Jonathan Shapiro and Patrick Durbin

‘Unlevel playing field': HFT uses ultra fast trading systems that profit from millisecond discrepancies in stock prices. Photo: Bloomberg

High frequency trading a practice involving super-fast computers alleged to have rigged the sharemarket is costing large investors almost $2 billion a year, according to industry super funds who want the practice curtailed.

The speed advantage enjoyed by high frequency trading [HFT] had turned the sharemarket into an unlevel playing field, said Industry Super Australia, which has asked David Murray’s Financial Services Inquiry to tax the industry as happens in Europe.

A global debate about HFT has erupted following allegations by noted United States author Michael Lewis that the billion dollar profits made by the industry are coming at the expense of the rest of the market.

Causing a stir: Michael Lewis, author of Flash Boys. Photo: Bloomberg

Zac May, head of policy at Industry Super Australia and a former Securities Exchange Commission staffer in the US, backed Lewis and called for a Tobin-style tax on financial transactions and rules to slow down trading speeds.

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Industry super is focused on investing in companies and the real economy,  he told AFR Weekend.

Trading in microseconds has nothing to do with that, but it creates an opportunity for exchanges and HFT to clip the ticket between buyers and sellers, Mr May said.

HFT uses ultra fast trading systems that profit from millisecond discrepancies in stock prices. Large institutional investors, concerned that HFT’s faster computers are skimming profits from their own trades, routinely use complex algorithms to turn their own trades into much smaller parcels that cannot be detected by others in the market.

The practice is never done by retail investors.

Several traders told AFR Weekend that as a result, retail investors’ buy and sell orders were often larger than institutional investors’ trades and were hence more lucrative to HFT. Some high frequency traders referred to retailing investors’ trades as dumb-flow as it was easier to detect in the market and use to their advantage.

ASX chief executive Elmer Funke Kupper said he was still scratching his head about the impact of HFT on retail investors in Australia.

There are highly liquid stocks that get handled twice when they could have been handled once, he said.

Retail investors tend to miss out in this process. On a $10,000 order it may only be a few dollars, but multiplied by millions of transactions it adds up.

Trading orders up for grabs

Among the allegations in Lewis’s book Flash Boys is that US online retail broker TD Ameritrade sold its orders to US hedge fund Citadel for hundreds of millions of dollars. Echoing this allegation, several Australian trading experts said retail trading orders are often routed to Chi-X, an alternative exchange to the Australian Securities Exchange known for its high prevalence of high frequency traders.

Asked how they direct their clients’ orders, Commsec, Nabtrade and ANZ E*Trade pointed towards their best execution policies whereby they are duty-bound to seek the best prices and fees for their clients.

While there is no suggestion that retail brokerages are not complying with their best execution policies, it is unclear how these policies deal with HFT.

One concern is that high frequency traders can see another trader’s buy orders and then buy the shares themselves, forcing up the price for the other investor and then quickly selling and pocketing the profit. One trader said retail investors trades were known in the industry as dumb flow because such investors do not chase the best price and do not care about signalling risk or disseminating information about their intention to the market. Everyone wants to interact with retail flow because it’s uninformed, said a trading expert that would not be named.

It’s uninformed because it’s not broken down into smaller bits and they chase the price because they just want to get a trade done, said the trader.

We all want to trade with that natural retail flow, said another trader.

Other traders have alleged high frequency traders are also exploiting the 15 kilometre journey between Australia’s two major stock exchanges, located on either side of Sydney Harbour, to profit from less sophisticated investors.

It takes 70 milliseconds for ultra fast computers to make the journey from the ASX to Chi-X computers via underground fibre optic cables.

Some traders allege this create an arbitrage opportunity. ASX’s chief Funke Kupper said that while there is nothing illegal about high frequency trading  fund managers have hardly heralded the practice’s arrival and he suggests its benefits were questionable.

We must think about the interests of end investors. Our markets exist to fund real companies and fund the retirement of our citizens.

Everything else cannot put at risk those two objectives. Australia’s regulators have done a good job in setting rules that support investors, Mr Funke Kupper said.

Does it matter?

Chi-X operators maintain that it offers better improved pricing and narrower spreads compared to the ASX. A spokesman cited an independent research report conducted by the University of New South Wales that estimated it has created welfare affects of up to $220 million in its first year of operation.

ASIC estimates high frequency traders account for about a third of all trades on the ASX.

While super funds are calling for new rules, some experts believe retail investors are not worse off because HFT means there is a tighter gap between buy and sell prices on a stock, making transactions cheaper.

[Brokers’] obligation is to get the best outcome for their clients. In some venues they will trade with high frequency trading.

The question is whether that really matters, said Carole Comerton-Forde, a globally renowned expert on market structures from Melbourne University.

There will be situations they are on the wrong side of the trade but there will also be situations where high frequency trading may work in their favour.

Vanguard’s head of investments, Rodney Comegys, said Australia’s market structure was not as complex compared to the US and therefore not as susceptible to disruptive high frequency trading practises.

The ASIC approach has been progressive in going out and even when there might be opportunities [for disruptive behaviour] they have flattened the playing field so the smaller investor has a chance, Mr Comegys said.

The regulators need to constantly analyse whether the current rules need to changed to limit opportunities and incentives for disruptive behaviour.

Industry Super Australia’s estimate that HFT costs the rest of the market up to $1.9 billion is calculated by taking a quarter of all stockmarket trades and multiplying it by the average spread between the bid and offer prices of the top 200 stocks.

This gives an estimate of assumed profits extracted by HFT from investors.

This article first appeared on AFR.com