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Introduction by Professor Richard Dunford, Associate Dean (International & External Relations), UNSW Business School

Welcome ladies and gentlemen. I think we will get underway. Thank you for joining us for this month's Learn@Lunch which is our bite sized lecture series featuring UNSW's leading academics. My name's Professor Richard Dunford, an associate dean in the business school and it's our great pleasure to see you here today.

Before I get started, I'd like to take this moment to acknowledge the Cadigal people of your nation, the traditional custodians of this land and pay my respects to their elders, past and present. In the 70 years since UNSW was founded, we've continued to refine and grow our commitment to providing lifelong learning opportunities to university alumni and friends, so we're delighted to have you here, join us for one of our events today.

I'd also like to thank those in attendance from our Scientia Circle Programme, that is our supporters who enable UNSW to advance knowledge through research and education by giving in their wills. Just a few housekeeping matters before I introduce our speaker. Please be aware that today's session will be recorded and it'll be available for podcasting via the UNSW alumni website. Please have your mobile phones switched to silent and finally bathrooms. Bathrooms are out the door to the right and there'll be staff out there on hand to direct you.

Now onto the critical element of what's about to happen, the speaker introduction. Professor Carole Comerton-Forde is professor of finance at UNSW's School of Banking & Finance. Her research is in the area of market structure with a focus on market liquidity and market integrity. Her current interests include the impact of high frequency trading and dark pools on market quality. Carole's acted as a consultant for a number of stock exchanges and market regulators around the world. She's currently an economic consultant for the Australian Securities and Investments Commission. Please join me in welcoming Professor Carole Comerton-Forde.

2:38 | Learn@Lunch presentation by Professor Carole Comerton-Forde

Thank you Richard. Hello everyone. Thank you for coming today. Modern securities markets. So I have been studying financial markets for over 20 years and it's an area that continues to fascinate me. Over the last 20 years the two most fundamental changes in markets have related to technology change and regulatory change, in particular trying to promote competition between markets.

Those two things have fundamentally changed the way markets work and in many ways have made markets more complex, and I think a lot of the reporting in the media often makes things sound more complex than it needs to be and people are left with views of markets which are more myth than reality. So today what I wanted to try to do was to try and dispel some of those myths and help you get a greater insight into how markets work today, what the changes are and why those things are not necessarily a bad thing.

I wanted to start just with a quick poll, so I'll get you to raise your hand in answer to a couple of issues to get a sense of what people think about the current markets. First question, dark pools allow people to trade without anyone else knowing. If you think that that's true, put your hand up. If you think a dark pool allows people to trade without anyone else in the market knowing about that? Okay, a few people.

High frequency traders front-run orders from other investors. Put your hand up if you believe that. Okay, a strong number believe that. And finally short selling allows prices to be manipulated and should be banned. Put your hand up if you agree with that statement. Okay, good.

So people were in support of these points and that's not surprising given some of the headlines that we read in the paper. I've just done a quick review of some of the headlines out of the Financial Review over the last few years and I'm not surprised you have the views you do. Things like, "Trouble brews as dark pools proliferate." "Brokers see problems in dark pools." "ASIC looks into dirty dark pools." "ASIC confronts a trading monster." "'HFT crackdown needed,'" fund says." "High frequency trading damaging the markets." And finally, "Behind the rise of short selling," and "ASIC crackdown on short selling."

So it's unsurprising people have very negative views about these aspects of markets. What I wanted to do today is, first I'll start out by talking about what are the objectives of markets? Why do we have equity markets? What function do they play in the world? I'll talk very briefly about the evolution of markets, so how have things changed over the last couple of decades? And then I want to help you get a better understanding of those three issues, so dark pools, high frequency trading and short selling.

When I was asked to do this talk and we wrote the little blurb that you read to market this event, I thought they were the three topics I wanted to cover and then as I came to prepare the talk, I realised I'd maybe been a bit ambitious in how much I would be able to get through. I maybe should have only picked two topics but we'll see how I go. And then finally I'll give a bit of a wrap up.

The objective of security markets is essentially, there's three key things that markets should be achieving and regulators should be thinking about when they're setting regulation in markets. Firstly capital allocation, so how do investors and companies get access to capital? We want to have a market that makes it possible for companies that have good projects that they need funds to invest in, to be able to access those capital at a reasonable cost and that that process happens fairly efficiently.

We also want markets to be liquid, meaning that it's easy for investors to buy into and sell out of positions in companies. Or another way of thinking about liquidity is, "Can I trade a large amount of stock with a relatively little price impact or little cost?" That would be a liquid market.

Then finally markets should provide price discovery, meaning that they should allow investors to discover the price of the stock so that assets are correctly valued. So that we find the right price and that we do that in a fairly efficient manner without too much volatility in prices. Essentially all of my research is about studying how the design of markets, so the structure of markets impacts those three objectives. And as I said regulators and policy makers should be thinking about those objectives when they're regulating the market.

Okay so the old days, this is what stock markets used to look like. This is a picture of the ASX trading floor back in the old days. The Australian market was actually one of the first markets in the world to automate, so we went electronic starting in 1987 and by 1991 all of the equity markets in Australia were completely electronic. So this trading floor is now Fitness First down on Bond Street.

But if you think about how the markets worked in those days, so we have a bunch of traders standing around the floor. You'll notice that they're exclusively men, not that much has changed. They're standing around, putting out buy and sell offers for a stock. This guy up on the platform is called a chalky so he's making a record of what the price of the stock is. And the process of trading takes place on the floor.

If you think about the days of the trading floor, obviously the people standing on the trading floor have a really big advantage over everyone away from the trading floor. So only the people on the floor are really observing prices in very quick time. They're observing the trades up on the chalkboard. Obviously it takes time to disseminate that information out to the market away from the floor.

This is the ASX today. This is the Australian Liquidity Centre, which is the ASX's data centre which is located over in Gore Hill on the other side of the harbour. So this is where all of the ASX trading technology is. It's the machine that matches up buy and sell orders in the market. It's also possible, just as in the days of the trading floor where traders could be co-located with the market, participants in the market can now be co-located with the exchange. So some of those machines are also the machines of the participants in the market and obviously they have an advantage, they're very close to the market.

Those people who are not co-located, it takes a little bit longer for their orders to come to the market but if you think about that speed differential, it's on a much more compressed time horizon than in the days of the trading floor. The Australian market, like most markets around the world, is now a competitive equity market so ASX is not the only company providing trading services in Australia.

As of October 2011, there's a company called Chi-X, offers a competing exchange in Australia so we have multiple trading venues. So ASX has their marketplace. They actually run two different order books, one that's lit and one that's dark and I'll talk in a moment about what the difference is between those. The ASX's dark pool is called ASX Centre Point and that started about a year before the Chi-X market began operating. There's also 15 broker-operated dark pools that are registered with ASIC and all of the trading in Australia is governed by the ASIC Market Integrity Rules.

That sounds like it's very complicated. It sounds like trading's all over the place but technology allows the market to be consolidated virtually. This is a picture of a trading screen that comes from IRIS. IRIS is a listed business in Australia, a financial technology company. They provide a trading platform for many participants in the market, both brokers and institutions to observe the market and interact with the market. And we also use this technology in the classroom to help students understand about how markets work.

Just to give you a very big picture of what we're seeing on this trading screen, the screen's divided into two areas. The left hand side is the order book, so all of the trading interest, everyone who wants to buy and sell the stock. And on the right hand side of the screen is the course of sales, so all trades that have been done today in the market. Well in fact what you can see on the screen is actually just six seconds worth of trading but if you scroll down the page you could see all of the trades that happened today.

What we see in the order book is we can see on this side is all of the people wanting to buy the stock. On this side is all the people wanting to sell the stock. So we're currently looking at the Commonwealth Bank. The best price is $79.77 to buy, and to sell at $79.78. So you can see there's a lot of people wanting to transact in this stock. That difference in the two best prices there is called the bid-ask spread so the difference between the best buying and the best selling price and that represents the cost of trading immediately.

So if you're a buyer you could put your order in at $79.77 and you would have to sit in the order book behind these two existing orders that are already there and wait for them to trade first. If you wanted to trade right away, you could submit a buy order at $79.78 and your order would get traded right away.

Okay, so you can see the market is very transparent. We see a huge amount of information about what's going on in the market. You can see this first column here is DS which is the data source, which is telling us where these orders are coming from. This first price point where there's two orders, they're both on TradeMatch, which is the ASX's trading system. The second best price, you can see it says mix, that means it's actually orders both on the ASX's trading system and Chi-X's trading system. Brokers will send orders to the market and can choose which venue they want to transact with.

Hopefully that gives you a picture of the information that we typically see around markets today and how the price has evolved. So obviously over time we see these prices changed, that's the price discovery process. As the demand and supply for stock interacts, the prices will evolve. The amount of orders in the order book tells us something about the liquidity in the stock, so how many people are wanting to buy, how many people are wanting to sell tells us how easy it will be to transact.

We might learn, if we were to see a lot more buying orders than we see selling orders, that might give us an indication that the price of the stock is likely to rise in the short term. That's what an electronic trading screen looks like. What is a dark pool?

A number of you, not too many, put up your hand and said you thought dark pools, when a trade occurred, no one in the market knew about them. That's a common myth. Some people also think dark pools allow insiders to trade without being detected. Some people think dark pools are unregulated. None of these things are true but none of it is helped by the term dark pool. You can't help but think there's something wrong when something is called a dark pool.

What does that really mean? The term dark basically refers to the fact that the orders or the market does not have any pre-trade transparency. So all of the information that we saw on the left hand side of the screen, all of the buy and sell orders in the market, in the dark pool we don't see any of that information. So we don't see anything pre-trade. When a trade takes place it gets reported immediately and you'd see it on the right hand side of that trading screen.

Dark executions or dark trades can take a number of different forms. You can have a trade on a crossing system or a dark pool, so in Australia colloquially people talk about dark pools, in the regulations they're actually referred to as crossing systems, so meaning venues that are matching up orders. That's one possibility. We could have a broker operated dark pool where essentially they're collecting all the orders from their clients and matching them up and when those trades match up, they report them to the market and everyone knows about them.

ASX operates a dark pool. Again where their orders are not being displayed in the market but when orders are matched, they're immediately reported to the market. We also have the possibility of a hidden order on the exchange. So I mentioned Chi-X. They don't operate a dark pool but what they do is allow people to submit hidden orders into the exchange order book, so the trading screen you saw before, it's possible that there's other orders that are in the book but they're not visible to the market, but they are available to be executed if someone sends an order to the market at the right price.

The last type of dark execution is a block trade, so a very large trade and that typically takes place either over the phone or it can happen electronically as well or via a dark pool. As I said, all of these trades executed in broker operated dark pools or executed via a sales trader over the phone, they have to be immediately reported to either the ASX or to Chi-X. So the market knows about them very quickly.

Typically dark venues or dark executions rely on the lit market for the pricing. For example in Australia for a dark trade to occur it has to occur within the bid and ask prices that are displayed in the market. So in the example we looked at before where the price was $78.77, $78 ... let me remember what it was ... $79.77 and $79.78 a dark pool trade must occur within those prices. So this trade we see up here at $79,77 and a half cents, that's a trade that's occurred on Centre Point and it's occurring at the middle of the two prices that are available in the market. So it's sharing the benefit of the price improvement between the buyer and the seller.

Essentially I should have remembered that I anticipated wanting to show that to you rather than going back, here you can see ... this is not literally what people see but to give you an illustration of what we're thinking about, essentially a dark pool is reporting to us the trades but not showing anything about the order book. And so what we see over on the right hand side of the trade now is actually the first five most recent trades were all done in the dark. The first two were done on Centre Point with the trade code CX and the next two were done in broker dark pools with the NXXT code. So there's lots of information being provided to participants in the market and it's still contributing to the price discovery process because we observe the trades very quickly.

Are dark pools new? The media reports that they appear to be new and that they are somewhat scary. Well the reality is dark pools are not new, they've always existed but we haven't previously labelled them dark pools. If you think back to the picture of the trading floor, dark trading could happen then as well. Essentially the floor traders, so the brokers standing on the floor, they could keep their orders in their pockets, they don't verbalise the orders that they have received from their customers. Essentially those are dark orders until they communicate the order to the market, the order is dark.

Another type of dark trading which has always existed is referred to as the upstairs market. Even in the days of the trading floor, very large trades didn't get negotiated on the floor, they got negotiated upstairs, so in the brokers' offices. So if you're wanting to trade a very large amount of stock, that would happen on the phone and would simply get reported to the floor after the fact. The same thing now happens with block trades in the electronic market, they get negotiated away from the market and then appear on the tape after the trade has been done.

So you might ask, "Why would a regulator allow these dark trades to happen? Why don't they force everyone to be fully transparent about what they want to trade?" Well essentially dark pools around facilitating trading for institutions. So institutions typically want to trade large lines of stock. Think about the typical super fund or index fund, they might want to trade a million dollars or 10 million dollars and you think back to that order book I showed you, the size of the orders in the market were very small. There was only $10,000 available to buy at the first price, about $200,000 at the next price. If I want to buy 10 million dollars’ worth of stock, if I were to put that order into the market, you'd basically wipe out the whole market and move the price very substantially.

We don't want that to happen. We want to promote mechanisms where institutions can trade large amounts of stock without leaking information to the market. So without signalling their intention because if I'm a large buyer coming into the market and I signal to you I want to buy a lot of stock, how are you going to respond? If you're smart you're going to move the price up because you know I want to buy and you know I have to buy, so why not make me pay more?

That's not the way we want markets to work. We want the price to be set in a reasonable way and to minimise the impact of large trading in the market. So that's essentially the purpose of dark trading and it's a critical feature of markets all around the world, always has been and I think always will be. But it is important that it's effectively regulated.

Some of the concerns that regulators express about dark pools are that if you have too many dark pools, you fragment liquidity across many venues. So I told you we have two stock exchanges. We've got ASX Centre Point and we've got 15 broker dark pools. So there's close to 20 venues in which liquidity is fragmented across. In only two of those venues can we actually see what liquidity is available so that makes the trading process much more complex. Technology helps but it doesn't totally solve the problem.

There's also issues around fairness. ASIC introduced some regulatory change back in 2013 which solved this problem but in the old days you could trade in the dark at the best bid and ask price. And so what that would mean is people would have their orders displayed in the market, they would observe trades getting done at the price at which they were willing to buy or sell but their orders weren't getting filled. That seems somewhat unfair in the sense that I'm advertising my liquidity, I'm telling you I'm willing to trade and yet someone who's not doing that is able to step in front of my order.

So ASIC solved that problem by requiring that process of trading with price improvement. So trading within the spread, having to offer a little bit better price in order to get your trade done in the dark.

Some of the other potential negatives are around what impact does it have on liquidity? So the spread in the market. The difference between the best buying and selling price. How much order depth is displayed in the market? If I can trade without displaying information, it perhaps discourages people from displaying their orders. So we don't want there to be too much trading shifting to the dark or it may potentially impact on the liquidity and also the price discovery in the market.

This just gives you a snapshot of what the overall trading on the Australian market looks like. Although we have competition, the ASX is by and large still the dominant player in the market so they account for about 65% of trading on their order book. Chi-X captures about 9% on their order book. The ASX dark pool is the largest dark pool in the market, it accounts for about 7% of trading and then what's left over is these two pieces, which are trades that are immediately reported to ASX or Chi-X after they've either been executed in a broker dark pool or via a broker sales trader with a block trade.

There's a bunch of academic work on dark pools that tells us that they do serve an important purpose in markets. Most of the academic literature thinks about traders in a very stylized way, so we think about traders who are informed, so people who know something about the stock and are good at anticipating what the future price of the stock will be. And traders who are uninformed, so don't really know anything about prices but they have liquidity needs and so they'll trade for reasons unrelated to price. So I want to buy a new car so I'm going to have to sell some stock in the market to get that liquidity.

What the literature tells us is that informed traders need to trade quickly. Trading on a dark pool can take much longer. The risk of not executing is higher and so informed traders tend not to trade in dark pools, they tend to trade on the exchange. Uninformed investors, so those who just want to trade, are not particularly informed about prices but have liquidity needs, they're more likely to trade in the dark pools. What that means is information gets concentrated on exchanges and that should contribute to and help the price discovery process.

That's the theory. We've done some work looking at the Australian market and for the most part that supports that theory. So we find that dark orders are less informed than lit orders. More dark trading concentrates information on the lit market. Quotes, so the bid and ask prices that we observe in the order book become more informative than the trades themselves.

Dark trading is a good thing for the market except when we have very high levels of dark trading, then it potentially starts to negatively affect the spread and the risk of trading with someone more informed than you. So ASIC's requirement to trade within the spreads contributed to solving that issue.

High frequency trading. Before talking about high frequency trading, I think it's helpful to think first about algorithmic trading. High frequency trading is a subset of algo trading and essentially algo trading is simply a method of executing trades via a computer programme in a systematic way. So you have pre-defined logic and rules around when and how you're going to trade.

One example of a commonly used algorithm is an algorithm used by an institution to simply break up their very large order to send small pieces to the market over a period of time to disguise the fact that they're a large trader and make them look more like a small trader. Interestingly algorithmic trading has become so prolific in markets that when you observe large trades on the ASX trading screen, it tends to be retail investors rather than institutional investors, because the institutions are so good at slicing up their trades. So algo trading is ubiquitous in equity markets.

So again lots of myths around high frequency trading. There's an unfair speed advantage. And think back to the story I told about the trading floor versus the automated environment and the difference in the speed advantage today versus when we had trading floors. It's front-running so they're trading ahead of clients. High frequency traders typically don't have any clients. They're trading on their own using their own capital.

High frequency trading's manipulative, it causes volatility. They add no value because they're not longterm investors. There's lots of participants in financial markets that are not longterm investors. If markets only comprised of people who were buying stock and holding it for the long term, you would never be able to sell out of your stock. There'd be no liquidity in the market. So we actually want markets that have a ecosystem of different types of traders with different types of strategies who all want to interact with each other because that will provide liquidity to the market and allow people to move in and out of the stock.

High frequency trading was probably at its frenzied best when Michael Lewis wrote his book Flash Boys back in 2014. I note that that's a fictional work but many people viewed it as very factual and that it should inform regulation. Anyone who's very interested, I would suggest they read a book by Peter Kovac who is a high frequency trader or was a high frequency trader in the US, who wrote a factual book. He basically mirrored Michael Lewis's narrative but presented the facts. I'm sure you've never heard of that book, it's called Flash Boys: Not So Fast. It's a very dry book but it does give you an accurate view of how high frequency trading works in the US market.

So what is high frequency trading? One of the reasons why there's confusion about high frequency trading is that there's no universal definition of what it is. High frequency trading is not a single trading strategy. What it is is any strategy that relies on speed so being able to access the market quickly, being co-located and then using algorithms to generate, route and execute orders in markets. So high frequency traders are basically characterised by sending large numbers of orders to the market, lots of amendments, lots of cancellations, taking very small positions and turning over positions very quickly for very small margins.

So they have very short holding periods. They might only be in the market for a few seconds or a few minutes. Typically, though not always, they don't hold positions overnight. So they never appear on a company share register. They're trading within the day and exiting the stock before the end of the day.

One common type of high frequency trading strategy is a electronic market maker. So someone who is continuously willing to buy and sell the stock throughout the day in small size but doesn't at the end of the day want to hold the stock, they're simply providing very short term liquidity to other people who want to trade the stock very quickly. All high frequency trading is algo trading but not all algo trading is high frequency.

High frequency trading peaked in about 2010 so this is just a summary of across markets around the world, how much high frequency trading there was at its peak. So clearly the US market had a high frequency trading problem. They accounted for more than half of the trading in the market. That's probably not a great thing. Even though high frequency traders do provide a function in markets which I'll talk about. Australia, the level of high frequency trading has always been a bit lower for reasons which I will talk about.

So essentially the things that make a market attractive to high frequency traders are firstly having high speed technology. Electronic trading platforms, as they've evolved over time have been more focused on providing fast access to the markets. That's attractive to high frequency traders. Having fragmentation, so having many different venues makes the market more attractive to high frequency traders because it gives them opportunities to look for pricing differentials across markets and to exploit those differences for profit. The benefit of that to the rest of the market is that any pricing and efficiencies across different trading venues quite quickly get arbitraged away.

If you think back to the slide I just had up on the screen, Asia and Brazil had very low levels of high frequency trading, that's because almost all of the markets in Asia except for Japan and the Brazilian market, there is no competition for exchange services. There's a single exchange in each country so those markets are much less attractive to high frequency traders.

You also need competitive pricing from the exchanges, so low cost. In the US market, high frequency traders actually can get paid a rebate by the exchange, so get paid to trade on the market. That's not allowed in Australia and that's one of the reasons why the level of high frequency trading is much lower.

Markets that are more liquid will attract more high frequency traders because they need to be able to move in and out of stocks quickly in order to make money. And small tick sizes, so small differences between the price at which you can send orders to the market and small trade sizes are also very attractive for high frequency traders.

In Australia we have fast trading systems. We've got some fragmentation but not super fragmentation. The exchange pricing is low but no rebates are allowed. The liquid end of the market, so the ASX 200 and stocks at the large end of the market are pretty liquid. And the tick sizes are for the most part relatively small and trade sizes are relatively small. So the Australian market is somewhat friendly to high frequency traders but not as friendly as the US, for example. So the regulatory framework has helped keep that balance right.

ASIC has done a bunch of work looking at high frequency trading. Issued a series of very detailed reports trying to understand what high frequency traders do, how they trade, how they impact the market. The way they do that is to look for accounts that display characteristics of high frequency traders. So they can't identify a trader is certainly a high frequency trader but what they can do is identify traders that exhibit characteristics that are consistent with high frequency trading.

And when they do that, what they've been able to show is that the number of high frequency traders in Australia is relatively small, so they only account for about half a percent of all of the accounts trading in the Australian market, but they account for a pretty big fraction of trading. So they're about 25% of the dollar value traded and about 27% of all trades that go through the market. Given that they're using trading strategies which involve sending very large numbers of orders to the market, and the reason for that is because they want to be able to manage their risk at very high frequency, so quickly adjust the prices at which they're willing to trade so they're sending many orders to the market. They account for about 45% of all of the orders that come into the market.

This picture on the right shows the time series of the fraction of dollar volume traded in the Australian market by high frequency traders. Broken out into quartiles for the ASX 200. So quartile one, the black line is the most liquid stocks in the ASX 200 through to quartile four is the least liquid in the ASX 200. And then the paler blue line is stocks ranked about 200 to 300 in the Australian market. So you can see that high frequency trading has peaked and is on its way down. The market is very competitive. It's harder for high frequency traders to be generating profits and so we've seen a little bit of a downturn in how much trading they do. You can see though, over time they've crept into the less liquid stock. So they're looking for opportunities outside market.

I'll skip over the profitability and just talk briefly about ... again there's a huge amount of academic literature studying high frequency trading and how it has impacted the market. And overall the story is pretty positive. I won't run through all these details. This is a piece of survey work done by a Dutch academic, Albert Menkveld, who essentially looked at all of the academic work and formed a view on what's the overall impact of this on the market? And so his summary is, "I believe economic benefits outweigh costs. Electronic markets and high frequency traders arrived and coincidentally transactions cost to client for investors. So institutional investors can now trade more cheaply in the market."

He says, "This suggests the identified economic benefits of high frequency traders outweigh their economic costs. Market quality might be further improved by exchange redesigned to stimulate the economic benefits of HFT and reduce their costs." So net net, his take away is this is not something for people to be concerned about in the markets.

So I correctly predicted that three topics was indeed too many and I should've stuck with two but I'll just give you a very quick flavour of short selling and from memory I think short selling was the thing that people disliked, or had most negative views about. Most people put their hands up that short selling should be banned. And short sellers are often seen as the villain in financial markets, so it's un-Australian. It destroys good companies. It's criminal.

Again in fact these myths are not correct. So short selling is essentially selling something that you do not own. Why would you do that? If you think a stock is over valued but you don't own it, you can't exploit that. So short selling means that you can sell a stock that you believe to be over valued, you're anticipating the price will go down so your profit from selling a stock, being correct about the price going down and then buying it back.

Regulations in most countries since the financial crisis have required short sellers to borrow the stock, so if you believe a stock is over valued and you want to short sell, you have to find an investor who owns that stock and is willing to lend it to you. And you'll pay a fee to borrow that stock. Index funds are common investors that will lend their stock to other investors to borrow.

Short selling is much riskier than buying a stock because the potential losses are unlimited. The price can continue to go up forever whereas if you own a stock, the price can only go to zero. So as a result short sellers are typically required to post a margin, so to provide a protection in case they are misinformed about the stock and the stock price does continue to rise.

So a short seller's profit is the difference between the sale price and the purchase price, less any fees he pays for borrowing and any margins he has to post if the price moves against him. Prior to the financial crisis naked short selling was common so you didn't have to borrow the stock. That was a problem because it meant essentially there was an unlimited number of people that could sell stock. With the borrowing requirement short selling is now much less problematic in markets.

Short selling is surprisingly much more common than you might have anticipated. We've got the most comprehensive short selling regulations in the world. We get two types of reporting on short sales, first we observe what's the position being held by short sellers? So short interest. How much shorting is there on company stocks? And on average that's approximately 3% of the ASX 200 stocks. There's much more activity in short selling, so almost 20% of trading activity during the trading day is short selling.

So what does the academic evidence tell us about short sellers? Well essentially on average short sellers seem to be pretty good investors. They tend to be informed. They tend to buy stocks when they are over valued so if you were to sell a portfolio of stocks that were heavily shorted and buy stocks that were lightly shorted, you would generate a return of about 15% per annum. So these guys are pretty good at predicting the prices and as a result they help keep prices efficient so they move prices towards a more efficient price.

Some of the other evidence tells us that short sellers can be very valuable liquidity suppliers, so they tend to be contrarian in very short horizons. If the price has gone up, short sellers will come into the market. When bid-ask spreads are very wide, it's more likely short sellers will be in the market reducing the cost of trading. Liquidity demanding shorts, so those that are trading aggressively trade when the spreads are very narrow and they tend to follow very short term price to clients.

So overall what all of this evidence tells us is if we were to constrain short selling ... so during the financial crisis when there were bans on short selling ... we introduced an upward buyer centre stock prices, so if prices are not efficient, they will be more highly valued than they should be.

To wrap up, hopefully I've at least provided you with some things to think about, even if you are not convinced by the evidence that I've presented. But dark pools, high frequency traders and short sellers are all very important features of modern markets. There needs to be appropriate regulation but when there is appropriate regulation around each of those types of trading, they're going to contribute to those three core objectives that we want of having a market that helps provide good capital allocation, provides liquidity and also improves the price discovery in the market.

Thank you.


46:10 | Q+A

Prof. Richard D:       Okay well look I was expecting a lot of questions. The organisers decided there should be a moderator and that's me. As much as possible, can you ask a question rather than make comments just to try and maximise how many questions we can get in the approximately sort of 12, 13 minutes we've got? You were very quick off the mark so we'll start here.

Speaker 3:               My question relates to transparency. Right at the beginning you were showing the ASX data and so on. That's not the sort of thing that I can read if it comes into the net and so I'd rely upon CommSec, ANZ E-Trade's data. Now what I've found in a number of cases such as PKI and even Wilson's Group and various other people, that there is a difference and sometimes a substantial difference between what is in CommSec and E-Trading and with what is being reported. And when I've tackled these people and the HEMs and so on, the directors have said the directors are right, not CommSec and not E-Trading. What's the truth of the situation?

Prof. Carole CF:      Okay so good question. The regulations in Australia mean that data that comes from markets becomes free after 20 minutes, so if you don't pay for any trading data from an exchange, then what you observe on say Yahoo Finance or on the ASX website, that's 20 minutes old. If you're a customer of a broker like CommSec, they will be providing you with a real time data feed so you're observing on the trading screen in real time the information as it's taking place on the exchange.

                                 In a very high speed world ASX actually has two different data products. So they'll sell one feed that's super, super fast for a very high cost and another feed that's a little bit slower for a lower cost. And the brokers in the market can choose which feed they want to pay for. The time differential is ... you're talking in milliseconds, so less than a second. So you as someone who's buying stock and making decisions, presumably for the longterm rather than being a high frequency trader and wanting to move in and out very quickly, whether you observe a price now or one second old isn't making a lot of difference to you.

                                So the information you're seeing on the screen is correct and it's accurate. It's not up to the millisecond but it's very accurate and reliable information and should be adequate for making longterm investment choices.

Prof. Richard D:       Okay a question right at the back, in the middle yeah.

Speaker 4:               Hi. Just the question about the feed that you were just answering, is there information in a feed that is available for people who have co-located their computer closer to the exchange? Say algorithmic-type people. As opposed to other people who haven't co-located their computer? Because you use the word co-located high speed computer. So that's the questions.

                                And the other one is just about you mentioned short selling and how great it is. Are these short sellers leveraging their capital or just using their own capital?

Prof. Carole CF:      Okay so I'll start with the speed issue. Someone who's co-located, they're obviously there ... it takes time for an order to move from one location to another right across the cables. So if you're co-located that means that that time is going to be very much reduced. The feed that you get coming out of the exchange, as I said there's two different feeds and they're identical except for how quickly you're observing the information. So you're not getting any additional insights by getting the faster feed, you're just getting it a few milliseconds faster. So the information is essentially the same information.

                                 The issue of speed differentials. Everyone who's co-located experiences identical speed. So if you think back to that picture I showed you of the ASX Liquidity Centre, some machines are obviously further away from others, than others are within the co-location facility. Well ASX actually lays the same cable length regardless whether your machine is here or up at you, right? So everyone who's co-located has identical speed experience. If you're not co-located, obviously that's going to be lower but again if you're not a high frequency trader these speed differentials should not make a difference to your investment strategies.

                                 On the short selling question. The problem with asking two questions at once is I can't remember the second one, so ...

Speaker 4:               Leveraging the capital.

Prof. Carole CF:      Ah, leveraging the capital. You mean are they borrowing in order to short sell?

Speaker 4:               Yes you have that data you're collecting. How many are using just their ... say they have $100 and then you go $100 long or they can go, say $50 long and $50 short and be mutual. Or they have $100, go long and then lever up position to be $20 short?

Prof. Carole CF:       You could be levering to go long and you could be levering to go short, that's really a decision for your broker to decide on what capital you have to post in order to take a position, so even with no leverage you're going to have to post margin calls. You'll have to post some collateral with the broker to cover the risk associated with the position you've taken. If you're levered the broker's going to require even more collateral so it's going to cost you more.

                                There are constraints just from a cost of doing business perspective that will constrain an investor's capacity to lever in those situations.

Speaker 5:               Thank you very much. You mentioned at the very start in the last few decades the big changes have been technology and regulation. It's forecast within the next decade that superannuation moneys will be 50% of the share market and of course continue to grow. Now my question is what effect do you think that will have on for example mainly pricing as being a big future issue for share markets?

Prof. Carole CF:       Yeah so they were the two biggest issues from a global perspective. You're absolutely right superannuation in Australia, both looking backwards has had a huge impact on the market. The amount of money in superannuation in Australia exceeds the market capitalization of the ASX and as you point out that's going to continue to grow even more rapidly as people continue to contribute to super and as the fraction of your income that you need to contribute to super goes up.

                                That creates a number of issues. One, it means as individuals you need to take responsibility for your superannuation and how it's being invested. And using institutional investors to manage that for you obviously can help a lot. Since the financial crisis there's been huge pressure on costs. So as returns have come down people are much more focused on how much does it cost me to use an institutional manager, and as a result we've seen a big shift into index or passive investing.

                                So rather than institutions stock picking, they simply track the index. That combined with the point you've made about the superannuation money rising means that there is a lot of upward pressure on prices. In the long term and we've already started to see it, superannuation funds in Australia need to be looking globally to invest. As Australians we can't have all of our money invested in die ASX or in Australian fixed income products or in Australian retail, so I think we're going to se more and more internationalisation of that Australian superannuation business as funds need to look externally to find good investment opportunities.

Speaker 5:               Do you think that whole thing might become a bit less transparent than it is now with large superannuation companies perhaps exerting more private control over where they put their money or is that not going to be an issue?

Prof. Carole CF:      I think there's already a relatively high degree of transparency in terms of asset allocation. The level of transparency in terms of the nature of the investments in Australia is relatively low. So in the US funds are required to report on a quarterly basis what their holdings are. In Australia we don't have any visibility over that. I think that would be a positive thing if we did but I think that's unrelated to the issue of superannuation growth.

                                 I think independent of any growth in super, I think it is useful to have reporting of holdings so that people understand what are the drivers of changes going on in a company share register? How is that affecting your investment returns and so on? For those that want to understand that. For people that want to be a little less hands-on in terms of understanding their superannuation investment returns, we simply need visibility on what are the returns? What are the costs? So what's my return after cost? I think it would be useful if we had a lot more focus on your returns after cost, that would help investors be more informed about their decision making.

Speaker 6:               With regards to short selling in the Australian context, is there any evidence that short sellers get involved directly or indirectly with off-market manoeuvres to pressure price down?

Prof. Carole CF:      When you say off-market manoeuvres, you mean simply trading in block size?

Speaker 6:               No, getting reports written. Publicising issues.

Prof. Carole CF:      You're talking about activist investors?

Speaker 6:               Yes.

Prof. Carole CF:      So certainly someone who's taken a short position could very well publish the research that they've undertaken in order to inform the market about the view they have taken. And all of the provisions around the Corporations Act and not providing misleading information to the market and so on would apply to those investors. You're not allowed, whether you're a long investor or a short investor, you're not allowed to misrepresent information about a company and that would apply to those activist investors.

Speaker 6:               Even if that information is published in another jurisdiction?

Prof. Carole CF:       Yeah. If they're going to take in research and they've published that information they need to be held to account in terms of if that information misrepresents the market. Then that's not acceptable. The company might not like the information that's presented and that's a different matter but it has to be defensible. They have to have valid information supporting the information that they're putting out to the rest of the market.

Prof. Richard D:       Okay we have a question right at the back.

Speaker 7:               Hello I have two questions, just a quick one. The first one is about the consistency of a number of buyers and number of sellers across different trading platforms. Sometimes people say on CommSec there are a certain number but then on the ANZ E-Trade it's different. Why is that?

                                 And second question is about how protected the non-high frequency traders are if these people try to fish up the price or wipe the price down?

Prof. Carole CF:      If there's differences in information across the different brokers platforms, it's simply a function of the speed of their technology because the information coming from the exchanges is the same. As I mentioned there's two different data feeds. If one's buying the fast feed and one's buying the slow feed then there will be very small differences. But the information is the same and consistent. There's no one getting a better feed or a worse feed depending on who the broker is. Again you've asked two questions that I've forgotten the second one.

Speaker 7:               How protected the non-HTF people are?

Prof. Carole CF:      HFT? Yeah. Okay so you saw that there's two different markets. They might be displaying different prices. The rules in Australia are different from some other markets. Institutional investors can choose to send their order to the market that they think is going to give them the best outcome. So for example let's say Chi-X had an order for 100 shares at a slightly better price and ASX had a order for 10,000 shares at one cent worse price. The institutional investor can choose to send the order to ASX if they want to get 10,000 shares filled rather than 100.

                                So the investor is in control of those decisions. Usually it's the investor's broker that's actually making those decisions and the technology will be making those decisions but investors have the capacity to make those choices. Retail investors in Australia, your brokers are obligated to always get you the best price. So if Chi-X is displaying a better price than ASX they must send the order to Chi-X. If ASX is displaying a better price they must send the order to that market.

                                 That's good from the price protection point of view of the retail investors. It's also a good thing from the, are you protected from high frequency traders point of view. In the US market the rules are all orders must go to the market with the best price, so if the Nasdaq is displaying a better price for one share compared to the New York market that's got 10,000 shares, the order must go and trade against the one share first. So that means that if that order is from a high frequency trader, they're guaranteed to get traded even if they're offering very little liquidity.

                                So the US markets provide much greater protection to the high frequency trader than the Australian market does and that's one of the reasons why when I talked about the friendliness of the market to high frequency traders, the Australian market is much less high frequency friendly.

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