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Sadikoen, Justin --- "High Frequency Trading and the Global Regulatory Response: A (False) Cause for Alarm in Australia?" [2015] UNSWLawJlStuS 3; (2015) UNSWLJ Student Series No 15-03


HIGH FREQUENCY TRADING AND THE GLOBAL REGULATORY RESPONSE:

A (FALSE) CAUSE FOR ALARM IN AUSTRALIA?

JUSTIN SADIKOEN

I. INTRODUCTION

With the advent of technology, the world’s equity markets have recently seen the implementation of computers and the automation of its exchanges develop at an unnerving rate. This development has enabled high frequency trading to emerge as an extremely profitable trading strategy for some firms. Although at times beneficial, high frequency trading is not without its risks and has the potential to cause serious damage to capital markets in Australia, as observed by the events of the United States (US) stock market’s ‘flash crash’ on 6 May 2010.[1] On this day, US capital markets experienced an extremely brief period of severe volatility thought to have been exacerbated by the operation of high frequency traders in capital markets. Such financial devastation presents a regulatory nightmare to supervisory bodies across the globe who have scrambled to find the balance between facilitating the positive aspects of high frequency trading and mitigating the risks involved.

This paper seeks to first discuss the history of high frequency trading and the current state of play in capital markets across the world. It then seeks to define what high frequency trading really means, highlighting some strategies undertaken by high frequency traders before assessing the costs and benefits high frequency trading provides to a capital market. Building on from this, the paper then observes and highlights regulatory responses in the European Union (EU), the US and Australia, before finally assessing whether the regulatory response is adequate in Australia given the vast structural differences between the Australian and US market.

II. THE HISTORY OF HIGH FREQUENCY TRADING AND THE CURRENT STATE OF PLAY

Capital markets in Australia have developed significantly since the establishment of individual stock exchanges in each state pre-federation and the subsequent advent of the Australian Associated Stock Exchanges (AASE) in 1937.[2] Stock markets in Australia originated as a call system whereby an employee of the AASE would call out the names of the listed companies on the trading floor, inviting brokers to bid or offer on each company. Eventually, the markets evolved into a post system where an operator colloquially known as a ‘chalkie’ wrote up bids, offers and completed transactions in chalk on blackboards as they were executed by brokers.[3] As evident from the above, the trading floor was historically a physical marketplace where orders were completed.

With the advent of technology, however, the concept of trading in a physical location has been eroded. With the first after-hours electronic trading platform established by the Sydney Futures Exchange in 1987[4] and the eventual shift towards a fully electronic trading platform in the ASX options market in 1997,[5] the physical separation of participants in the market resulted in the creation of genuine competition between these participants.[6]

Stemming from these technological advances, high frequency trading has emerged as a significant occupier of volume in trades across markets across the world. The exact prevalence of high frequency trading is somewhat difficult in itself to measure as a result of data collection restrictions that inhibit the ability to measure the volume of trades that can be attributed solely to high frequency trading.[7] By some metrics, high frequency trading made up 73% of the day-to-day volume in the equity markets in 2010 in the US.[8] In Europe in 2010, high frequency trading accounted for 38% of trading.[9]

Although it is possible to analyse the trades made by firms regarded as participants in high frequency trading in the Australian market, it is the case that other firms that engage in high frequency trading do so by proxy.[10] As such, industry experts and brokers estimate that the amount of high frequency trading in Australia sits between 15-25% of trading.[11] Comerton-Forde pointedly remarks that this estimate is significantly higher than the estimated 3-4% by the ASX in February 2010.[12]

III. WHAT IS THE PROBLEM?

A Defining High Frequency Trading

High frequency trading can be broadly defined as a system of trading that utilises technology to leverage speed in order to execute a large number of trades in a matter of milliseconds.[13] Such technology generally consists of computers built specifically to maximise speed. This hardware is also supported by software in the form of algorithms – also known as black-box trading – designed to execute trades when certain, pre-defined parameters are met by the price of a share across different markets.[14] The software utilises these algorithms to analyse the difference in price across multiple markets and will make orders on the basis of any advantage across these markets. Speed is placed at a premium across the competing high frequency trading firms as those who have the competitive advantage of speed will typically be more profitable.

The International Organisation of Securities Commissions has described high frequency trading as having the following common features:

• The utilisation of sophisticated technological tools for pursuing a number of different strategies, including market making and arbitrage;

• The quantitative use of algorithms to analyse data along the investment chain, including market data, trading strategies, trading costs and trade execution;

• Characteristically high day-to-day portfolio turnover and an disproportionately large number of orders being cancelled relative to trades executed (order-to-trade ratio);

• Characteristically flat or near flat positions held at the close of each day of trading, minimising risk to be carried overnight;

• Usually employed by trading firms or desks; and,

• ‘Latency sensitive’, meaning the success of its utilisation is contingent upon those traders who are able to maximise any speed advantage due to potentially direct electronic access to stock exchange servers or co-locations with these stock exchange servers. [15]

B Strategies Employed by High Frequency Traders

High frequency traders employ specific strategies in order to best optimise the speed that provides them with a competitive advantage. Most of the strategies that they seek to utilise can be described by the all-encompassing term, ‘latency arbitrage,’ which refers to the competitive advantage obtained when a firm is able to act quicker than others players in the market.[16] There are five key strategies that high frequency traders utilise. First, high frequency trading firms place a premium on the ability to co-locate their computers and software as close as physically possible to the data feeds offered by stock exchanges. This is done so in order to shave off milliseconds of lag in the electronic communication between their servers and the stock exchange’s server, thereby maximising latency arbitrage.[17] Secondly, high frequency traders act strategically as automated market makers in order to provide liquidity to the market while simultaneously attempting to arbitrage the bid/ask spread of stocks by placing and editing ‘limit orders’ or non-market orders, assisted by the computer-generated speed.[18]

Thirdly, statistical arbitrage is utilised where the price of several stocks deviate from their respective historical trends. In this situation, a trader would sell the stocks that are likely to come down to their historical trend and buy stocks that are likely to come up to their historical trend.[19] The technology utilised by high frequency traders allows them to execute this strategy within a matter of milliseconds. Fourthly, in exchanges across the US but not in Australia, high frequency traders are also provided with rebates by an exchange for providing liquidity to the market.[20] This strategy provides high frequency traders with significant operational income given the sheer quantity of trades they execute in pursuit of their other strategies.

Finally, one of the most concerning strategies that high frequency trading firms seek to employ is the use of their competitive advantage to gauge liquidity in the market and search for potentially large buy orders made by institutional traders. High frequency traders utilise ‘fleeting orders’ or orders that are placed and then cancelled shortly thereafter in order to gauge large buy orders.[21] With this information, the purchase the available shares of that security and sell those on to the institutional investor seeking the large buy order for a higher price than was originally available, commonly known as ‘front running’.[22]

C The Benefits of High Frequency Trading

High frequency trading is purported to offer several benefits to a market. One benefit that high frequency trading provides is with regards to price efficiency. Price efficiency is the concept that the price of a security is efficient because it is reflective of all the information available to the market at that point in time.[23] There is strong evidence in support of high frequency trading having a significant positive correlation to increased price efficiency.[24] High frequency traders ‘facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors,’[25] thereby reducing the ‘noise’ within prices and making prices more efficient overall.

High frequency trading is also argued to improve price discovery in the market. Price discovery is related but distinct to price efficiency in the sense that price efficiency represents the accuracy of prices in reflecting available information, while price discovery is the manner in which this available information is represented in the price.[26] Satchell argues that high frequency trading is likely to provide improved price discovery relative to time, given that it minimises the time it takes for a price to reflect certain information.[27]

Liquidity, although challenging to define, has been viewed by Satchell as representative of the ‘number of resting orders that allow for trades near the current price.’[28] Resting orders are those orders which are placed away from the current market price until the market price reaches that order, thus ‘resting’ until that point. To give an example, a resting order may be an order placed at $50 when a stock’s current market price is at $60. It has been observed that high frequency trading firms provide the market with liquidity, and reinforcing this observation is the fact that exchanges often provide high frequency traders with compensation for providing liquidity to the market.[29]

The veracity of the above benefits have been supported by empirical data. Brogaard undertook a comprehensive analysis of data consisting of orders or trades in the US market through a stratified sample of data of certain stocks from 2008-09. [30] This analysis found that high frequency traders do not appear to engage in the systematic front-running of non-high frequency traders, high frequency trading volume does not change significantly with market volatility and that high frequency traders may in fact reduce volatility overall.[31]

D The Costs of High Frequency Trading

In contrast to these benefits, there have understandably been concerns with the nature of high frequency trading and the manner in which it affects the market adversely. The Australian Securities and Investment Commission (ASIC) and its high frequency trading taskforce in Report 331 identified algorithmic trading as a responsible factor in causing excessive messaging and noise in Australian capital markets. ASIC found that this excessive messaging and noise particularly caused by small and fleeting orders and high order-to-trade ratios.[32]

Furthermore, concerns surrounding predatory trading strategies reliant upon technology and speed[33] were raised. Despite vocal opposition from the industry, however, ASIC did not find any systematic manipulation or abuse of the markets in its empirical research.[34]

With respect to liquidity, high frequency traders’ competitive advantage in latency arbitrage means that, in moments where the market suffers a shock, the risk management systems that high frequency trading firms utilise will act quicker than other counterparts and cease trading when risk is abnormally high. This means that in times where the market is in the midst of a shock, high frequency traders may in fact reduce liquidity.[35]

However what is perhaps the greatest concern surrounding high frequency trading is the impact that it has upon volatility in the market. At around 2:45 pm on 6 May 2010, the major market indexes in the US market dropped by over 9%, including a 7% drop in little under a 15 minute span, only to recover those losses just as quickly.[36] In a report from the Securities and Exchange Commission (SEC) addressing the ‘flash crash’, it was found that the activity from high frequency traders and their algorithmic trading exacerbated unusual volatility in the market.[37] The report found that:

The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini down approximately 3% in just 4 minutes from the beginning of 2:41 pm through the end of 2:44 pm. During this same time cross-market arbitrageurs who did by the E-Mini, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY also down approximately 3%. [38]

The investigation and subsequent report held that the high frequency traders exacerbated the ‘flash crash’ of 6 May 2010 as they ‘began to quickly buy and then resell contracts to each other – generating a ‘hot-potato’ volume effect as the same positions were passed rapidly back and forth.’[39] It can thus be argued that as high frequency traders traded over 27,000 contracts between themselves whilst only buying an additional 200 contracts,[40] high frequency traders often create the illusion of liquidity in the market with the risk of extreme volatility.

IV. REGULATORY RESPONSES

A In the US

In response to the ‘flash crash’ of 6 May 2010, the Securities Exchange Commission (SEC) commissioned an investigation into the occurrences and abnormal market behaviour of that day. As discussed above, the investigation found that while the actions of high frequency traders was not necessarily the cause of the ‘flash crash,’ they did exacerbate the severity of the volatility experienced.[41] Rather, the SEC concluded that characteristics specific to the US market structure were attributable for the crash. In response to the ‘flash crash,’ the SEC proposed four regulatory changes which were implemented seeking to reform the ‘existing market-wide circuit breakers,’[42] that were inadequate during the events of 6 May 2010. The implementation of these reforms is carried out through amending each of the individual exchanges’ respective rules, as they are self-regulatory organisations. These amendments are then filed with the SEC pursuant to Section 19(b)(1)[43] of the Securities Exchange Act of 1934 and Rule 19b-4 thereunder.[44]

1 Circuit Breakers

To improve upon the failure of the existing market-wide circuit breakers to respond adequately to the ‘flash crash,’ the individual exchanges have amended their respective rules with respect to automatic circuit breakers that stop trading on an individual security when the threshold of a 10% price change is met within a 5-minute period.[45] If the threshold is met, the circuit breakers will act to cease trading on a nation-wide basis for a period of 5 minutes on all the US markets on which that individual security is traded.[46]

2 Erroneous Trades

Erroneous trades were another issue that, in the aftermath of the ‘flash crash,’ was identified as a regulatory concern. Where a broker or a dealer enters a quantity or amount in error, investor confidence can be adversely impacted if one exchange operator’s response differs greatly from another.[47] The ambiguity of the situations in which the exchanges could exercise its power to annul erroneous trades led to individual exchanges executing rule changes that more clearly define their powers and limit the discretion they can exercise order to improve investor confidence.[48]

3 Stub Quotes

In order to comply with their quotation obligations to submit both bids and offers, market makers often quote prices that are nowhere near the current market price.[49] This practice is known as submitting stub quotes, i.e. quoting at $1.00 where the market price is $50.00. Market makers do not envisage these quotes to be executed. However the ‘flash crash’ demonstrated that the stub quotes were in fact executed with the sudden loss of liquidity arising from market makers withdrawing their quotes suddenly. In response to this, markets in the US have placed a blanket ban on stub quotes,[50] requiring market makers to quote within pre-defined parameters indexed around the national best bid and offer.[51]

4 Consolidated Audit Trail System

Recognising that, as a result of the ‘flash crash,’ regulators required greater market surveillance, the SEC recommended and implemented a central database through which all trades and activity across the US’s many capital markets is reported. This database allowed regulators access to in depth information concerning orders ‘from receipt or origination, through the modification, cancellation, routing and execution of an order.’[52] Such a centralised reporting system would allow regulators to manage investigations with expediency and efficiency.

B In the EU

High frequency trading in the European Union is regulated by the European Securities and Markets Authority (ESMA), which oversees and implements the Markets in Financial Instruments Directive (MiFID).[53] The main purposes of the MiFID are to ensure consumers are protected with respect to investment and to ensure that there is an adequate level of competition in European capital markets.[54] MiFID I was adopted in April 2004,[55] providing a framework for the regulation and legislation that paved the way for MiFID II to adequately legislate upon matters pertinent to high frequency trading by creating financial markets which are more resilient, efficient and transparent.[56]

In response to the events of 6 May 2010, the European Commission in its public consultation of the MiFID Review noted that the regulation of capital markets in Europe required further amendment in response to the development of high frequency trading. Arising from this process is MiFID II,[57] a set of proposed amendments to MiFID I that concern, amongst other areas of securities regulation, the impact of high frequency trading on European capital markets. Open for public consultation until as recently as 1 August 2014, it remains to be seen what the actual regulatory impact MiFID II will have on high frequency trading. The public was asked to make submissions on the two following competing propositions with respect to defining high frequency trading.

Firstly, the ESMA propose that firms utilising co-location and large amounts of bandwidth to execute faster orders, with a high rate of orders day-to-day, must be defined and recognised as a high-frequency trading firm.[58]

Further and in the alternative, ESMA’s second proposition concerns the frequent nature of intraday order messaging rates, proposing that each individual market should intermittently analyse the average daily lifetime of orders which have been modified or cancelled. High frequency traders often modify and cancel orders in a short span of time in order to front-run, and as a result of the implementation of this rule, they would therefore fall below the market’s average daily lifetime.

In comparison to the US regulatory response, it appears that the European countries are more likely to exercise more regulation with respect to high frequency trading and the problems it poses for European capital markets.[59] Indeed, Michael Barnier, EU Financial Services Chief is quoted to have said of MiFID II:

With these rules the EU is putting in place one of the strictest set of regulations for high-frequency trading in the world. While HFT trading might bring some benefits, we need to make sure that it doesn’t cause instability, and isn’t a source of market abuse. That’s what these rules set out to achieve.[60]

C In Australia

High frequency trading in Australia has only recently become a regulatory concern, with ASX TradeMatch, Chi-X and ASX PureMatch all exchanges on which high frequency traders can take advantage of market fragmentation.[61] The corporate regulator, ASIC has largely taken a ‘hands-off’ approach with respect to regulatory reform, preferring to rely on the existing regulatory structure and an open dialogue between the regulatory body and participants in high frequency trading to tackle pertinent issues.[62] Despite this, there have been a few amendments to the regulatory landscape in response to the concern surrounding high frequency trading.

1 Volatility

ASIC has undertaken an extensive empirical study surrounding the concerns and perceptions that investors may have in its Report 331: Dark Liquidity and High Frequency Trading.[63] In response to investor concerns about high frequency traders’ behaviour in moments of high volatility, ASIC found that ‘high frequency traders displayed negligible change in their contribution to depth in the S&P/ASX200 securities given different states of volatility.’[64] However ASIC qualified this observation in light of the events of the ‘flash crash,’ which it classifies as a moment of extreme volatility as opposed to high volatility. ASIC’s regulatory response to this is to implement new Market Integrity Rules reported to the market in Regulatory Guide 223: Guidance on ASIC Market Integrity Rules for Competition in Exchange Markets.[65] These new rules include enhancing market operator controls for extreme price movements and including a ‘kill switch’ to shut down problematic algorithms in moments of extreme volatility.[66]

2 Unfair Access

In relation to unfair access for other traders, ASIC has concluded that co-location services are not inherently unfair, as ‘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.’[67] In particular, ASIC concluded that the transparency of pricing that market operators set for proximity and the availability for all traders to have access to these services means that no specific investor or participant has access to data before the broader market does.[68]

3 Predatory trading

ASIC also discussed investor concerns surrounding predatory trading strategies engaged in by high frequency traders.[69] Noting that these strategies would comprise market abuse under Market Integrity Rules already in existence, ASIC has noted in its role as the market regulator to investigate and enforce the law where necessary.[70]

The position that ASIC has taken with respect to predatory trading strategies is one that places heavy reliance on the efficacy of the current Market Integrity Rules to adequately regulate concerning behaviour from high frequency traders. Exemplary of this is ASIC’s approach to liquidity detection. ASIC’s analysis of liquidity has detected some examples of predatory activity,[71] and as a result traders have either modified the offending aspects of their algorithms, left the market completely or been referred to ASIC’s enforcement arm for further investigation.[72] As a result, ASIC has observed that volatility ‘declined by approximately 40% due to modification to algorithms or exit from the market.’[73]

4 Regulatory Changes

ASIC has also recently sought submissions on proposed amendments to the ASIC Market Integrity Rules with respect to high frequency trading.[74] Among ASIC’s primary concerns were the impact that small and fleeting orders have on market quality and fairness, effectively causing excess messaging and market noise. Additionally, ASIC sought to preserve the market’s integrity by preventing manipulative trading arising from the use of high frequency trading.

Resulting from the submissions sought, ASIC proposed a new rule regarding a minimum resting period for small and fleeting orders in order to reduce excessive messaging and market noise. ASIC has since abandoned this proposal, citing a measured drop in small and fleeting orders from 3.6% in the July–September quarter of 2012 to 1.6% in May 2013. ASIC has attributed this drop to the raising of market participants’ awareness as to ASIC’s concerns surrounding small and fleeting orders and the market noise it creates.[75] In light of the considerable reduction in small and fleeting orders, ASIC decided not to proceed with implementing this proposal at the present moment, instead opting to reconsider and monitor it should such orders return to problematic levels. [76]

ASIC also sought submissions on proposing additional guidance and clarity with respect to order-to-trade ratios in light of excessive messaging and market noise. In regards to this, ASIC proposed and adopted several amendments to ASIC Regulatory Guide 241: Electronic Trading.[77] This would have the practical effect of altering the considerations surrounding whether a false or misleading market has been created, taking into consideration the frequency and volume of orders and the order-to-trade ratio to determine whether a false or misleading market has been created by high frequency traders.[78]

Finally, ASIC has implemented a ‘kill-switch’ that will operate to cease trading where problematic algorithms cause excessive volatility in markets.[79] This measure has been implemented in response to the extreme volatility caused by the ‘flash crash’.

V. IS THE REGULATORY RESPONSE IN AUSTRALIA ADEQUATE?

A Comparison between Australian and US Markets

As discussed above, the US market facilitates the highest level of high frequency trading in the world with 73% of daily volume attributable to high frequency trading and the US market being considered generally as extremely friendly to high frequency trading.[80] As such, the US market is an apt model that has the factors necessary to encourage high frequency trading. Utilising the US market as a measuring stick will thus give the greatest indication of the factors that will shape the regulatory landscape in Australia.

The first key factor that facilitates high frequency traders to operate within certain markets is the level of fragmentation across different capital markets within a country.[81] With greater fragmentation in a country across its capital markets, high frequency traders are afforded greater opportunities to take advantage of pricing inefficiencies across different exchanges.[82] In comparison to the US market, which has 18 exchanges,[83] Australian equity markets have only three established exchange venues, being ASX TradeMatch, ASX PureMatch and Chi-X, the latter two having been launched in late 2011.[84] This reduced level of fragmentation may mean that the regulatory response from ASIC does not need to be as dramatic or severe as that by the SEC or ESMA.

Latency within and across markets is also a factor that high frequency traders rely upon to be able to best make trades at high speeds with minimal lag.[85] Markets across the US offer technologically advanced markets optimised for high frequency traders to move in and out of trading positions quickly and to their advantage.[86] In Australia, similar issues arise, with ASX offering ASX Net, a high-speed distribution network and ASX Liquidity Centre, which offers co-location services.[87]

Low transaction fees are also a significant factor in enabling high frequency traders to operate successfully in a given market, given the small margins generated by high frequency trading strategies. In the US, but not in Australia, liquidity providers are provided a rebate on their transaction fees across highly competitive equity markets in exchange for providing liquidity to that market, fuelling high frequency trading further.[88] With the introduction of Chi-X in Australia, the ASX has reduced its trading fee in order to compete with the cheaper pricing offered by Chi-X.[89]

Small minimum tick sizes, which are the minimum price increments at which an order must be placed for a stock, also provide high frequency traders with more increments at which to find arbitrage opportunities.[90] The average stock price in Australia is around $3, which is substantially lower than the US average of around $30.[91] This means that there are more increments on average in US stocks, giving high frequency traders more of opportunity to exploit arbitrage. High frequency trading is thus more likely to occur in high priced Australian stocks.

B Implications for the Australian Regulatory Response

From this, it is apparent that the appetite for high frequency trading in Australia is not nearly as great in the US due to the structural differences between the countries’ respective capital markets. The prevalence of high frequency trading in Australia is amongst the lowest levels in the world, estimated to be at around 15-25% daily volume in comparison to the relatively higher figures in the US and Europe, at 73% and 38% respectively.[92]

Despite this, the concerns that face regulators globally with respect to high frequency trading remain in Australia, albeit on a smaller scale. In summation, the regulatory concerns appear to materialise in the form of increased market fragmentation, predatory trading, excessive volatility and illusory liquidity. In a report commissioned by the Financial Services Council,[93] Baseline Capital conducted an empirical research into the state of high frequency trading in Australia, undertaking a statistically quantified investigation into each of the above regulatory concerns. Baseline Capital’s conclusions included the following:

• There is little evidence that the introduction of Chi-X and the ASX data centre (adding to market fragmentation and technologically enabling high frequency traders to operate) have had a marked impact on trading behaviour;

• There is little evidence of predatory high frequency trading behaviour in Australia. Predatory trading behaviour can be instead attributed to more traditional, lower frequency automated trading activity; and,

• Illusory liquidity, although not necessarily prevalent, should be discouraged and high frequency traders should instead be incentivised to provide real liquidity.[94]

Thus, according to the results of Baseline Capital’s study and ASIC’s empirical research, it is apparent that the issues which impact capital markets negatively overseas are not as prevalent in Australia. [95]

The question remains whether the regulatory response in Australia has been proportionate and adequate. Although ASIC has reservations about the excessiveness of small and fleeting orders in creating market noise, it has chosen only to address the issue if the number of small and fleeting orders returns to problematic levels. One approach that other jurisdictions have taken in order to combat excess messaging is to impose a message tax in order to penalise high message rates or high order-to-trade ratios that cause market noise. [96] This measure is one that ASIC could take in order to pro-actively tackle these issues before they do, in fact, return to problematic levels.

In order to address extreme volatility, ASIC has, as noted above,[97] implemented a ‘kill-switch’ mechanism in order to prevent the events of the ‘flash-crash’. This is in line with the regulation undertaken in the US and given it is the market most conducive to the operation of high frequency trading, this response from ASIC is most definitely a proactive step in preventing extreme volatility.

With respect to latency and high frequency traders’ ability to leverage technology in order to minimise it, it is ASIC’s position that there is no impropriety in exchanges selling co-location services as the prices offered for such services are not only offered to all investors but at transparent and economically reasonable prices, thereby advantaging no particular class of investor.[98] If ordinary investors were to invest the same resources as high frequency traders into maximising speed, they would be able to. ASIC’s position encourages an efficient and free market. Indeed, Baseline Capital’s research indicates that co-location has not impacted trading behaviour significantly and as such, this position is justified as it allows the market to reap the benefits that high frequency trading provides.[99]

The greatest concern however may be the purported predatory trading that high frequency traders engage in. According to Baseline Capital’s empirical study, little evidence is present to suggest that predatory trading exists in Australia. In any event, ASIC believes that the contemporary Market Integrity Rules in place provide sufficient protection for investors as any predatory activity would constitute an offence. In light of this, predatory trading may be an overstated concern which has not materialised much at all in Australian capital markets to date.

VI. CONCLUSION

High frequency trading has its positive and negative aspects, however it remains a developing area of law that needs to be monitored closely and responded to adequately. It remains to be seen how the respective regulatory responses will cope with another ‘flash crash.’ However, it appears that the lessons taught and learned as a result of the events of that day have spurred regulators to undertake adequate action.

The developing threat of high frequency trading has garnered a significant regulatory response from peak supervisory bodies in the EU, the USA and Australia. Particularly in Australia, this purported threat may not in fact be much of a threat at all, given the underlying structural factors which reduce the prevalence of high frequency trading in Australia. In light of these structural factors, the moderated response from ASIC in Australia has been wholly balanced and appropriate and it is important not to over-regulate high frequency trading so as to negate its benefits.


[1] See below n 36 and accompanying text.

[2] ASX, History (2014) Australian Stock Exchange <http://www.asx.com.au/about/history.htm> .

[3] Ibid.

[4] Ibid.

[5] Stock Exchange, Guide to Equity Options for Investment Managers (2010), 8.

[6] Ibid.

[7] Carole Comerton-Forde ‘Is Australia HFT-Friendly?’ (2012) 3 JASSA 12, 12.

[8] Katherine Heires, High Noon for High Frequency; Profits Are Now Measured in Microseconds. Will Regulators Tell Traders: Not so Fast? (3 August 2009) Securities Technology Monitor <http://www.securitiestechnologymonitor.com/issues/19_101/-23768-1.html?zkPrintable=true> .

[9] Tabb Group, Europe’s Paradox: Tabb Says Over 80% Of Buy Side Firms Trade In The Dark But Equally Complain About The Lack Of Transparency In The Marketplace (2 November 2010) Tabb Group <http://www.tabbgroup.com/PageDetail.aspx?PageID=16 & IteID=969> .

[10] Comerton-Forde, above n 6, 12.

[11] Ibid.

[12] Australian Stock Exchange, Algorithmic Trading and Market Access Arrangements (8 February 2010).

[13] Eugene Clark ‘The Legal Tortoise and the High Frequency Trading Hare: The Challenge for Regulators’ (2011) 25 Australian Journal of Corporate Law 274, 274.

[14] Ibid.

[15] Technical Committee of IOSCO, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (July 2011).

[16] Irene Alrdirdge, High Frequency Trading (John Wiley & Sons, 2010), 3.

[17] Clarke, above n 13, 275.

[18] Ibid, 276.

[19] Ibid.

[20] Ibid.

[21] Joel Hasbrouck and Gideon Saar, ‘Technology and Liquidity Provision: The Blurring of Traditional Provisions’ 12 Journal of Financial Markets 143, 147.

[22] Clarke, above n 13, 276.

[23] Ibid.

[24] See, eg, Jonathan Brogaard, Terrence Hendershott and Ryan Riordan, ‘High Frequency Trading and Price Discovery’ (Working Paper No 1602, European Central Bank, November 2013);
Albert J. Menkveld, ‘High Frequency Trading and the New-market Makers’ (Working Paper No 11-076/2/DSF21, Tinbergen Institute, 15 August 2011).

[25] Jonathan Brogaard, Terrence Hendershott and Ryan Riordan, ‘High Frequency Trading and Price Discovery’ (Working Paper No 1602, European Central Bank, November 2013), 3.

[26] Ibid.

[27] Stephen E Satchell, ‘An Assessment of the Social Desirability of High-frequency Trading’ (2012) 3 JASSA 7, 8.

[28] Ibid.

[29] Ibid.

[30] Jonathan Brogaard, Terrence Hendershott and Ryan Riordan,‘High frequency Trading and Price Discovery’ (Working Paper No 1602, European Central Bank, November 2013), 5.

[31] Ibid, 32.

[32] Australian Securities and Investment Commission, Dark Liquidity and High Frequency Trading, Report No 331 (2013) 80.

[33] See above n 21 and accompanying text.

[34] Australian Securities and Investment Commission, Response to Submissions on CP 202 Dark Liquidity and High-frequency Trading: Proposals, Report No 364 (2013) 23.

[35] Ibid.

[36] US Commodities and Futures Trading Commission and US Securities and Exchange Commission, Findings Regarding the Market Events of May 6, 2010, (30 September 2010), 5.

[37] Ibid.

[38] Ibid.

[39] Graham Bowley, 'Lone $4.1 Billion Sale Led to ‘flash crash’ in May', New York Times (online), 1 October 2010 <http://www.nytimes.com/2010/10/02/business/02flash.html?_r=2 & scp=1 & sq=flash+crash & st=nyt> .

[40] Sal Arnuk and Joe Saluzzi, 'Toxic Equity Trading Order Flow on Wall Street: The Real Force Behind the Explosion in Volume and Volatility', (Themis Trading LLC White Paper, 2010).

[41] Andrei Kirilenko, Albert Kyle, Mehrdad Samadi and Tugkan Tuzun, ‘The Flash Crash: The Impact of High Frequency Trading on an Electronic Market’ (Working Paper CTFC 2011).

[42] CFTC and SEC, above n 36, 32.

[43] 15 U.S.C. 78s(b)(1).

[44] 17 CFR 240.19b-4.

[45] Office of Investor Education and Advocacy, New Measures to Address Market Volatility (2012) SEC <http://www.sec.gov/investor/alerts/circuitbreakersbulletin.ht m> See, eg, NYSE rule SR-NYSE-2011-48, Amendment No. 1, <http://www1.nyse.com/nysenotices/nyse/rulefilings/pdf.action;jsessionid=EA5FEAA215A489FE69A42167F91D17B2?file_no=SR-NYSE-2011-48 & seqnum=2> .

[46] Ibid.

[47] SEC, SEC to Publish for Public Comment Proposed Rules for Clearly Erroneous Trades (2010) <http://www.sec.gov/news/press/2010/2010-104.htm> .

[48] See, eg, International Stock Exchange Rule 2128, <http://www.sec.gov/rules/sro/ise/2014/34-71806.pdf> .

[49] Nina Mehta and Gregory Mott, ‘SEC Bans Market-Maker `Stub' Quotes Blamed for Losses in May 6 Stock Crash,’ Bloomberg (online), 9 November 2010, <http://www.bloomberg.com/news/2010-11-08/sec-bans-market-maker-stub-quotes-blamed-for-losses-in-may-6-stock-crash.html> .

[50] SEC, SEC Approves New Rules Prohibiting Market Maker Stub Quotes (2010) <http://www.sec.gov/news/press/2010/2010-216.htm> .

[51] An aggregate of quotes across marketplaces processed and then disseminated by a Securities Information Processor.

[52] SEC, Speech by SEC Chairman: Opening Statement at the SEC Open Meeting – Consolidated Audit Trail, (2010) <http://www.sec.gov/news/speech/2010/spch052610mls- audit.htm> .

[53] Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC [2004] OJ L 145/1.

[54] Directive 2008/10/EC of the European Parliament and of The Council of 11 March 2008 amending Directive 2004/39/EC on markets in financial instruments, as regards the implementing powers conferred on the Commission [2008] OJ L 76/33.

[55] The European Commission, MiFID 1 – Legislation in Force (2014) <http://ec.europa.eu/internal_market/securities/isd/mifid/index_en.htm> .

[56] The European Commission, New legislative framework for markets in financial instruments published in the Official Journal (12 June 2014) <http://europa.eu/rapid/midday-express-12-06-2014.htm?locale=en> .

[57] Phillippe Guillot, ‘MiFID Debate: CA Ceuvreux’s Contribution’ Chevreux, 27 November 2009 <http://thefinanser.co.uk/files/ca-cheuvreux-on-mifid.pdf> .

[58] European Securities and Market Authority, Consultation Paper: MiFID II/MiFIR ESMA (22 May 2014) 231.

[59] Clark, above n 13, 285.

[60] Jim Brunsden ‘High-Frequency Traders Get Curbs as EU Reins In Flash Boys’ Bloomberg (online) 14 April 2014, <http://www.bloomberg.com/news/2014-04-13/high-frequency-traders-set-for-curbs-as-eu-reins-in-flash-boys.html> .

[61] See below n 81 and accompanying text.

[62] See below n 68 and accompanying text.

[63] ASIC, above n 32.

[64] Ibid, 84.

[65] ASIC, Guidance on ASIC Market Integrity Rules for Competition in Exchange Markets, RG 223, 12 August 2013.

[66] ASIC, above n 32, 18.

[67] Ibid, 88.

[68] Ibid.

[69] Ibid, 89.

[70] Ibid.

[71] Ibid, 91.

[72] Ibid.

[73] Ibid.

[74] ASIC, Dark liquidity and high frequency trading: Proposals, (2013) <http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/cp202-published-18-March-2013.pdf/$file/cp202-published-18-March-2013.pdf> .

[75] ASIC, Response to submissions on CP 202 Dark liquidity and high frequency trading: Proposals, Report No 364 (2013).

[76] ASIC, 13-142MR ASIC refines dark liquidity, high-frequency trading rules, (2013) <http://www.asic.gov.au/asic/asic.nsf/byheadline/13-142MR+ASIC+refines+dark+liquidity,+high-frequency+trading+rules?openDocument> .

[77] ASIC, Electronic Trading, RG 241, 21 August 2013.

[78] Ibid.

[79] See, eg, ASIC Market Integrity Rules (ASX) 2010, r 5.6.3.

[80] Comerton-Forde, above n 6, 12.

[81] Ibid.

[82] Ibid.

[83] U.S. Securities and Exchange Commission, Exchanges <http://www.sec.gov/divisions/marketreg/mrexchanges.shtml> .

[84] Comerton-Forde, above n 6, 12.

[85] See above n 13 and accompanying text.

[86] Comerton-Forde, above n 6, 13.

[87] Ibid.

[88] Ibid.

[89] Ibid.

[90] Ibid.

[91] Ibid.

[92] See above n 6 and accompanying text.

[93] Baseline Capital, Changing Technology in Capital Markets: A Buy Side Evaluation of HFT and Dark Trading (November 2012) <http://www.fsc.org.au/downloads/uploaded/Changing%20Technology%20in%20Capital%20Markets_2182.pdf> .

[94] Ibid, 45-46.

[95] See above n 75 and accompanying text.

[96] Baseline Capital, above n 93, 10.

[97] See above n 79 and accompanying text.

[98] See above n 67 and accompanying text.

[99] See above n 23 and accompanying text.


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