High frequency trading toxic effect on equities market

New research from the University of Sydney Business School contends that high frequency share is having a toxic effect on Australia financial markets, confirming the disquiet experienced by many investors and regulators. The research says that high frequency trading favours ‘predatory strategies that queue-jump institutional and retail investors’ and has driven up transaction costs for ordinary investors relative to high frequency traders.

‘High-frequency traders gain from their speed advantage at the expense of slower institutional and retail traders, and this advantage primarily comes from dealing on advanced information not available to all investors’, says a report issued by researchers Dr Amy Kwan and Dr Richard Philip on their study. ‘This behaviour, known as front running, is seen by many investors as predatory.’ Dr Philip was himself a high frequency trader who says he ‘saw the light and returned from the dark side’ to undertake academic research.

Those in favour of high frequency trading say it facilitates the efficient implementation of legitimate transactions and trading strategies, provides extra market liquidity and also acts as automatic market makers and results in tighter spreads and increased volumes. Academic studies to date have suggested it improves overall market quality.

Describing high frequency trading as ‘one of the most significant changes to market structure in recent years, as it capitalises on faster response times than slower traders when new information arrives in the market,’ the researchers, however, express concern that it may ultimately discourage participation by genuine investors and borrowers.

The also express concern about the economic advantages experienced by dark pools, noting that ‘abuses may appear in the form of private dark pools, where brokers trade against their own clients or the rise of grey markets, where partial information is withheld from certain clients but not others’. The report states that dark pools are often operated by investment banks and broker-dealer firms and facilitate trading in equities outside of the established public exchange mechanism. The venues were set up to allow investors to buy and sell large parcels of shares without having news of their orders move the price.

However, Dr Kwan and Philip are concerned by the lack of transparency of dark pools compared to stock exchanges as well as by the fact that they are favoured by financial institutions and brokers who are able to make anonymous trades without the same level of public scrutiny as the exchanges.

The researchers acknowledge that Australian regulators have taken steps to ensure that securities are traded on a level playing field but express concern about the long-term effect that high frequency trading might have on the evolution of the market.

The report on the study can be found here.

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