PIERPONT How high-frequency trading chisels genuine investors PUBLISHED: 7 HOURS 53 MINUTES AGO | UPDATE: 3 HOURS 16 MINUTES AGO SHARE LINKS:email inShare 1 print-font+fontReprints & permissions The largest crime in sharemarkets, which happens every day, is front-running. It is never prosecuted because it’s almost impossible to prove in a court of law. Photo: AFP PIERPONT Local funds ignore disclosures about dark pools When chaps at the Croesus Club first began chatting about high-frequency trading and dark pools, Pierpont thought he knew what they meant. The highest frequency trading your correspondent ever saw was back in 1969 in the high days of Ken McMahon’s Mineral Securities Australia. The traders in Minsec were capable of buying a million shares in a penny stock on any given day, which was huge volume in the days when transactions were recorded by hand, and share registries comprised bits of paper. Such was the repute of Minsec that their buying would drive the price higher as punters scrambled to follow them into the selected stock. Then Minsec would sell and make profits. Their trading was so rapid that sometimes, the trader by the window would start selling before the trader by the door had finished buying. And as for dark pools, Pierpont assumed they were the home of Creature from the Black Lagoon – a movie about a monster which was living peaceably in an Amazonian swamp until it was attacked by research scientists. It killed them all except for a well-endowed young lady whom it abducted, presumably for a bit of research on its own account. The girl escaped after being abducted twice but the creature lived on for a couple of sequels. Anyhow, that was the state of Pierpont’s knowledge until he read Flash Boys, the latest book by Michael Lewis. Along with Tom Wolfe, Pierpont rates Michael as the world’s best living author. His books are invariably well researched and well written, and shed new light on whatever subject he touches. And he really understands high-frequency traders (HFTs) and dark pools. One second is the time it takes for Mrs Pierpont to start delivering a free character reading of your correspondent when he returns from a long lunch at the Croesus Club, and Pierpont always regarded this is as the minimum measurable span. He was wrong. Modern science has now given us the millisecond, which is one-thousandth of a second; the microsecond (one millionth); and the nanosecond (one billionth). Nanoseconds are still largely theoretical as far as markets are concerned, but the first two are not, because they are the time zones in which HFTs work. FRONT-RUNNING IS NEVER PROSECUTED Flash Boys is all about the way HFTs distorted American equity markets, making billions of dollars at the expense of ordinary investors. The largest crime in sharemarkets, which happens every day, is front-running. Front-running is buying or selling ahead of a client. It is never prosecuted because it’s almost impossible to prove in a court of law – even before a judge who actually understands finance. Let’s say the Australian office of a big Wall Street bank gets an order to buy a million BHPs. At the start of trading, the proprietary traders in the local office buy 100,000 BHPs on the house account. Then they unleash the order for the million shares which head office wants to buy. As the foreign order drives the price higher, the local office sells its 100,000 and shows a profit for the day. HFTs are front-runners and arbitrageurs. Because all the trading is done at ultra-high speed, no human does the trading. What the humans do is program the computers with algorithms and the computers do the trading. In the US, the operator of an HFT would typically blanket the market with buy and sell orders for 100 shares for nearly every company on the board. Those small orders (the practical minimum in the US) put the HFTs at the front of the buying and selling queue. HFTS MAKE BILLIONS OF DOLLARS A YEAR Let’s say Procter & Gamble is quoted on the screen at $US80.50 bid and $US80.52 offered. Then an investor wanted to sell 10,000 and the shares were offered at $US80.51. An HFT enters the market and chips away at the order, buying 131 shares, then 189. But elsewhere in the market, the HFT is selling the same parcels at $US80.52. The HFT profits by the arbitrage while the investor loses. The genuine trader has been chiselled for a cent or even a fraction of a cent, but if HFTs do that on every trade, every day, they can make big profits. On one calculation, HFTs made a billion dollars a year from the US sharemarket alone. Michael quotes Virtu Financial, one of the largest US HFTs, which publicly boasted in early 2013 that in 5½ years of trading it had experienced just one day when it lost money. That loss was said to be caused by human error. “Aha!” Pierpont can hear readers saying. “But while an HFT might have been at the head of the buying queue, some of the buyers behind it might have been genuine, and so the order could have been filled.” Maybe, but that’s where the dark pools come into play. Dark pools, in their primitive form, have been around a long time. Every time a broker crosses an order in-house by matching one client’s buying order with another’s selling order, that could be called a dark pool. The result used to be reported on a public stock exchange, however. DARK POOLS NATURAL HABITATS OF HFTS Dark pools are essentially off-market stock exchanges. A US client who orders a broker to buy 10,000 Procter & Gamble at market will usually have no idea where the order will be executed. At their peak around 2013 there were 45 dark pools operating in the USA. Those dark pools were the natural habitat of HFTs, just as the Dark Lagoon was the natural habitat of the creature. And any client whose broker routed his order through a dark pool had much the same experience as the maiden who was abducted by the creature. Dark pools in the USA are often run by banks or brokers. Their internal rules are undisclosed. Only the person who runs the dark pool knows whose buy and sell orders are allowed inside. In theory, if a customer asks his broker to buy Procter & Gamble, the broker is supposed to find the best price. If the best price is on the NYSE, the broker is not supposed to do the trade through his own dark pool, where it was quite possible the broker’s own traders were trading against the customer. Or that the HFTs there would fleece the client for a cent or two. The big Wall Street banks controlled 70 per cent of all sharemarket orders and all of them tended to rout the orders through their own dark pools before putting them on the open market – if they ever got that far. An ordinary citizen whose order is routed through a dark pool is not 100 per cent certain to be ripped off, but it increases his risk, just as swimming in the Ord River increases his risk of meeting a hungry crocodile. Now arbitraging is a legitimate activity in markets which can smooth little differentials which arise if the London price of BHP is out of whack with the Sydney price. But HFTs arbitrage differentials they themselves have created. The names of HFTs never appear on share registers because they arbitrage in tiny amounts and end every day with their book flat. The liquidity they add to markets is therefore spurious. One of the most important roles of any stock exchange is to raise capital for companies. HFTs make big money for themselves but never contribute a cent to capital raisings. HFTs could be put out of business tomorrow. All that is required is for a $5 fee to be charged on every share transaction in Australia (except for dividend reinvestment plans). That wouldn’t bother any legitimate buyer of shares but would knock out the HFTs which typically trade in very small orders. GOVERNMENT SHOULD IMPOSE TAX But the operators of dark pools and public exchanges won’t charge such a fee because the HFTs pay them for access. The operators effectively are collecting money from HFTs in return for allowing them to front-run legitimate investors. The federal government could impose a tax which would achieve the same objective but there’s no indication anyone in government is interested. Michael said that for HFTs the dark pools were “like a broken slot machine in the casino that pays off every time”. It would keep paying off until someone said something about it; but no one who played the slot machine had any interest in pointing out that it was broken. “Some large amount of what Wall Street had done with technology had been done simply so that someone inside the financial markets would know something that the outside world did not,” Michael said. In his view, the US sharemarket had become a class system, in which the haves paid for nanoseconds which gave them a perfect view of the market while the have-nots had no idea that nanoseconds had value and never saw the market at all. Flash Boys gives the background to the establishment of a new exchange called IEX, which has been set up to handle HFT trades fairly and transparently. IEX is still small by US standards but is gathering strength from institutions which are tired of being ripped off by the big banks. ANDREW ROBB BE WARNED However, the big boys on Wall Street have a long record of regarding their customers as prey and getting around any laws that are inconvenient. All this is rather relevant because Australia is in the process of negotiating the Trade in Services Agreement (TISA), with the reported intention of deregulating our financial markets by allowing foreign banks greater freedom to operate here. Pierpont is reluctant to lecture such an intelligent trade minister as Andrew Robb, but what TISA is proposing is exactly what sparked the Keating recession of 1990-92. At Pierpont’s last count, there were 17 dark pools in Australia (ASIC calls them “crossing systems”), most of them run by the foreign banks which Lewis attacks in Flash Boys. ASIC claims that these pools account for a much lower proportion of trades than those in the USA and that its regulations have them well under control. The current TISA draft contains a provision that disputes in our financial industry should be settled by a non-Australian outside arbitrator. This would be a highly dangerous provision. Australian banking and stock exchanges are pretty well regulated already compared with those overseas. That regulation was the fundamental reason why Australia escaped the worst of the global financial crisis, and Pierpont hopes Andrew is aware of the peril of abandoning it. There may have been only one creature in the Amazonian Black Lagoon, but they’re rife in the dark pools. Pip! Pip! Pierpont www.pierpont.com.au
