Home' Policy Magazine : Policy Vol 31 - No 4 Contents 14 POLICY • Vol. 31 No. 4 • Summer 2015-2016
HIGH FREQUENCY TRADING: FACT AND FICTION
and are enforced accordingly, although it should be
noted that market integrity breaches are a very small
proportion of ASIC’s enforcement actions.
Some trading strategies employing HFT aim to
detect and trade ahead of large institutional orders,
potentially increasing trade execution costs for large
institutions like fund managers, a cost that could
then be passed on to retail investors. This practice
is sometimes misleadingly called ‘front-running.’
‘Front-running’ has a legal and regulatory meaning
and refers to the practice of trading ahead of
client orders or on the basis of client information.
Trading on the basis of public information using
order detection algorithms is entirely legitimate
and should be distinguished from practices which
involve trading on the basis of client information.
Since HFT firms do not have clients, they cannot
trade based on client information and engage in
Order protection rules in central limit order
books are designed to protect financial markets
from abusive behaviour. Large block trades on the
part of institutions are often executed in limited
display venues (so-called ‘dark pools’) rather than
‘lit’ markets, with a view to preventing movements
in price due to large block trades and to protect
them from HFT strategies. Fund managers can
themselves use algorithms to detect noise created
by HFT and informed trading. To the extent that
HFT trades against temporary price changes of the
type likely to be associated with large block trades, it
lowers institutional transaction costs, to the benefit
of retail savers and investors.
26 The use of dark pools
and the internalisation of retail orders to ‘protect’
them from HFT may in fact increase costs to retail
and other investors.
There is some evidence of HFT firms trading
ahead of non-HFT participants in the Australian
equity market, increasing limit order transaction
costs for the latter due to an increase in execution
shortfall, at least based on one unpublished study.
However, this is more of a distributional issue and is
not necessarily inconsistent with the view that HFT
lowers overall transaction costs over time. The long-
term decline in institutional trading costs in the US
equity market, which is characterised by a large HFT
share of total market turnover, is indicative of the
overall reduction in transaction costs attributable to
HFT. In weighing the costs and benefits of HFT,
it is important to distinguish between static costs
to individual markets participants and long-run
dynamic gains to the market as a whole due to
declining transaction costs.
Is HFT unfair?
Market participants and regulators seek to ensure
that markets are procedurally fair in the sense
of providing equal treatment and equality of
opportunity. However, financial markets are not
intended to provide fairness in terms of equality
of outcomes. In the context of a well-regulated
market, HFT is procedurally fair, but may result in
unequal outcomes for different market participants.
In particular, HFT firms may profit at the expense
of other market participants. As Angel and
McCabe note, HFT ‘does no more to perpetuate
the inherent unfairness – in the sense of equality of
outcomes – of life than many other features of our
Because HFT is more efficient
in supplying liquidity, it is likely to win market
share from other less efficient financial market
intermediaries in a competitive market.
The desire for speed in trade execution is
fundamental to financial markets and part of what
keeps them informationally efficient. Michael
Lewis’s book Flash Boys popularised the notion that
the US stock market is rigged by HFT at a cost
to retail investors. However, his book presents no
evidence that such ‘rigging’ takes place. As Peter
Kovac notes, ‘Lewis’ allegations of an omnipresent
front-running scheme rest almost entirely upon
three anecdotes and three hypothetical examples...
His entire theory is based solely upon the fact that
the market showed a new price after a large trade.’
Lewis missed the real story, namely, the benefits to
retail investors from the rise of ‘a diverse multitude
of firms constantly competing to offer better prices’
at the expense of traditional equity broker-dealers.
Michael Lewis’s book Flash Boys
popularised the notion that the US stock
market is rigged by HFT at a cost to
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