Could the Australian stock market be fitted with a “kill switch”? Reports suggest ASIC will propose that mandatory emergency brakes be fitted to high-speed, high-volume, and occasionally highly irrational High Frequency Trading (HFT) systems to prevent a United States-style “flash crash”.

So what is it, and how would it work? Crikey asked Pepperstone Trading CEO Owen Kerr for clarification …

What is high frequency trading?

“Basically, trading firms will have some sort of computer-based strategy program on computers very close to the exchange, which react to split second movements in the market. The big thing is latency; the time taken for transmission of a message to the market,” Kerr said.

“The whole idea with HFT is getting in before the other guy, so as soon as a quote comes in they will put in a bid before an average person could. So essentially you’ve got the average guy on the stock exchange competing with a super-fast computer brain.”

The complex strategical algorithms are designed not only to move fast, but in incredibly high volumes. As a result, HFT has been responsible for huge increases in the number of trades being made over the last few years. HFT trading is estimated to be responsible for up to 70% of exchange volume in the US.

Does HFT always work?

Kerr says that despite the programs being designed for maximum efficiency and optimal market outcomes, the computer based systems have a fatal flaw.

“Because these systems are all mechanical and don’t have any rational thought,  they can jump in and exacerbate any large market move. So when there’s a large selling movement, they’re all triggered at the same time; they all feed off each others’ information,” he said.

On May 6 last year, the Dow Jones plunged about 1000 points — around 9% — after a fundamental trader responded to a morning of unusually high volatility by issuing 75,000 E-Mini sell contracts. On another occasion, the time taken to execute this sell program was five hours — on May 6, after a morning of unusual market volatility, the Sell program executed all 75,000 contracts in just 20 minutes. Between 2.45pm and 3pm, the shock had temporarily wiped about US$1 trillion from Wall Street, at which time most prices were returning to normal levels. It was the second biggest intraday drop in the Dow’s history.

How much HFT practice happens in Australia?

ASIC says HFT now accounts for about 15-25% of equity market turnover in Australia. “We anticipate this figure will grow with the expected introduction in the fourth quarter of 2011 of ASX’s new data centre with enhanced co-location facilities, and the commencement of Chi-X and ASX’s PureMatch order book,” a spokesperson said.

What is a kill switch?

Essentially it’s harm minimisation when the market drops sharply. “The idea of a kill switch is to temporarily shut down the market for 10 minutes or half an hour to give it a chance to recover,” Kerr said.

What impact would a “kill switch” have?

Kill switches have been around for a long time in futures markets to stop commodities prices getting out of control. HFT in Australia is in it’s infancy, but its popularity is rapidly rising.

“Although the ASX’s technological infrastructure isn’t as advanced or as fast as in the US, the increasing popularity of HFT in Australia means ASIC’s implementation of kill switches will be a good investment for the stability of Australian security trading,” he said.

What happens to Chi-X if the “kill switch” is tripped on the ASX or vise versa?

“Most firms would have access to both markets; Chi-ex will be a shadow or secondary market, so in the case of one market being frozen, you would probably see the flow go straight over into the other,” Kerr said.

He says despite the occasional irrational blow-out of computer error, the overwhelming effect of HFT is market liquidity and thus stability: “HFT generally makes the market more liquid: The more action there is, the more it reflects the real prices.”