Liquidity provided by market maker trades on alternative trading venues can be a hindrance to true price discovery and may result in added transaction costs for fundamental investors, says Will Psomadelis, head of trading, Australia at Schroders Investment Management.
Psomadelis' view contrasts with commonly-held assumptions on the advantages provided by high-frequency trading (HFT), such as spread compression, a boom in liquidity and an increase in market efficiency, leading ultimately to cheaper execution costs. “While I am not directly against the introduction of a second exchange, I fail to understand how we will benefit from the maker-taker model that Chi-X is proposing when you really evaluate the true impact of artificial liquidity and artificially compressed spreads,” he adds.
The Australian Securities and Investments Commission (ASIC) recently consulted the market on its ”CP-145, Australian market structure' document as a prelude to adapting the country's financial markets regulatory framework to a multi-exchange environment after the government gave an “in principle” approval in March 2010 to Chi-X Australia's application to establish an alternative lit equities market in competition with the Australian Securities Exchange (ASX). Chi-X Australia, a subsidiary of market operator and exchange technology provider Chi-X Global, intends to offer maker-taker pricing which offers fee incentives to liquidity providers and has become synonymous with the growth of HFT in Europe and the US. The common users of HFT strategies are electronic market makers and statistical arbitrage players. In its response to the ASIC consultation, the ASX said that maker-taker fees could create “pricing inefficiencies and distortions” and as such should not be permitted in Australia.
Psomadelis believes that price discovery could be hindered by ”artificial' liquidity moving prices around on no fundamental basis as high-frequency traders interact with institutional orders. “The difference between real liquidity and market maker-induced churn is the focus. Market maker trades always have to be unwound so the artificial liquidity provided won't help institutional volumes. Tighter real spreads can only be achieved by more natural liquidity and is the function rather than the driver of a naturally liquid market. Spread compression actually adds no net benefit to the market as every time someone pays the spread, someone earns the spread.”
In CP-145, ASIC proposed a minimum size threshold for dark orders: to be exempt from publishing pre-trade quotes, an order would either have to be worth at least A$20,000 and priced within the best bid and offer across all markets or be classed as a block trade or large portfolio trade. The threshold for being classed as block trade is A$1 million for the most liquid equities and A$500,000 for other equities.
Psomadelis believes that blocks will prove the true price discovery mechanism in future and that this will protect the interests of retail investors, the end-client backbone of most institutional investors. The fact that block trades are usually driven by superannuation funds means that retail investors are necessary for block liquidity, he asserts, adding that retail investors in super funds benefit from the grey market through reducing the implicit cost of trading (leakage).
“Block trades on the grey market negotiated between two sophisticated investors are the pinnacle of the price discovery process. We are fortunate that ASIC has appreciated this point of view and endorsed large block trades, at prices even outside the current spread, as a legitimate form of execution if acting in the best interests of our clients,” Psomadelis says.
But his hopes for the development of off-exchange block trading stand in stark contrast to Psomadelis' expectations for lit exchanges dominated by HFT flow.
“If the majority of the volume in the US aggregated markets is HFT in nature, as has been estimated by TABB Group, and HFT traders are not fundamental investors, then there is a strong argument that the lit exchange has turned into nothing more than a casino and that real liquidity has moved off the exchange,” he says. “At best, the introduction of these strategies will have no impact to fundamental investors and at worst it will be harmful to returns for anyone that invests fundamentally in the market. It is for this reason that I question the support for the introduction of a competing exchange that will ultimately skew the mix of investors and subsequently stock price drivers towards technical trading algorithms and away from fundamentals.”
An increase in HFT inevitably multiplies the number off bid and offer quotes, but the fact that a lot of HFT strategies are un-invested overnight and have up to and over 100% turnover during the day means that this extra liquidity does come at a cost. Every time a market maker trades, explains Psomadelis, they need to cover their position to cut their risk so ultimately control of your order is effectively transferred to the market maker. “What we will see is more churn, not more liquidity,” he says. “The price of a stock should reflect its fundamentals, so the correlation spike we have seen over in the US points to a distorted market where that may not be the case.”
While inter-day volatility may remain unchanged, because HFT firms rarely invest overnight, intra-day volatility will increase as stocks overshoot changes in their fundamentals through momentum HFT strategies. The focus should be on improving market efficiency through more real investors undertaking the process of real capital allocation.
“I am also not arguing that HFTs should be banned,” says Psomadelis. “Rather I am saying that they shouldn't be promoted as the charity that provides a better trading environment, and its up to everyone to understand the true impact of this new form of churn that will increase in our markets soon.”