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Chapter 3

High-frequency trading and dark liquidity

3.1        Since August 2010, the Australian Securities and Investments Commission (ASIC) has had responsibility for the supervision of real-time equities trading on Australia's domestic licensed markets (the Australian Securities Exchange (ASX) and Chi-X) in accordance with the Corporations Act 2001 and ASIC market integrity rules. Part of ASIC's remit is to examine market changes and determine the adequacy of the existing regulatory regime. ASIC's key objective is to promote 'investor confidence through fair and efficient markets'.[1]

3.2        Australia's financial markets are undergoing significant structural and behavioural changes.[2] Two areas of evolution, both within Australia and globally, involve high-frequency trading and dark liquidity (also referred to as dark venues or dark pools). High-frequency trading and dark liquidity were raised by ASIC and the ASX at the December 2012 hearings and have been the subject of media attention and public concern.

3.3        In mid-2012, ASIC established two taskforces to inquire into and report on high-frequency trading and dark liquidity. These reports were released on 18 March 2013, three days after the committee's public hearing. As a consequence, ASIC provided little evidence relating to dark liquidity and high-frequency trading at the public hearing and this chapter therefore relies mainly on the ASIC report.

3.4        For ease of explanation, the attributes of dark liquidity and high-frequency trading are dealt with separately in the following sections. However, dark liquidity and high-frequency trading interact in their influence on investor activity,[3] and are therefore considered together in the section on new Market Integrity Rules. In its concluding comments, the committee draws attention to these interactions and their implications for regulatory proposals.

Dark liquidity

What is dark liquidity?

3.5        Dark liquidity refers to client orders that are matched away from the 'lit' exchange market. There is no pre-trade transparency with dark trading because the orders are not displayed on order books and are 'not known to the rest of the market before the orders are matched as executed trades'.[4]

3.6        Dark trades in Australia can occur on both the public exchange markets, such as the ASX’s Centre Point and hidden orders on Chi-X’s order book, as well as at unlicensed venues away from the markets.[5]

3.7        In a dark trade, a market participant[6] 'may choose to fill the order from its own inventory (known as internalisation), or may choose to "cross" it with other client orders' rather than send the order to the lit market.[7]

3.8        ASIC ascribes the development of dark liquidity to technological change:

Advances in technology have made it easier to trade away from exchange markets and have facilitated a proliferation of dark trading venues known as ‘crossing systems’ and ‘dark pools’.[8]

The size of dark trading in Australia

3.9        ASIC found over 20 dark venues in Australia, accounting for around 7 per cent of the total equity share.[9] The amount of trading in dark pools has remained relatively unchanged at 25–30 per cent of total trading. In recent years, however, there has been a significant change in the type of trades that are occurring in dark pools, with 'fewer large block trades, and many more small trades'.[10]

Private incentives to trade in the dark

3.10      There are several incentives for clients to trade in the dark, including the ability to conceal trading intentions from other traders, and the potential to get 'better prices or faster execution'.[11]

3.11      Market participants are also able to save on the fees associated with the exchange market and can also choose 'which client flow to interact with'.[12]

3.12      However, a key finding from ASIC's investigation is evidence that some clients perceive dark venues to be safer than lit markets because they allow clients to avoid interaction with algorithmic and high-frequency trading on the lit exchange markets. ASIC believes that fundamental long-term investors have moved away from lit markets because they view high-frequency trading as 'predatory, unfair, and a barrier to efficient long-term investment'.[13]

Public benefits of dark liquidity

3.13      Treasury notes two key public benefits that accrue from the presence of dark liquidity. Firstly, dark pools benefit the market by creating competition through the development of rival markets. Secondly, the ability to execute very large or block trades in dark venues has the advantage of avoiding a market impact on the lit exchange.[14]

Concerns about dark liquidity

3.14      Concerns about dark liquidity include regulatory inconsistency between lit markets and dark venues, detrimental impacts on efficient price formation in lit markets, conflicts of interest between market participants and clients, and a loss of investor confidence.

3.15       Treasury has expressed concern that the regulatory landscape is inconsistent between markets that are effectively competitors, for example public exchanges and dark pools', because:

• dark pools are not formally licensed, with operators subject to the market integrity rules only through the fact that they are all market participants in public exchanges and hold an Australian Financial Services Licence (AFSL); and
• markets that are unlicensed face fewer compliance requirements, and are also not directly included in the cost recovery regime for market surveillance. This creates a competitive advantage for those outside of the market licensing regime, and also reduces the effectiveness of market supervision.[15]

3.16      The lack of pre-trade transparency in dark pools has led to concerns that the growth of dark liquidity will impede price discovery and optimal price formation in the lit exchange markets.[16] Furthermore, a shift in liquidity from lit markets to dark venues will reduce the number of lit orders, potentially widening bid-offer spreads and leading to worse prices for all involved.[17]

3.17      Australian research by Carole Comerton-Forde and Talis Putnins concludes that dark liquidity in excess of 10 per cent of total trading (excluding large block trades) harms price formation. By contrast, their study confirmed current understandings that having up to 15 per cent by dollar volume of block trades executed away from the lit markets could 'be beneficial to aggregate price discovery'.[18]

3.18      Further issues around dark liquidity relates to fairness. Dark venues are not regulated like the public markets, and there are concerns that dark venues '"free ride" on the pricing and information set on exchange markets'.[19]

3.19      The ability of dark venues to fill orders internally or cross them with other client orders has triggered concerns about the fairness of crossing systems, because the dark venue has prior knowledge of the trading intentions of a client.[20] A conflict of interest arises when a dark venue may act as both executor of, and active participant in, a trade. Principal trading by a crossing system operator may undermine investor confidence in trade execution and market integrity.

3.20      A further concern is that under existing rules on dark liquidity, investors in lit markets are exposed to a higher level of risk from trades that occur in dark pools because:

... dark orders can be filled before orders at the same price that have been waiting in the queue on a lit exchange market. This results in investors that display liquidity waiting longer for their orders to be executed, which exposes their orders to greater risk of non-execution and adverse price movements (i.e. adverse selection).[21]

High-frequency trading

What is high-frequency trading

3.21      High-frequency trading is a subset of algorithmic trading that uses sophisticated technological tools with a resulting impact on the execution of orders:

Advances in technology have also fundamentally changed the way orders are generated and executed by all users of the market. Rather than orders being generated and executed manually, most orders are now generated and executed by computer programs running decision and execution algorithms.[22]

3.22      ASIC notes that '[a]lgorithmic programs are now used widely by market participants and buy-side clients to execute trades on and off market' and that 'at least 99.6% of all trading messages submitted to market...were sourced from an automated order processing program'.[23]

3.23      ASIC distinguishes high-frequency trading from algorithmic trading and notes that high-frequency trading exhibits the following characteristics:

• high daily portfolio turnover;
• high order-to-trade ratios where large numbers of trades are cancelled in comparison to trades executed;
• flat or near flat positions at the end of the trading day;
• holding positions for as little as seconds or fractions of a second; and
• reliance on the ability to be faster than competitors and to take advantage of services such as direct electronic access and co-location.[24]

3.24      ASIC found that the flat positions at the end of a trading day are the element that most distinguishes high-frequency trading from other algorithmic traders:

The attribute that most clearly characterises high-frequency trading and differentiates it from other trading is the percentage of turnover bought and then sold, or sold and then bought, within each trading day. High-frequency traders tend to close out a high proportion of trading intraday, so their overnight positions are relatively small. This metric distinguishes high-frequency trading from the more widespread execution algorithms which trade in only one direction during a day.[25]

The size and location of high-frequency trading in Australia

3.25      ASIC analysed all trading on Australian equity markets 'over the nine-month period from January to September 2012'.[26] It found 550 high-frequency traders[27], but pointed out that high-frequency trading in Australia is dominated by a small group of trading entities that comprise 'specialised trading desks within major investment banks, proprietary trading firms and some hedge funds'.[28] The 10 largest high-frequency trading entities account for approximately 60 per cent of all high-frequency trading turnover, while the 20 largest high-frequency trading entities account for approximately 80 per cent of all high-frequency trading turnover. High-frequency trading accounts for 27 per cent of total turnover on the ASX 200, and 22 per cent of total equity market turnover.[29]

3.26      In total, high-frequency trading accounted for 32 per cent of total trades and 46 per cent of total orders, 'consistent with the finding that high-frequency traders generally have higher order-to-trade ratios'.[30]

3.27      ASIC found that although 95 per cent of high-frequency trades occur in the lit market, high-frequency traders are also active in dark venues, including crossing systems. The 5 per cent of high-frequency trades conducted in the dark is still significantly less than the 14 per cent of trades conducted in the dark by other traders.[31]

Concerns about high-frequency trading

High order-to-trade ratios

3.28      ASIC found that high-frequency trading shares some of the same attributes as other algorithmic trading, including high order-to-trade ratios and short resting times.[32] High order-to-trade ratios generate large numbers of messages or 'noise' and mean that market participants and operators, as well as ASIC, need to store and manage larger amounts of data. This can increase trading costs.

3.29      However, order-to-trade ratios on the Australian market 'fell substantially in February 2012 and trended downwards over the rest of the period analysed'. ASIC notes that this fall coincided 'with the implementation of Treasury’s cost recovery program which, for market participants, commenced on 1 January 2012'.[33]

3.30      ASIC also notes that the limited data that is available appears to indicate that order-to-trade ratios in Australia are low compared to some overseas jurisdictions, such as Canada, the United States, and Europe.[34]

Holding times and fleeting orders

3.31      One of the concerns about high-frequency trading has been that sub-second trading allows cross-market arbitrage between lit exchanges. However, ASIC found that holding times were longer than previously anticipated, with the average trading time being 42 minutes. The breakdown of holding times is as follows:

• 0.1 per cent of high-frequency traders held positions for less than one second;
• 1.2 per cent were held for an average of two minutes or less;
• 18 per cent were held for less than 10 minutes; and
• 51 per cent for less than 30 minutes.[35]

3.32      ASIC also found that while small fleeting orders 'contribute to market noise' and 'do not add to market liquidity and are potentially misleading when posted at new price levels', high-frequency trading was not responsible for the vast majority of small fleeting orders. Instead, 76 per cent of these orders are likely to arise from the algorithms used by other market participants.[36]

Co-location

3.33      High-frequency operators have been criticised for having an unfair advantage, particularly where a trader's processing system is co-located with a market operator's execution engine. Co-location benefits traders whose trading and business strategies rely on speed, because of the reduced delay or latency in 'transmitting and receiving trading messages'.[37] However, ASIC notes that the 'need for low latency market access is not crucial to all investors'.

3.34      Furthermore, ASIC did not find co-location unfair and noted that both algorithmic traders and high-frequency traders have access to, and use, co-location facilities:

We do not regard the fact that market participants can co-locate to obtain a speed advantage as inherently unfair. Speed of access to the market has always been contestable, from the days of physical proximity on the floor, when an open outcry system operated. We recognise that not all market operators choose to operate at the co-location site with the lowest latency, but for those who do, our concern is to ensure that the facilities for doing so are made available to them on a fair basis and on transparent terms.

Our assessment is that access to these services is fair. Market operators offer economically reasonable and transparent pricing, inclusive of ongoing fee costs, that is publicly available and access to these services is available on a non-discriminatory basis. Network connections within co-location facilities are precisely measured, and all participants within the facility receive their data feed with exactly the same latency as any other participant running the same options.[38]

Predatory trading

3.35      A number of concerns have been raised concerning predatory trading strategies that depend on technology and speed for their execution. Concerned investors have raised the following with ASIC:

• layering: the creation of large numbers of orders, often at various price points, to create a false impression of demand or supply. These orders are then deleted, or moved, as they move closer to trading;
• quote stuffing: a strategy to impede the processing of markets, or participant processes, by overloading an order book with trading messages;
• latency arbitrage: a strategy that detects the submission of individual orders and steps ahead of it by using superior speed;
• liquidity detection: a strategy that determines the direction of fundamental investor demand and ‘front runs’ its execution to create higher execution costs for market users; and
• momentum ignition: a strategy that drives prices artificially over range.[39]

3.36      Further concerns about high-frequency trading relate to the perceived lack of value created by high-frequency trading, and the potential detrimental impact on long-term investment and capital allocation.

3.37       Predatory trading strategies constitute market abuse and ASIC investigates all suspected instances 'and takes enforcement action if appropriate'. ASIC found 'no direct relationship between high-frequency trading and abusive layering', but is investigating one 'instance of potential market abuse using layering by a high-frequency trader'.[40]

3.38      ASIC had 'no concerns at this stage that systemic levels of quote stuffing would compromise the current processing capacity of the Australian equity markets'.

3.39      ASIC also found that concerns about arbitrage were misplaced because:

... market operators are required to provide market data on a fair, transparent and non-discriminatory basis. No trader is capable of detecting any submitted market message before acceptance by that operator.[41]

Furthermore, ASIC observed that high-frequency traders and other algorithmic traders operate at very high speeds and that other market participants need to account for this when using their own 'smart order routers' which may be considerably slower.[42]

3.40      Investors are concerned liquidity detection and the possibility that 'high-frequency trading is interposing ‘toxic’ liquidity between natural buyers and sellers, and thereby increasing execution costs for fundamental investors'. ASIC found instances of 'potentially predatory activity' and in response, the traders have:

... in some cases responded positively to our intervention by modifying their algorithms, ceasing all trading in the market and in other cases they have been referred to Enforcement for investigation.[43]

As a result of the 'behavioural change by traders', market quality has improved markedly with a 40 per cent reduction in pre-open market volatility.[44]

3.41      In response to concerns about momentum ignition, ASIC found 'no evidence of strategies being employed to create or exacerbate price moves and accordingly to open or unwind positions at a favourable price'.[45]

3.42      Over the last year, ASIC did identify and take action against market abuse perpetrated by some high-frequency traders:

ASIC has identified instances of abusive and dysfunctional trading by some high-frequency traders. This has primarily involved foreign high-frequency traders and large-scale wash trading, with this conduct presently the subject of enforcement action.[46]

Market making and maker-taker pricing

3.43      ASIC is also keeping a watch on two activities that are associated with, though not exclusive to, high-frequency trading: market making and maker-taker pricing and proprietary trading firms accessing markets as participants.

3.44      Market makers 'provide liquidity when it is generally weak or absent', and also 'manage short-term imbalances in supply and demand'. Market makers are 'formally registered' in many overseas exchange markets where they are 'subject to specific obligations' and entitled to 'specific benefits'. ASIC notes that these arrangements have not been part of the Australian equity market, but that electronic liquidity providers are becoming 'more prevalent' as a result of the 'increasingly low-latency trading environment in Australia and the introduction of competition in exchange markets'.[47]

3.45      Maker-taker pricing is used to attract liquidity by exchange market operators. ASIC notes that this phenomenon is now appearing in Australia. ASIC remarks that the evidence about the extent of the impact of maker-taker pricing is mixed, but notes that the payment of a rebate to a price maker by an exchange market operator can 'create inefficiencies in pricing' and 'distort trading behaviour'. Neither Chi-X nor the ASX maker-taker models pay a rebate to price makers. ASIC notes that it 'would be concerned if pricing incentives influence behaviour in a way that is not in the best interests of clients and wider market integrity'.[48]

Proprietary trading firms accessing markets as participants

3.46      There has been an increase in 'the number of proprietary trading firms entering Australian markets' relative to 'firms executing trades for clients'. Many of these proprietary trading firms employ algorithmic and high-frequency trading strategies which carry risks that include:

... large potential market exposures via orders which they may not only not be able to fund, but which may cause disorder where the market is volatile, or where an attempt is made to close out an unintended position.[49]

3.47      ASIC intends to make sure clearing firms have effective systems in place to deal with the potential risks including:

... appropriate and effective management of clearing and market-related risks throughout the clearing and settlement system. This must include real-time monitoring and control by clearing participants of pre and post-trade exposure of their clients, in a highly automated environment where algorithms can quickly create disorderly market events.[50]

New Market Integrity Rules for dark liquidity and automated trading

3.48      ASIC remarks upon 'the inherent tension' between the 'short-term private advantages' that accrue to those trading in the dark and the 'long-term public good of contributing to the price formation process' which promotes investor confidence and the efficient capital allocation to listed companies.[51]

3.49      The original rules on dark liquidity were designed to protect block trades because it was deemed beneficial to execute block trades away from the lit market. Given the concerns about the growth in small trades being conducted in dark pools, the recent shift that has occurred in dark liquidity operations with fewer block trades and a greater amount of smaller trades has regulatory implications.[52]

3.50      In response to concerns about dark liquidity and high-frequency trading, the government has introduced new Market Integrity Rules relating to dark liquidity and automated trading that are due to take effect between May 2013 and May 2014. These include:

• a price improvement requirement for dark trades, to encourage more trading to occur on lit exchange markets and support the price formation process (May 2013);
• enhancements to the market operator controls for extreme price movements, including automated trading pauses (May 2013 and 2014);
• enhancements to market participant filters and controls for automated trading, including a 'kill switch' to immediately shut down problematic algorithms (May 2014); and
• enhancements to the data ASIC receives to improve our market surveillance (March 2014).[53]

3.51      ASIC expects that the new meaningful price improvement rules will 'encourage more trading to occur on lit exchange markets' and will also 'protect lit orders from being traded ahead of by dark trades at the same price'.[54]

3.52      ASIC expects that the automated trading pauses and 'kill switches' will reduce the potential for algorithms to exacerbate market volatility and cause liquidity to disappear.[55]

Further regulatory proposals

Treasury consultation paper

3.53      As well as the new Market Integrity Rules, further regulatory proposals have arisen from both a Treasury consultation paper and the investigation into dark liquidity and high-frequency trading by the two internal ASIC taskforces.

3.54      Treasury released a consultation paper in November 2012, Australia's financial market licensing regime: Addressing market evolution. Amongst other proposals, feedback was sought on legislative changes to regulate dark pools, crossing systems and high-frequency trading.[56]

3.55      ASIC supports the first option put forward by Treasury to 'create flexibility in the Corporations Act, augmented by ASIC rules and guidance' in order to 'create a number of market categories with tailored licensing requirements':[57]

ASIC supports the principle of flexible licensing and supports proposals in the Treasury consultation paper for the introduction of specific Market Integrity Rules relating to some dark pool activities.[58]

3.56      ASIC also supports the Treasury proposal to make the relevant traders directly subject to Market Integrity Rules:

We support the position that traders that design and use algorithms should be subject directly to Market Integrity Rules.[59]

ASIC consultation papers

3.57      Following the release of its report into dark liquidity and high-frequency trading, ASIC released a consultation paper in March 2013 on dark liquidity and high-frequency trading. Proposals to amend the Market Integrity Rules relating to dark liquidity included:

• a minimum size threshold for dark orders;
• transparency, disclosure, fairness, monitoring, record keeping, and system controls requirements for crossing operators;
• reducing tick sizes for tick constrained securities;
• enhanced conflict of interest obligations for market participants; and
• indications of interest relating to the possible leakage of a client's trading intentions.[60]

3.58      A minimum size threshold for dark orders is proposed as a 'safety net against future degradation of price formation if dark liquidity grows despite the introduction of meaningful price improvement in May 2013'. ASIC notes that the introduction of a threshold 'is likely to eliminate 90–99% of dark trading below block size, which accounts for 20–40% of dark trading value below block size'.[61]

3.59      ASIC proposals to address high-frequency trading relate to excessive messaging and market noise (in particular, small and fleeting orders and order-to-trade ratios) and manipulative trading.

3.60      Despite the significant reduction in message volume since the introduction of cost-recovery in January 2012, ASIC has 'concluded that small and fleeting orders are impacting market integrity and efficiency and investor confidence' and that therefore 'it is appropriate to require these orders to rest for a minimum amount of time in our markets'.[62]

3.61      ASIC does not see order-to-trade ratios as a market-wide problem, but is concerned to ensure that it does not become a major issue in the future. Accordingly, ASIC proposes to update its guidelines for market participants to include the appropriate consideration of the impact of order-to-trade ratios.[63]

3.62      Various forms of manipulative and predatory trading are already covered in the Corporations Act as well as the rules that apply to the ASX and Chi-X. However, ASIC also proposes 'to enhance the current Market Integrity Rules to address manipulative trading practices that may be affected through trading algorithms'[64].

3.63      At the 15 March hearing, Mr Medcraft indicated that having conducted its investigation, ASIC viewed algorithmic and high-frequency trading as the 'new normal' and that ASIC would look at managing it:

In relation to algorithmic trading, of which high frequency is a subset, the general theme is that it is probably the new normal and we need to see how we manage it.[65]

Committee view

3.64      The committee is concerned that activity outside the lit market may impede the discovery of clear price signals on the lit market and looks forward to hearing from ASIC about the impact that the new price improvement rules have had on dark trading volumes.

3.65      The committee agrees with ASIC's approach to addressing small volume dark trades with the meaningful price improvement mechanism, particularly in light of research that finds a detrimental impact on optimal price formation once the volume of dark trades (excluding block trades) exceeds 10 per cent. The committee notes the Treasury proposals to introduce regulatory consistency in terms of licensing and compliance between lit markets and dark venues. However, the committee also notes the view expressed by Treasury that dark venues provide a public benefit by enhancing competition in the Australian market. The committee is mindful of retaining a balance between the needs of the lit market including optimal price formation and the benefits of greater competition. Given that the meaningful price improvement rule will already be in operation, and that proposals to apply licensing and compliance requirements to dark venue operators may be taken up, the committee seeks ASIC's perspective on the need for a minimum size threshold for dark trades.

3.66      The committee is concerned about the level of competition on the lit exchange markets in Australia, and whether there is any evidence that a lack of competition is causing investors to seek better deals in dark pools. At the next oversight hearing in June, the committee will seek comment from ASIC on this issue.

3.67      The committee is concerned that with the capacity to act as both executor and active participant in a trade, a dark venue has the ability to trade against its client. The committee is pleased that ASIC is consulting on this issue and the committee is keen to know what feedback ASIC has received about this conflict of interest.

3.68      The committee is concerned about the potential detrimental impact of high-frequency trading on the efficient allocation by the stock market of capital to firms over the long term. The committee looks forward to questioning ASIC about its method for looking at high-frequency trading and the conclusions it has reached in this regard.

3.69      The committee notes that ASIC aims to move investors out of dark pools and into the lit market with the price improvement rule. However, the committee is concerned that long-term investors are moving out of the lit exchange markets and into dark pools in order to escape high-frequency trading. The committee seeks an explanation from ASIC about this apparent contradiction particularly given that ASIC has indicated that high-frequency trading may be the 'new normal'.

3.70      The committee is keen to know whether ASIC's conclusion about misplaced concern over high-frequency trading is a result of the relatively low volume of high-frequency trading, or is it a broader governance issue where ASIC believes that effective mechanisms are in place to deal with higher volumes of high-frequency trading. The committee is also keen to know whether ASIC believes that long term investors are mistaken in their concerns about high-frequency trading, and whether ASIC would re-visit the issue of high-frequency trading if there were further developments in the future.

3.71      The committee is mindful that new market integrity rules are due to come into effect over the next eighteen months. At its next oversight hearing in June, the committee will question ASIC on how its taskforces will overlap with these rules.

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