Black-box traders need transparency, says quant veteran

While high-frequency trading has brought efficiencies to stock markets through lower commissions and narrower spreads, the ability of some traders to cause dramatic spikes in stock performance suggests regulation and transparency around black-box investors is required.

Brian Brown, once pan-Asia head of systematic trading at Morgan Stanley in Hong Kong, says there is complete transparency around holders of stock, but none around traders of stock.

The top-10 shareholders of stocks are generally household financial names, such as Fidelity Investments, Capital Guardian, BlackRock, Vanguard and T Rowe Price. But the top 10 traders are a mystery except to well-connected market participants.

Yet the fragmentation of markets and the advent of algorithms and other forms of electronic trading mean that even Asian blue-chips such as HSBC can see their stock suffer severe intra-day spikes.

Most investors, particularly in the retail market, have no way to see this sort of thing coming and no idea what causes it. This can harm market confidence, Brown says. He draws a distinction between an investor seeing a stock affected by a buy or sell announcement by Warren Buffett, versus having a stock impacted by unknown traders.

He argues that the principle is the same; there are good reasons for requiring transparency with regard to stocks' owners, and that today, given the impact on volumes and volatility due to black-box quant funds, there should also be rules on identifying who trades a stock. Such information would at least help investors understand what kind of dynamics may drive movement in their holdings.

Moreover, if the holders of stocks are well-known companies, the top-10 traders of stocks in the US, where most high-frequency traders operate, are a who's who of industry insiders.

They are Citadel, Getco, Highbridge, Knight Group, Renaissance Technologies, SAC Capital, Susquehana, Tewksbury Capital, Two Sigma and Wedbush Morgan, according to Brown. He says the high-frequency trading funds industry in the US now has assets under management of up to $250 billion, shared among the biggest dozen funds.

Brown spoke yesterday in Hong Kong to plug his book, Chasing the Same Signals, which he wrote after leaving Morgan Stanley in 2007. He now runs Shogi Group, which has developed a model to distribute independent broker research via algorithms.

Today over 50% of turnover in US equities and nearly 40% of global turnover is derived from black-box computerised trading, which has changed the business model for broker/dealers. Computers have become better than sales traders at executing client orders and pricing the risk of baskets of securities.

This has led to slashed commissions, tighter spreads and the loss of jobs at banks. The lost income over the years has encouraged investment banks to seek profit elsewhere, including through increased use of leverage and securitising products.

Similarly, the composition of trading has changed. Ten years ago, 90% of turnover came from long-only funds. The advent of electronic trading (as well as trends such as the rise of index funds) means alternative participants dominate trading -- including a mix of hedge funds, arbitrageurs, algorithmic traders and electronic market-makers.

The typical strategy of black boxes is to identify short-term deviations in the margins between a pair or set of similar stocks (the classic case is Coke and Pepsi). By itself, this offers negligible gains, but multiplied across a universe of stock pairs and traded many times in a day, the cumulative outcome of thousands of tiny bets is powerful.

Brown says Asian markets have benefited from the rise of high-frequency trading in America. Asian markets are too fragmented and have too many barriers, such as stamp duties on transactions or regulatory restrictions, to have allowed the development of black-box trading.

But now investors in these markets are enjoying the impact of more efficient trading that flows from the US, a phenomenon Brown likens to Wal-Mart's impact on retailing.

Yet the speed and pace of black-box trading in the market needs to be better understood, by regulators, exchange officials and investors, he adds. Brown believes electronic traders need to be categorised separately from broker/dealers or hedge funds.

"There shouldn't be controls on turnover, but black-box traders should have to report their activity on a monthly or quarterly basis, just like long-only fund managers," he says. "The benefit of this to the end investor is transparency."

Investors are increasingly interested in getting allocations to high-frequency trading funds because they provide low-volatility returns uncorrelated to market beta. The difficulty is getting access, as the number of established managers is small, and many, such as Renaissance Technologies, have been closed to new investors for years.

In Asia, there are a handful of small start-ups in this field, mostly run by former prop-desk traders, but none with any capacity, and the region continues to be a challenge for high-frequency traders. The exception is Japan, where the markets offer enough liquidity and variety, and where the Tokyo Stock Exchange has recently upgraded its trading systems to accommodate high-frequency traders.

Korea is also making strides in terms of liquidity and offering co-location of buy-side servers in proximity to the stock exchange.