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The rise of computer trading on the ASX – mum and dad investors getting burned

Thursday, August 23, 2012
The Australian Securities Exchange is seen by many as one of the most transparent markets in the world, a place where everyone is informed at the same time and where investors big and small can trade shares on equal terms.

The ASX says of itself and its own standards, “By providing systems, processes and services needed for a fair, orderly and transparent market, ASX inspires confidence in the markets.”

 


Unfortunately, the recent emergence of computer based trading has meant that the market is no longer fair, orderly or transparent and therefore confidence in the market is at an all-time low.

These trading houses are making vast sums of money, and the mum and dad investors, who are the ‘lifeblood” of our exchange, are being severely disadvantaged.

In Australia, it is believed that computer based trading accounts for up to 30 per cent of the total volume on the ASX, and in the micro-cap/ mid-cap area of the market it may be as much as 50 per cent of all trading volume.

Computer based trading is not a new phenomenon, it has been in existence in the United States and other international markets for some years, but we have only seen the emergence of this type of trading on the ASX in the past 12 months.

In essence, there are two types of computer based trading platforms, Algorithmic trading and High Frequency Trading (HFT).

Both are managed by very complex computer programs that have no interest in the core drivers of investment decisions, such as a company’s assets, its management, or its prospects, but only the ability to generate profit from trading.

Algorithms create masses of small orders which can be observed being traded in certain patterns throughout the day and are used to acquire, or dispose of, large parcels of shares in a manner so as to not affect the market in those shares.

Here is where it becomes an issue. HFT participants also use algorithms to firstly detect another algorithm trying to orderly dispose or acquire shares, then preys on the large order it has found which is being executed into the market.

The HFT algorithm will then begin to place orders into the market that are in front of the original algorithm, forcing the original algorithm to buy at higher and higher prices.

Meanwhile, the HFT algorithm has been buying shares ahead of the original algorithm and then selling them at a higher price all the while using the original algorithm to drive the price into its favour.

This sets the original buyer at a disadvantage as it has created an unfair and false market. The same situation can occur while pushing the price of the stock downwards.

HFT algorithms react very fast to these orders.

They ‘flashes’ their offers and bids into the market in milliseconds so that they are almost impossible to transact except via other HFT orders.

When they come against each other or find each other acting in unison, there is no manual over-ride.

Recently this was seen in the US where Knight Capital lost US$440 million and is also what is believed to have caused the 2010 flash crash when the US market dropped 1000 points and then recovered within minutes.

Billions of dollars were wiped out, gone, investments destroyed, retirement funds wrecked, lives altered. Sounds like something from a horror movie doesn’t it?

But where it really begins to turn nasty is when two or more HFT algorithms all begin to work against one another resulting in the share price being forced in a more extreme manner - either up or down.

In unfavourable economic times, when normal market investors are thinner than usual, the direction is then more than likely to be in the downwards direction.

Which companies are most affected? High volume, mining companies who make up almost half of those listed on the ASX (950 out of 2200 ASX-listed companies) are particularly vulnerable.

Some would say this is the market in action, and liquidity is being created.

The problem is genuine participants are being used as cannon fodder. Institutional brokers are also being impacted, having to depend on HFT at micro commissions which offset their ability to run a traditional equities brokerage.

The winner is the professional trading houses and in a zero sum game like the bad market we are in retail investors are potentially the big losers - they can't operate as fast and don't have the huge computer power available and straight to market execution systems that these guys have.

Up to 50 per cent of trading in smaller ASX-listed companies is being done by computers with no interest in the company, its assets, its people or its prospects, and at a speed far superior to any human trade.

If an operator manually entered HFT-type trades, they would be penalised for manipulative trading – why should there be one rule for man and another for machines programed by man?

David Tasker

National Director, Investor Relations – Professional Public Relations

david.tasker@ppr.com.au

 

 


This article first appeared in The West Australian