Do fears over algo trading add up?

That algos account for a large share of trades doesn't mean they move prices

Whether by stealth or by design, trades by algos - the new breed of investors who trade using superfast computers and complicated mathematical programs - now make up a big portion of the trading activities on the stock market.

Data furnished by the Singapore Exchange shows that on an average trading day in the second half of last year, algos were involved in as much as 34 per cent of the daily stock turnover.

A further breakdown shows roughly two-thirds of these trades performed by algos were with institutional investors, while the rest were with retail investors.

It is also interesting to note that unlike huge markets such as New York, where a big proportion of trades is executed by computers competing against other computers, direct trades between algos are relatively insignificant here - accounting for only about 4 per cent of trading activity.

In particular, some of them offer other investors an opportunity to get in and out of stocks easily with their continual bid and offer price quotes throughout the trading day.

The SGX unveiled an ultra-fast trading system seven years ago in a controversial move to attract algos to trade on the local stock market, despite misgivings expressed by many market participants here. ST FILE PHOTO

Another startling revelation is that despite complaints about a dearth of retail participation in the local stock market, such investors continued to be linked to 40 per cent of the shares traded by value on an average trading day. About half of retail investors' trades were done with fund managers, while the rest were roughly split between other retail investors and algos.

Attracting algos to trade on the local stock market was a controversial move by the Singapore Exchange's (SGX) former chief executive Magnus Bocker seven years ago, when he unveiled an ultra-fast trading system as part of his efforts to improve market liquidity.

This was despite the misgivings expressed by many market participants here over the wisdom of pushing ahead with high-speed trading when concerns had been raised about them in big financial centres such as New York where they had become a regular fixture.

Indeed, it has been a worry that has never really gone away, even as algos have become part of the local trading scene. Take a letter by reader S. Nallakaruppan to this newspaper two years ago. He expressed concern that these very large institutional investors with enormous resources and computerised trading systems can influence prices to a large extent - leaving the investing public at a huge disadvantage. His fear never materialised.

The fact that algos account for a large share of the daily trading does not mean they move prices with their trades using super-fast computers. Indeed, if they had done so, the SGX's market surveillance unit would have spotted the trading irregularity and taken action against them.

Instead, what an algo does is to react quickly to tiny price changes in either direction and not to make big bets on big price changes in any one direction - observing and arbitraging any tiny wriggles in stock prices in the hope of making a tiny profit on each trade.

Thus, some proponents of algo trading argue that since high-speed trading involves minute changes in prices, it shouldn't matter to regular investors like you and me because we tend to measure our returns in weeks, months or even years. This is unlike algo trading where a huge number of trades can be executed in the blink of an eye - and where the profit on a trade may be a mere cent or two.

Not surprisingly, the loudest complainants are the human proprietary traders - the remisiers and day traders - who are also trying to profit from continually trading huge blocks of shares and view machine trading as unwelcome competition, as even a tiny change in price may add up to a considerable sum in trading costs. What they are most aggrieved about is the clearing fee rebates offered to algos, which they say put them at a big disadvantage.

Currently, the SGX offers clearing fee rebates for two categories of traders - "market makers" and "liquidity providers".

Market makers are traders who are obliged to put up bids and offer quotes throughout the day, with spreads as narrow as three to four minimum bid sizes, on stocks priced at 50 cents or more. About 120 stocks are covered by them.

To qualify as a liquidity provider, a trader must trade more than $1 million on a particular stock a day. The stock must be priced at 20 cents or more.

A stockbroking director noted that with the SGX clearing fee rebate, an algo needs as little as 0.1 per cent in the difference of the share price to break even. But a proprietary trader may need as much as a 0.5 per cent difference in stock price to cover his costs.

He said: "It doesn't matter if the algos make money or not on their trades, so long as they don't lose more than the value of the rebate they are getting. That is why human traders feel that the cards are stacked against them."

There are other gripes. Some stock pundits contend that the interest drawn to blue chips by algo trading has intensified the misery of smaller stocks, which find it even more of a struggle to grab investors' attention.

It is a problem worldwide. In Singapore, the 30 stocks making up the Straits Times Index (STI) account for about 68.9 per cent of daily trading activity, even though there are about 770 stocks listed on the SGX.The situation is even more dire in other markets like Australia, where stocks in the S&P/ASX200 Index account for 89.9 per cent of market turnover, and Taiwan, whose Taiex component stocks make up 89.8 per cent of market turnover.

What can be done to redress the imbalance? One move proposed by the SGX is to widen the bid-offer spread for stocks with share prices between $1 and $1.99 to one cent, from 0.5 cent. That would make stocks in this price category - presumably outshone by blue chips - more attractive to human traders who may want to flip their positions as quickly as possible, but need a wider spread to cover their trading costs.

However, another question that ought to be asked is whether there is scope to relook the criteria for offering clearing fee rebates to liquidity providers.

With the exception of the STI component stocks, most other counters - especially the smaller ones - are unlikely to attract $1 million in trades a day. But that is the hurdle a trader must cross to qualify for an SGX clearing fee rebate as a liquidity provider. Is this setting the bar too high, favouring algos whose superfast computers can generate big volumes of trades in highly liquid stocks to cross the $1 million hurdle, but which show little interest in smaller-cap stocks that may find favour with proprietary traders?

Some will say this will not add up to any meaningful savings for human traders, but it will at least be a goodwill gesture showing that the system is not merely favouring a few sophisticated traders.

Like it or not, algo trading is here to stay. We just have to incentivise other market players too and make them feel they have just as important a role to play.

A version of this article appeared in the print edition of The Straits Times on March 27, 2017, with the headline 'Do fears over algo trading add up?'. Print Edition | Subscribe