The speed of light is constant, but regulation of the way it is leveraged by sharemarket high-frequency traders is not, and that is the key to understanding why Australia's regulators are watching but not panicking as their counterparts overseas hit the panic button over high-frequency trading (HFT).
New York Attorney-General Eric Schneiderman quizzed stock exchanges including the New York Stock Exchange and Nasdaq about HFT last month, and this week sent subpoenas to six high-frequency trading firms. Europe is introducing curbs on HFT that European Union financial markets commissioner Michel Barnier says will be among the strictest in the world, and on Thursday a HFT sharemarket float was postponed in the US.
The long fuse on all this action is concern that HFT and so-called dark pools - markets that trade privately without disclosing real-time price information - are making the market less fair, and more volatile (HFT is difficult to track but studies so far don't show a link to higher volatility).
The short fuse is a book by gifted financial journalist Michael Lewis, Flash Boys: A Wall Street Revolt, which explains how HFT works, and claims that it amounts to front running - an illegal practice in which brokers use their knowledge of client orders to do profitable trades themselves.
To get a handle on why HFT is putting the frighteners on US and European regulators, let's first return to that constant, the speed of light.
Light in a vacuum travels at 186,000 miles, or 300,000 kilometres, a second, or 300 kilometres per millisecond, and as optical fibre has replaced copper wire in communications systems, communication speeds have moved up towards the limit. HFT traders use powerful computers to deliver corresponding increases in the speed of buy-and-sell messages that travel on the communications network to stock, commodity and other exchanges.
A rapid blink of the human eye takes about 100 milliseconds: The New York Times calculated recently that in the US sharemarket about 1800 separate bids or offers and 600 sharemarket trades occur in the same time.
As Lewis explains in Flash Boys, high-frequency traders have the ability to beat slower traders to deals, and their advantage is magnified if there is a large network of exchanges, as there is the US, which hosts 13 public exchanges and about 45 dark pools.
Orders to buy or sell are placed in these multi-platforms in a platform-neutral way, with the aim of getting clients the best deal. Computers hunt across the platforms for the best combination of supply and price. The trading venues are all physically located in different places, however, and connected to communications networks via various detours.
A hierarchy of so-called ''latency'' - the amount of time between an order being sent - is created. It is measured in milliseconds, literally less than the blink of an eye, but if an order is not filled at the first exchange that is reached and that exchange is trading openly as all traditional exchanges do, HFT programs can detect the unfilled order and either compete with it by moving the offer price up, or sell into it immediately, ahead of slower-moving competitors.
This ability to ambush trades is what is being characterised as front running by Lewis and many commentators as the regulatory probes increase.
Whether it is, is not clear, however. Front runners know that an order is being placed because it has been placed by a client, and use the information to trade on their own behalf before the market knows that the client order exists. They are insider trading. HFT ambushes of trades that have slipped into the public domain would on the other hand appear to be cruel, but fair - comparable with trades by nimble operators that were conducted more quickly than competitors in the old, manual trading environment. The US investigations will in part test this point: whether or not exchanges and HFT traders are giving the HFT firms inside knowledge about trades before they are generally known.
America is moving belatedly on all this. HFT operator profits have fallen from about $US5 billion a year in 2009, when the first few nimble firms were making a killing, to about $1.25 billion in 2012, but HFT trade still accounts for more than half the US trading volume.
Here it accounts for about 25 per cent, and a review by the market regulator, The Australian Securities and Investments Commission, last year decided a major regulatory crackdown was not needed. The multi-platform HFT ambush does not work so well here, for one thing, because there are only two open-access platforms, the Australian Securities Exchange and Chi-X Australia, which started trading in November 2011.
In the US, exchanges were also allowed to compete for trades by offering rebates to firms that placed orders. That seeded a huge and market-distorting increase in the number of orders placed - orders that are often withdrawn after the rebate is triggered.
Here, both public exchanges charge fees for buy or sell orders. Chi-X's fee for buy orders is discounted, but ASIC would not allow either exchange to actually bid for business. It also discourages bogus orders by placing a levy on orders placed, to fund its supervision of the markets.
Australia's superior regulatory regime is partly serendipitous. HFT came here after it hit big northern-hemisphere markets. Our regulators learnt from the mistakes their overseas peers made. It's probable in fact that the US and Europe will over time move to a regulatory model that closely resembles the one we have here.
mmaiden@fairfaxmedia.com.au
