This 3-on-1 interview was too good to refuse responding too!
RG: Elmer, this is far more serious than what you’re saying. What we’ve got looking at here is a totally immoral practice where a series of inside traders learn what’s happening in the market... As an ordinary retail investor, either for a fund or for themselves, as their orders come on, these guys slip in and get a better price – either the in or the out. It’s totally immoral, it’s wrong and it does the stock market no credit to Australia and you can see when you have immoral practices like that what can happen overseas.
What is 'immoral practice' on electronic markets usually depends on which side of a trade you sit. The large long-term institutional investor sees the medium-term trader as immoral, who sees the daytrader scalper as immoral. Each is trying to get in/out of stocks in advance of the other, and ride the created price change. Each is trying to eat the other's lunch.
Now, everyone sees insider traders as immoral - and for good reason. But are you really saying that HFT is insider trading? Are you serious? What 'inside information' are they trading on? If you are referring to the 'advance notice' of market data they receive, well the only reason that all firms are not receiving and acting on this data at the same time is they are not capable of it technologically. Should the investor that only gets prices from the newspaper complain that there are "insiders" out there using intra-day prices with newfangled gadgets?
You seem to be confusing this scenario with the US practice of flash-orders, which I would argue could be a form of inside/front running (since the poor retail client has no control of the disclosure and the fact they are about to being re-routed).
RG: Now, I think there’s only [one] solution, there’s only one moral solution and that is that the high frequency pipes should be cut and we have proper trading. And unless you do cut them, you will have dark pools.
How would you cut the pipes? Presumably you'd determine some arbitrary ratio or indicator that distinguishes the good guys from the bad, and put the bad guys out of business? As I've said previously:
The idea of regulating HFT out of existence disturbs me: how do you decide what is HFT? It is kind of like trying to get rid of criminal bikie gangs: do you define them by the fact they ride bikes, the number of tattoos they have, or the kind of beard? Perhaps you could invent some ratios, and research the correlation between these ratios and criminal activity. What you end up doing is making certain combinations of bikes, tattoos and beards illegal - not the activity itself.
Also, to think that the HFT's will just lie down and die? They will adapt to any prescribed ratios or rules - and if overseas experience is anything to go by they will then turn these new regulations to their advantage. The regulations requiring re-routing where a better price for an order is known on another exchange, or the ability for exchanges to provide price improvements from non-lot pools are two examples of this.
EFK: Well, that’s an extreme and almost medieval solution..
RG: No, no, no. It’s the correct solution. It’s the moral solution. It’s the right solution.
It is one potential solution - I think there are other, and much better, solutions.
RG: I think that we now have in Australia a situation where people are losing faith in the equity market, as they’re doing in the States too, [...]
I actually think the scaremongering about HFT in the press is doing a lot more to destroy the faith in the equity market, than predatory HFT itself is. I don't dispute for a second the fact that predatory HFT exists, but we need to get the scale of the problem right - otherwise the medicine may be worse than the disease.
and the first thing that you have to do is to make sure that they get a free and fair access to the market as they used to have and they no longer have
We have free and fair access - it's just that HFT's are doing more with this access than others are. The root problem is that the market rules (price-time priority) favours those who can move the fastest. We should start there, not trying to invent some new rules to specifically kill them off.
and the reason we’ve got dark pools is because of high frequency trading. The way to stop dark pools, which I can see the problem with them, is to stop high frequency trading.
I agree that dark pools are the 'canary in the cage' in that they indicate there is a problem. I would argue that HFT is not the 'problem' people are trying to avoid by going dark, however, they are just a symptom. The problem is the market rules favour those with speed - and dictate that 'first in, wins'. This works OK on human time scales (we are happy to compete with other humans on speed) but now everything has gone electronic, it confers an unfair advantage to those with ultra high speed. This advantage computer-against-computer is even more amplified than computer-against-human, as programmers do some dangerous things in order to squeeze the last microsecond of speed out. These compromises create some pretty stupid algorithms, that create what the boffins call some dangerous non-linearity. That's geek speak for wild market weather.
RG: Should we change the regulator so we get a tougher regulation to stop it, if you can't do it?
Is another set of bureaucrats going to do a better job?
EFK: I think we’re blessed with very strong regulators here who actually have a very deep understanding of this. But one of the things you have to recognise here is that we’ve changed the market structure and I think if we’d thought about it a little bit longer, two or three years ago, we may not have done that. But we’ve done it; it’s not going to go away. So, we now have to deal with the consequences of that and it’s a very important point right now.
The market microstructure appears to have changed as a result of change in the participant activity - not the market rules themselves. HFT has logically worked out that the market rules reward speed. These issues could all be solved without ASIC even getting involved. If the ASX provided more control to liquidity providers (minimum execution size, TimeMatch, exchange-side algorithms for starters) a lot of these issues would disappear as soon as the buy-side reacted to the new found tools.
These firms getting 'picked off' by HFT are big boys, and should be able to look after themselves. I mean, seriously: even retail traders have to go via a broker - why don't the retail online brokers in Australia advocate for their clients and provide tools to assist them? Instead of innovating in the market, why are we instead getting the lazy response of complaining that the regulator should restore their profitability on their behalf!
RG: And how did we change the market structure? Where did we go wrong? EFK: Well, we allowed fragmentation to proliferate, both with the introduction of another exchange...
Well, this may serve the corporate script of ASX to pin the blame on Chi-X for this - but the issue is more to do with the participants getting faster and being rewarded by the previously benign price-time priority rules with an advantage over the rest of the market. ASX and Chi-X have both (quote reasonably) assisted these firms, with providing ever-faster market engines. What I see is a lack of response from other side of the market; where are the non-HFT's asking for more control over their liquidity? A market that serves their purpose. They are too busy running to the regulator and complaining about the situation - I think an action that demonstrates their collective lack of understanding of what is actually the root cause of the problem. It is as if the non-HFT's believe that the 'HFT ripoff' is an inevitable part of electronic markets - and the only option is to regulate them out of existence.
and I’m not saying competition is bad by the way, what I’m saying is the consequences of fragmentation and the trading models that that allows to create can be damaging unless you manage it well. So, unfortunately whenever you change these structures, there are unintended consequences.
The inevitable increase in market fragmentation caused by competition (read: Chi-X) is only a small part of the 'nutrition' provided to HFT's. The far larger benefit is conferred to them by ASX's massive increases in matching engine speed. It is very hipocritical of the ASX to argue against competition in the name of fragmentation, given that the ASX have themselves a number of (fragmented) markets. Chi-X only have one.
In my mind, the fragmentation consequences of having two order books in Australia is an acceptable compromise in order to achieve competition. The ASX should practice what they preach and rationalise back to one order book; end their own fragmentation experiment.
While I think two order books are justifiable, a dozen or more isn't: having a plethora of dark pools is a major negative - and I'll be watching to see if their market share grows as an indicator on the perceived health of the overall market.
AK: But Elmer, the fragmentation you talk about here, but more especially in the US, allows high frequency arbitrage, right? I would have thought there’s nothing wrong with that? [...]
At the end of the day it increases the cost to the non-arbitraging traders.
[...] The problem of front running, which Bob is on about, surely is not caused, not brought about, by the introduction of another exchange?
Exactly right Alan. But then again there is no HFT front-running going on in Australia anyway.. :)
Perhaps the concept of 'front-running' has come from the practice of algos that 'sniff out' orders that are being executed by large institutions? After identifying what the institution is doing (by analysing public data - it is not front-running) they then jump in and add the to the cost paid by the institution. This kind of not-really-front-running needs to be recognised:
Of course dark pools cater to this type of problem, but I think not enough work has been put into solving this problem in the lit market. The exchanges could help with allowing them more control over their liquidity.
EFK: Yeah. So, I don’t confuse... There’s a connection between the two because fund managers tell us they’re going 'dark' because they don’t want to be in a place where they run into high frequency traders that front run.
Fund managers would say that; what I think they really mean is that they only know how to behave in a predictable enough manner, that the HFT's can always work out, in advance, what they're about to do. Sorry, that's not front running.
EFK: [...] One of the reasons there’s fragmentation is something we call internalisation. So, this is retail brokers matching trades within their own engines as opposed to passing them through the exchange;
Yes, this is a huge issue - and a 'market-within-every-broker' that has always existed. I can't help thinking, however, one of things making internalisation so attractive is that the broker has complete control over their own orders that get internalised (can't meet a HFT in there). Perhaps if ASX provided more control to liquidity providers, there would be less incentive to internalise everything they can. Of course the other reason is that ASX fees are lower on internalised trades, so there really is an economic incentive to do so.
EFK: Cutting the pipes is not the answer. SB: Pricing might be. EFK: Pricing is. RG: Or pricing the pipes?
RG: pricing the pipes higher will only embed the perception (and reality?) of conspiracy between HFT firms and the ASX. And who can blame them - they are there for shareholder return! If the ASX were to drive up the price of HFT data feeds, I can see the media crying: "ASX sells front-running feed to the even more select few!".
EFK: Well, you could argue that... Well, why don’t we just say if a retail broker internalises trades ‘in the dark’, just oversee them the way you oversee an exchange, you know.
I think it's a great idea to increase obligations on a dark pool / internalisation. Add some obligations that the exchanges face - that would be fairer.
EFK: So, the best market place, the most efficient market place, is the place where everybody gets together because that’s what the finance market tells us and we believe that’s true. AK: You just want your monopoly back.
Of course he does AK, but that's not going to happen!
As a wild thought experiment: imagine an NBN-style solution to this. This would give the ultimate solution from a 'minimise the spread by concentrating the liquidity in one place'-perspective.
ASIC would (presumably) run a single order book, on which Chi-X and ASX (and other newly regulated dark pools?) would operate. If EFK were serious about his desire for liquidity concentration (and not the self-interest of the ASX), then he would possibly advocate for this? Unfortunately for ASX, though, it puts the ASX competitors on equal footing with the ASX itself - can't have that!
Maybe it's not such a crazy idea (well, no more crazy than the NBN). I guess the exchanges would become super-brokers, and in a sense you end up making ASIC the new ASX. Just like the NBN, exchanges could no longer compete on technology (since the one order book would be used for all), however I think that ship has sailed. No-one other than predatory traders want markets to get faster from here. My view is that a matching engine is a commodity utility now: just like power or telecommunications.
[note: this NBN experiment has been explored further]
RG: You’re the one that’s doing the wrong thing. You have got the wrong... You’ve put these things in.
The market rules have (globally) become unfair to non-HFT traders, but this happened slowly. The ASX (or Chi-X for that matter) did not create HFT or encourage it in any way. HFT's responded to the price-time priority rules in Australia, the same way they have over the world: they tuned themselves to work the most profitable way within them. They literally are just hackers in the market, or in another language, unencumbered innovators.
What we actually need is for the ASX/ASIC/Chi-X to look at this situation and say: technology has changed the markets. The markets now need to fight back and adapt to those changes thrust upon it. Pushing the debate back onto ASX as to why they created this problem misses the point - they are reactionary in this regard (and I'd argue in general) not proactive (that's what I want them to be).
AK: Oh, are you saying that CHI-X can’t exist without high frequency trading? EFK: I suspect that model is more dependent on it than our model. In fact multiple exchanges really to some degree depend on that kind of model.
I'm not so sure about that. What I am sure about, however, is that if Chi-X provides a venue that allows liquidity providers more control over their orders, than ASX does, then (regardless of current reliance on HFT revenue) business will head their way. Investors will see that Chi-X provide a safer environment to transact, with less exposure to HFT predators. Of course, that is up to the competitive tension - hopefully this will now lead to some innovation.
AK: So, that’s an interesting statement. I mean so are you saying that the stock exchange competition actually relies on high frequency trading in order to have competition?
I think this is kind of true, if you make the assumption that the market rules can never change - ie. we are stuck with the doctrine of price-time priority forever. If you are able to question that doctrine however, I think there is a whole world of other possibilities..