the electronic marketplace including high-frequency trading, algorithms and automated order processing. We have a new market surveillance system and an impressive staff to ensure we understand and can respond to new challenges. We have taken a proactive approach to ensure we have a regulatory framework that can deal with the technological advancements that exist in our market.
This reflects and is consistent with ASIC's approach to changing market dynamics. It is an approach that consults with industry, considers longer-term trends, conducts in-depth analysis, and provides for a bigger picture solution to changing market issues -; rather than merely imposing more regulation.
What is high-frequency trading?
'High-frequency trading' is not a technical term and definitions can vary. High-frequency trading is often used to describe a type of trading that requires very fast computer programs to generate buy and sell orders on markets such as ASX, ASX 24 and Chi-X. These programs can enter and amend orders much faster than orders generated by people.
High-frequency traders use computer algorithms to enter orders on both sides of the market, to profit from incremental price differences while managing risk as prices change, rather than to look for underlying value in a financial product. This behaviour is similar to that of many other traders in our market. The algorithms are able to process information quickly and can result in the entry of small-volume orders on the market to fulfill a particular trading strategy.
While it is often equated with algorithmic trading, and high-frequency trading does indeed use algorithms, not all forms of algorithmic trading can necessarily be described as high frequency. The attributes ASIC uses to identify 'HFT-like' trading accounts are therefore not confined to those entities that identify themselves, or are identified by others, as 'high frequency traders'.
ASIC's work in dealing with the challenges posed by a changing market -; in particular in dealing with high-frequency trading -; has been multi-pronged.
ASIC has sought to ensure that the regulatory framework is best equipped to deal with the behaviours shown by HFT-like trading in Australia. It is important to be market-specific because there are significant differences between markets in different jurisdictions, for example, HFT-like trading is far less prevalent in Australia than in the US.
Nevertheless, risks emerging from developments in market structure, including growth in automated trading and the changing nature of dark liquidity are being addressed by ASIC and Australian market operators and participants.
In August 2012, ASIC published Consultation Paper 184 Australian market structure: Draft market integrity rules and guidance on automated trading (CP 184), proposing rules and guidance on participant level controls for automated trading.
In November 2012, we made the following market integrity rules, which were phased in gradually:
- extreme price movement rules for ASX and Chi-X, and amendments to crossings during takeovers (November 2012)
- automated trading -; tightening of rules to require direct and immediate control over filters and orders (May 2014)
- commencement of suspicious activity reporting rules (January 2013)
- meaningful price improvement and block trade rules (May 2013)
- market operator enhanced data reporting rules (October 2013).
In March 2013, ASIC published Report 331 Dark liquidity and high-frequency trading (REP 331). This report was the culmination of work conducted by two taskforces established by ASIC to specifically consider high-frequency trading and dark liquidity.
The taskforces considered the impact of high-frequency trading and dark liquidity on the quality and integrity of Australia's financial markets, with a focus on the interests of listed companies and investors, and Australia's competitiveness as a regional financial centre.
Both taskforces put significant effort into producing a report which helped consumers and investors to better understand these issues and provided confidence that our markets were (and are) fair and efficient, and operating with integrity.
In relation to HFT-like activity, ASIC conducted in-depth and detailed analysis of our data from our surveillance feed from ASX and Chi-X, to identify the nature and extent of this activity in our market. More broadly, we also engaged with industry and regulators here and abroad, reviewed relevant research and identified regulatory gaps. While there were a number of key findings, ASIC discovered that 98.8% of high frequency traders held positions for holding times of more than two minutes and 88% of high-frequency trade orders were at the best price in the market. ASIC also considered order-to-trade ratios within the Australian market. In comparison to major international markets, the Australian order-to-trade ratios were (and continue to be) considerably lower. The Australian order-to-trade ratio currently sits at approximately at 9:1.
Table: International comparison: Order to trade ratios (2012)
|USA||Greater than 30:1|
|European Union||Greater than 30:1|
In publishing REP 331, ASIC proposed a number of rules, some of which came into force in stages (i.e. they were refined in response to consultation and because the industry responded to some of our concerns). The final rules that were released in August 2013 followed extensive internal analysis and consultation with industry. They were:
- Manipulative trading circumstances of order -; market participants must consider additional circumstances in considering whether a false or misleading market has been created; the frequency in which orders are placed, the volume of products that are the subject of each order, and the extent to which orders made are cancelled or amended relative to the orders executed (from February 2014)
- Manipulative trading rules harmonised -; market participants of the ASX 24 market need to comply with new requirements to prevent manipulative trading -; the same requirements that apply to the ASX and Chi-X markets (February 2014)
- A prohibition was introduced on payment for order flow (February 2014).
As we continued to monitor trends in high-frequency trading, where appropriate, we adjusted proposals for new rules. In particular, while low latency trading has the potential to exhibit unwanted behaviour and create excessive 'noise', we decided not to proceed with a new rule regarding small and fleeting orders, as the few participants responsible for observed noise, responded immediately to our concerns.
This is consistent with ASIC's generally approach: of monitoring the longer term Australian trends, and acting in the interests of the Australian market. Furthermore, our work on both high-frequency trading and dark pools did not end with the taskforce report.
As consistent with our regulatory remit, ASIC also takes pre-emptive action when concerned about particular strategies or systems which can be fixed relatively quickly. Not only does this generate quick and effective outcomes, and, very importantly, reduce costs and disruption to industry, but where appropriate, it also removes the need for further investigation and reduces the strain on ASIC resources.
Such action has included contacting trading firms and querying their execution strategies, algorithmic trading and filter issues. This has also included 'noisy' algorithms, where we have asked brokers to consider whether the actual conduct was consistent with the intended behaviour of the algorithm.
As an example, for the six-month period ending 31 December 2013, there were 18 such instances of pre-emptive action. This also underlines the open dialogue that ASIC has with industry in ensuring our markets remain fair and efficient.
Automated order processing certification
ASIC has also taken an increasingly concentrated approach to the certification of automated order processing systems. Our market analysts and specialists have strong working relationships with all automated order processing providers, and a well-developed and deep understanding of the manner in which these systems operate.
This allows for a disciplined, stringent and methodical approach to the automated order processing certification process. The impact of this on the avoidance of operational issues down the track should not be understated.
Naturally, in some instances, the circumstances of a matter warrant it being referred to ASIC's Enforcement department for further investigation. There were two automated order processing-related matters referred to Enforcement in the six-month period ending 31 December 2013, making for five in total for the 2013 calendar year.
Further, in the six months to 31 December, there were four infringement notices  issued by the Markets Disciplinary Panel in relation to automated order processing, for a total of $385,000.
Our supervision of the market, including high-frequency trading, has been bolstered by the successful rollout of ASIC's new market surveillance system. Market Analysis Intelligence (MAI) enables ASIC to interrogate very large data sets, as well as reviewing granular information on the behaviour of high-frequency traders and algorithmic traders.
In addition to ASIC's real-time surveillance which also monitors HFT-like trading, we also conduct post-trade analysis. Currently, for example, we are looking at a high-frequency trading participant who appears to be regularly putting in 'bait and switch' type orders. Using MAI, we have identified hundreds of such instances by this participant's facilitation desk.
Sophisticated monitoring tools, combined with staff experienced in trading and trading technology have enabled us to monitor with greater effectiveness than ever before the changing conditions, patterns and trends -; both here and abroad -; in what are dynamic financial markets.
Australian financial markets
ASIC's approach to the regulation and supervision of Australia's financial markets continues to be a proactive one. While we monitor trends and engage with our regulatory counterparts across the globe, our focus remains on ensuring that Australia's regulatory framework is one that suits local conditions.
While market conditions -; including in relation to high-frequency trading -; may be more toxic overseas, to suggest that they are as a result toxic here, is folly. Australia's ability to withstand most of the force of the GFC is but one example of the fact that our local economy, our financial markets and the regulatory framework around them continue to be strong, disciplined and appropriate. This, together with our successful pursuit of fair and efficient financial markets is something that should be welcomed.
Note 1: Under reg 7.2A.15(4)(b)(ii) of the Corporations Regulations 2001, compliance with an infringement notice is not an admission of guilt or liability and neither entity is taken to have contravened section 798H(1) of the Corporations Act 2001.