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Dialled In: Dark Pools And HFT


Australian Securities and Investment Commission’s (ASIC), Senior Executive Leader, Markets & Participant Supervision, Greg Yanco, discusses dark pools and HFT, on a recent GlobalTrading conference call, with market participants Matt Saul, Head of Trading Asia ex. Japan at Fidelity Investment Managers, Rob Liable, Division Director at Macquarie, and Nathan Lewis, Sales Trader at CLSA.
Greg Yanco 1Greg Yanco, ASIC: The one part of dark liquidity where I think we are still concerned regards the impact of too much business going into the dark, to the point where it might impact the quality of the lit market. However, we have recently made the rule to require meaningful price improvement in the dark, which we think will arrest the drift of a lot of business into the dark or reverse the trend. We have seen some promising data from Canada where they already have this rule in place. So the dark liquidity task force we have established is looking at the impact of both of those developments on the quality and integrity of the market. We have undertaken a thematic review of dark pools and high frequency trading. A thematic review is a term that for a regulator means we are looking for misconduct as well as looking at the market quality issues.
So, with the dark pools, one of our concerns was about the impact on market quality. We have found research suggesting that we are already seeing some impact, but I believe that the proposal regarding meaningful price improvement will address that. We are still looking at the concept of a minimum order size in dark pools. I think that will come out again in our consultation. Tick size is an interesting area, as there are a number of stocks always used as examples where it’s said that the tick size is too big. Really the key is if the spread is too big people don’t want to jump over, so they trade in the dark within the spread. So we are looking at other markets, looking at different tick sizes. We are also finding a lack of transparency in dark pools; there is a lot of high frequency trading in there, but it isn’t described as high frequency trading. We have been looking at whether there should be obligations requiring transparency about what is in a dark pool. I did a presentation recently in Singapore with some of our findings. We are seeing some predatory trading but the dynamic here is that the buy-side clients are pretty big, and they have taken an active interest in their brokers’ other clients, as in what high frequency traders they have got in the dark pools.
On high frequency trading generally I think the brokers here are alert to the fact that the high frequency clients aren’t always their best clients, so they have been very responsive to our enquiries about some of the unwelcome behaviour that we have seen. There are not that many high frequency traders that are large enough to cause problems, so we are really dealing with that using our existing powers. We might look at some of the guidance around manipulation but we think that the tools we have got are sufficient. We are sending a few matters through to enforcement, so most of these have been about disorderly conduct. We are also looking at what we can do about noisy small orders. I don’t think we will eliminate them, but we may do something to actively discourage very small orders.
Nathan LewisRob and Nathan, are you finding the same as well with your buyside clients coming in and asking about your other clients and asking about that HFT data?
Nathan Lewis, CLSA:
Our traditional clientele is the big long-only fund, as we are an agency-only broker without the hedge fund focus in the past. So yes, the guys who are looking down into our crossing engine want to know who is in it, and we don’t have any HFT or aggregators inside, because that’s what suits our clientele best [laughter].
Rob Laible, Macquarie Bank: We do not have HFT clients in general, or aggregators inside our dark pool either. In general, clients want the flexibility to control who they trade against – principal risk or agency. I am just wondering, when you talk about dark pools and them potentially affecting the quality of the lit market, what’s your observation around the overall volume that is done off exchange? Has that been pretty much flat and are dark pools taking some of that liquidity from the upstairs market or is something else happening?
Greg: Well there are two things, one is that last point you made is correct. But the upstairs trades are getting smaller and being executed using broker algorithms in dark pools and on the lit market as well, which is another issue. Another thing we found is that a lot of the disruption that we hear the buy-side is concerned about is actually caused by other similar buy-side algorithms. But the second part of the thing about the market share of dark liquidity is the lit market, even though overall I think there has been a reduction, conditions have been bad, there has been increase in electronic trading on lit markets. So if high frequency trading wasn’t in the lit market, I think if it didn’t exist there would be a much bigger appearance of growth in the dark pools. But what we have seen is growth in dark pools taking business from the lit market, but also from the upstairs market.
Matt SaulMatt Saul, Fidelity Investments Management: Just to that point, did you query why people want to use the dark, and in terms of just rather than trying to force people out of the dark, understanding why people are in the dark and then looking to tackle some of those issues? Because, I mean these products and these demands didn’t spring up for no reason.
Greg: Well, I think there are a number of things happening, one is brokers being enterprising. Another is I think broker algorithms are directing business to the dark. We are looking more at that because we have seen a very good example in our market where a whole lot of buy-side business is being done in the dark, and then immediately being replicated in the lit markets. And the replication is being done at a couple of basis points profit. So the question remains who is causing those dark trades? There are also people saying that they are not happy with the high frequency trading in the lit market. Of course there is always a reason for dark liquidity, participants say that they don’t want to expose themselves to the lit market and flag their intentions. All their trades are big enough that they would cause lots of market impact in the lit market and they are better off being done in the dark. Now that last bit is what we encourage, some of the other stuff concerns us so we are alert to the argument that you want to trade in the dark because you don’t like what’s happening in the lit market.
But then in the dark market we are seeing a lot of those conditions that people say they don’t like in the lit.
Matt: Yeah, that’s good. Well as an additional to that, I think there would be a lot of comfort if you are tackling concerns in the dark, and that’s probably well and good, but this was done in conjunction with some measures to try and improve the quality of the lit market. We have been having discussions with the ASX about providing net settlement data and net market share data, things like that. Just to improve some information; the lit market has become the last place you want to go if you have to.
Greg: Well I work around the individual high frequency traders that exhibit what you would call unwelcome behaviour. Our focus there has been successful in eliminating some behaviour with the help of the participants. We are not saying at all that high frequency trading is bad for the market, what we are saying is there is two things happening, one is that there has been some unwelcome behaviour that we have dealt with, but what we have really found is a lot of the behaviour that’s complained about is actually buy-side algorithms on the other side as well. So a bit of this is about the market being made aware of the nature of the market itself. There are algorithms being used by everyone. The shape of the buy-side algos is not dissimilar to the shape of the high frequency traders, they are just a little bit faster. In one slide of the aforementioned presentation that shows the number of orders in the market, 20 of the high frequency traders, who do about 80% of the HFT business, generate about 45% of orders: the rest of the orders are being produced by the other part of the market, their volume is close to 55%.
That’s an awful lot of orders and it is buy-side algorithms, and a lot of them are run by brokers.
Matt: The discussions I have had with some of my peers as well, the way the structure of the market has evolved in the last couple of years is why, and whether it’s the participants or the changes to the structure, that’s why people have moved away from it. They will adapt their behaviours once the new regs come in, but I don’t think it changes what people see is the problem with the lit. I know everyone says that spreads are narrower, but spreads on the stocks being one or two cents, for only one or two shares doesn’t make the market.
Greg: Well, that’s not our measure. Spread is not ours, ours is depth; particularly in the smaller stocks. So those numbers; the HFT accounts are a tiny proportion of the percent of the accounts in the market, about 28% of turnover and about 45% of all the book changes.
Rob LaibleHow do you see ASIC as a global regulator?
I learnt a lot of my business in the US, and what I could say is that when regulatory changes occurred, there was a huge ripple effect in the underlying market microstructure and operating models. People that were technologically sophisticated and able to move quickly and really spent the time going through the requirements were able to create an advantage for themselves. The market got so far ahead of the regulators each time one of these major initiatives took place. Speaking for myself, I would say that ASIC seems to be very deliberative and consultative and that’s always a good thing because the best surprise is no surprise. You don’t want to be disruptive to a market, that’s for sure.
Nathan: I have spent a vast majority of my time trying not to talk to ASIC but I do know that our compliance team head has been on numerous steering committees with ASIC on these topics and has always found them useful and commercial.
Rob: Greg was mentioning before the dark pool taskforce and possible registration; in Hong Kong they have a Type7, and it’s a fairly rigorous process you have to follow including things like questionnaires and face to face meetings and follow-ups, and a fair amount of due diligence. I think that a lot of what your operating model is technically then becomes on record. Then if something does occur there is a blueprint on file that the regulator can pull out and make sure that you’ve got some best practice policies. I think as someone who has spent pretty much an entire career broking and using innovative technology, you would like to be able to see some consistency across the regulatory environment because you don’t want to create a whole new kind of order designation, risk limits and governance and all the other stuff for each individual market. You would love to see consistency so you only write the code once, instead of 10 times for the various markets in Asia for instance. So if there is more collaboration between the regulators in Asia, I think that would be great.
Is there an appetite for global regulatory push?
Well it’s already here. We are strong proponents of IOSCO, we adhere to the IOSCO principles of securities regulation and a lot of our policy thinking is based on the IOSCO principles. For example the direct electronic access principles help form our views about what we are going to do on high frequency trading. With the recent changes we have done within that framework, the other rules about the participants are based around the principles for regulation of market intermediaries. It is the same on the market side, my colleague in the Financial Market Infrastructure Group is on the committee that looks at exchange regulatory principles. So we are already there in that space.
I think we have a fairly robust regulatory environment at the moment and with the high frequency traders, a lot of the behaviour that was unwelcome we have been able to use existing powers to deal with. Otherwise we think the market is efficient and one where people can invest with confidence.
On the funding for regulators, what are your thoughts on how to pay for what the regulators need?
Well, I think everybody understands that you need good risk management controls. As I mentioned before, what you would like to do is see as much consistency as possible. I think everybody along the food chain has some responsibility and you don’t want to just dump it all on the brokers because they are perceived to have unlimited deep pockets. That’s just not true, particularly in this environment. So I do think everybody has responsibility and I think the focus really should be on individual bad behaviour as opposed to trying to root out a particular kind of category of trading.
For instance, I remember when program trading had this “black eye” associated with it and people didn’t understand what program trading was! There was index arbitrage, there was sector rebalances, there was monetisation of cash flows, but during a crash in the US everybody just attacked it. I think we need to be a little bit careful about how we describe high frequency trading because it tends to be a catchall phrase. Certainly if you could look back at the innovation of the industry from a specialist with an order book making the market, that’s not so efficient.
So of course you want to automate that process. Automated market making is different from the kind of predatory spoofing and techniques that could be used within a high frequency trading strategy. I would like to see the regulators really focus on the bad apples if you will, and not try to over-regulate a particular kind of trading without distinguishing between the two.


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