not sure if this has been posted before, it's a few months old...

not sure if this has been posted before, it's a few months old but very relevant

Murky dangers in dark pools
August 25, 2012
Richard Livingston

Imagine you're doing the grocery shopping. A glance at your Woolies iPhone app suggests you're out of Weet-Bix, priced at $5.49 a box. So you wander over to the cereal aisle to grab one.

By the time you get there, a funny thing has happened. The price is now $5.50. Still, it's only 1¢ - no point worrying about such a small amount. You put the box in your trolley and move on.

What you don't know is that a bunch of computer geeks have developed a system to track your iPhone activity. Once they saw you check the Weet-Bix price on your phone, they quickly bought a box from Woolies for the price you saw and relisted it at $5.50.

If such a system existed, it would be called ''high-frequency shopping''. The geeks invest a small fortune in the computer system and pay big bucks to Woolies for the licence to operate it on the premises. Both parties insist a ''free market'' should allow the practice and, anyway, they're improving Weet-Bix liquidity. Everyone's a winner!

I'm not convinced. All I know is that I'm paying 1¢ more for my Weet-Bix than I need to.

Woolies, of course, wouldn't allow it because if it did, many customers would shop at Coles.

For the Australian Securities Exchange, there is no Coles, which is why it allows high-frequency trading, which is the sharemarket equivalent of clipping the ticket on our hypothetical Weet-Bix buy.

Every market trade is now subject to being clipped by a ''speed of light'' computer (owned by a hedge fund or investment bank) hooked into the ASX system that can see your trade coming and get in beforehand, knowing your price. In the old days, it was called front-running.

Zero-sum game

High-frequency trading (HFT) delivers slivers of profit on millions of trades while the ASX charges juicy fees for super-fast access to the systems that make it work. The whole thing would be ridiculous were it not so dangerous.

HFT now accounts for more than 70 per cent of all trades on the NYSE and is said to have been the source of the 2010 Flash Crash. This, though, is not the biggest issue. That the money these traders make comes from your super fund and portfolio is. High-frequency trading is a zero-sum game played against you, the blindfolded investor.

With so much money at stake, you would think the ASX and the traders would have a few arguments that might withstand cursory inspection. Instead, they're laughably weak: liquidity and efficiency are the usual justifications and the ''free market'' is their stake on the moral high ground. True liquidity comes from bringing more stock or cash to the market over time. HFT brings volume but a time horizon measured in nanoseconds. That's not improving liquidity.

The high-frequency traders are standing between trades that would have occurred anyway.

The free-market argument is also rubbish. Retail investors (and issuers) aren't free to opt out of being on the losing side of the trade. Most don't even know how they're getting ripped off. Investors are also regulated into trading on the ASX. It compels them to trade on its market and then argues for a free market when it and its buddies have their hands in investors' pockets.

ASX chief executive Elmer Funke Kupper has warned of the ''dangers in changing the market structure'', and he's right.

The ''dark pools'' where shares are traded beyond the reach of the ASX put its revenues at risk. These are the investing equivalent of the competing supermarket. People use them to avoid getting ripped off.

As for the efficiency argument, we can live without pricing shares by the nanosecond. It's certainly not worth the cost of allowing HFT traders to front-run in order to get it.

Unfortunately, we can't just ban HFT without a tidal wave of rent-seeking, bogus arguments.

We could avoid all that, using the ASX's own free-market pontification, by asking investors at the time of their next trade: ''Do you want high-frequency trading, YES or NO?''

That won't happen, either. ASX customers can't take their business elsewhere. It's not practical for small investors to use dark pools so they get stiffed, one cent at a time, millions of times a year. The difference between HFT and insider trading is primarily legalistic. Everyone except the ASX, which is being paid not to look, can see it for what it is.

Richard Livingston is the chief executive officer at Walnut Report, (walnutreport.com.au).This article contains general investment advice only (under AFSL 282288).