China won't be Shanghaied by HFT

The Shanghai Stock Exchange’s clampdown on high frequency trading is intended to deter speculation, and not to keep out professional trading firms with a genuine interest in capturing the Chinese market’s opportunities, says Dean Ashley Owen, China chief representative of Newedge Shanghai Representative Office.

Chinese regulators are wary of the potential systemic risks to the economy associated with high frequency trading (HFT), and hence is taking a cautious approach to allowing HFT activity in the stock and futures markets.

“The Chinese regulators need to ensure there are no systematic risks to the economy,” says Owen. “With over 1.3 million futures accounts, of which less than 5% are classified as institutional accounts, the regulators and exchanges need to make sure that retail investors are protected. The fear is that the emergence of sophisticated computer trading will come at the expense of the guy on the street.”

Owen says Chinese exchanges don’t place increasing volumes as a priority. Whereas other Asian exchanges are going out of their way to attract high frequency trading, he says the Chinese understand a certain amount of HFT can benefit the price discovery mechanism by increasing liquidity, reducing transaction costs and tightening spreads. But they want to ensure moderation.

The Shanghai Stock Exchange (SSE) published a Chinese-language report on 8 March titled “Four Categories of Speculation: The Reasons for Long-term Market Downturn and Investors’ Loss” identifying new shares speculation, small-cap stocks speculation, underperformed stocks speculation and frequent trading as problems it will target with “technique and system”.

SSE revealed it will impose new measures to counter speculation on its exchange, including imposing trading limits on high-frequency trading firms which cancel a high proportion of their orders.

Without releasing timing details, the exchange said it would impose trading limits on firms engaging in “abnormal trading behaviours” such as making orders in a large sum or at high prices, or conducting frequent false orders and withdrawals. Firms identified as consistent offenders will be branded as unqualified investors, and subject to punishment by the China Securities Regulatory Commission (CSRC).

“China does not specifically target and restrict high frequency trading,” said Owen. “The recent rule changes are specifically aimed at reducing the risk of market manipulation. The consequence has been that it makes high frequency trading very difficult.”

Toughening up 

Despite the attraction of the Chinese markets, a toughened regulatory stance on speculation on futures exchanges since late last year has only added to the existing complexities of implementing market access, trading software and network connectivity under a tightly-controlled regime.

The Zhengzhou Commodity Exchange, Shanghai Futures Exchange and Dalian Commodity Exchange separately issued rules in November to curb “abnormal” trading as commodity prices hit record highs. The measures included a cap of 500 on the number of order cancellations clients can send in a day. The exchanges will alert the CSRC if investors are found trading between their own accounts or frequently placing and cancelling orders. Investors are also disallowed from using related accounts to hold positions in a way that exceeds their individual limits.

Andy Woodhouse, managing director Asia Pacific at RTS Realtime Systems, says the Chinese regulator’s actions aren’t unique to China. Fines and control measures have been implemented in the US and other Asian exchanges in different ways.

“They don’t want to see ridiculous volatility going up without any kind of fundamental basis to it. Most of our clients understand that, and they are trying to trade faster, but not necessarily play the speed game,” says Woodhouse. “China is just trying to decrease pure speculative electronic trading. It remains welcoming of professional traders.”

Likewise, Woodhouse says markets like Hong Kong and Singapore don’t want to see “ridiculous” speculative trading. There are a lot of strategies that are more in the realm of speculative versus real trading. At times, the differences between these strategies can be somewhat vague.

“As China is maturing through the process and is coming up with their own view as to the kind of controls that they want to put in,” says Woodhouse. “But they also want to attract these investments coming in, to increase the liquidity and the diversity of investors.”

The appeal of the Chinese market arises from the new trading opportunities it offers that can be captured using smart trading ideas. This is unlike the case in developed markets where returns are dependent on speed and competition has crowded out many traditional HFT strategies. “In the last year or two, there have been diminishing returns if you’re playing a real high-speed game as markets mature. Today, traders need to trade smarter, being the fastest is becoming very expensive. That’s where we’re seeing a lot of interest,” Woodhouse added.

The measures taken by the Chinese futures exchanges caused volumes to drop significantly in 2011. Futures trading volume sank more than 30% in 2011, the first decline in five years, according to China Futures Association data.

But market participants expect futures trading volumes to pick up this year. The Dalian Commodity Exchange recently obtained approval for their fill-or-kill and fill-and-kill orders to be excluded from the 500-order-cancellations limit, a sign that regulators remain interested in the potential of the HFT client segment.