December 17, 2012

Brokers in Asia are trying to balance traditional investors and the new force of high-frequency traders to keep profits growing amid a pullback in overall trading volumes, seeking to move past a stalled debate on trading models.

They are also trying to pre-empt regulators as they seek to reconcile the sometimes conflicting interests of two sets of clients -- one of whom measures investment horizons in months and years and the other in nanoseconds.

"As a broker, we're constantly trying to find ways to pull those two disparate investment communities together," says Gabriel Butler, Asia head of electronic trading at Morgan Stanley. "That sweet spot is our focus now."

That means catering to the high-frequency firms, which offer higher volumes but yield lower margins, without alienating the traditional long-only investor base, which trades less but where margins are fatter.

High-frequency traders (HFTs) are powered by algorithm-driven computer models that instantly analyse trading patterns and can rapidly execute massive orders.

A big fear for traditional traders is that they are "gamed" by HFTs, including by methods such as bombarding an exchange or "dark pool" with thousands of quotes in a matter of milliseconds and then cancelling orders after real investors are drawn out.

Dark pools are trading venues where investors can trade away from the main exchanges. They are popular among large investors who can trade without revealing their identity or displaying prices to the general public.

To counter that fear, brokers are investing in technology and stepping up the use of algorithms that jumble and randomize orders or seek out alternative venues so that traditional investors can know their trading strategies are protected.

"The systems have to mimic what humans would do, but do it a lot faster," said Butler.

It has also meant more surveillance of orders filled and then quickly cancelled, and regular scrutiny of who is trading in their dark pools to ensure clients do not feel they are trading at a disadvantage to the HFTs.

"It's my job as someone who brings clients to the market to deal with the benefits and risks that HFT brings," said Glenn Lesko, CEO of Instinet Asia-Pacific.

"I'd say avoiding them is impossible and not even necessary. Having intelligent algorithmic capabilities is the answer."

THE QUALITY OF LIQUIDITY

The growing acceptance of HFTs reflects that in a world of shrinking leverage, fragmented markets and falling volumes, they provide much needed liquidity on trading platforms and valuable revenue for exchanges.

"It would be easy to label HFT strategies in general as either good or bad, but I believe in differentiating between HFT strategies which add useful liquidity and those that do not," said Jacqueline Loh, head of trading at Schroeders Asia.

"HFT strategies such as index arbitrage and gamma hedging provide good liquidity for long-only funds, while the more predatory HFT strategies mask the true levels of liquidity in the market," said Loh.

One HFT strategy in the cross-hairs for global regulators comprises sending large numbers of messages to exchanges in a short amount of time, which has been likened to a common technique employed by hackers to disable websites.

"I'd be quite surprised if there aren't real regulations put into place on quote-stuffing as well as excessive order cancellations," Kent Rossiter, head of trading for Asia-Pacific at Allianz Global Investors, who oversees trading for one of the largest pools of global money invested in Asian stocks.

LIGHT IN THE DARK

Authorities in Asia are working on regulations for both HFTs and dark-pool trading, keen to avoid the trading glitches and "flash crashes" elsewhere that have been attributed to the rapid rise of algorithmic trading, but there is no timeframe for when they will be finalised.

Hong Kong's Securities and Finance commission (SFC) has proposed brokers and technology providers take responsibility for orders that go through an electronic trading system. The Australian Securities and Investment Commission (ASIC) has proposed similar curbs and controls.

Partly to avoid finding themselves on the wrong side of future regulations, brokers have taken it upon themselves to ensure their trading engines are safe for all market players.

"Our surveillance is about ensuring we don't have participants that are disadvantaging other clients," says Ryan Holsheimer, head of Asian execution services for equities at Bank of America Merrill Lynch.

"The strategies probably people worry about are the ones where it is only liquidity-taking and the fill rates are low, the sort of flow that is just noisy. Those would be the strategies we would weed out from our dark pool."

(Editing by John Mair)

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