Risks to investors in a high frequency world ; why controls are needed to address High Frequency Trading’s potential for systemic risk.

Financial News Op-Ed 2 April 2013

High Frequency Trading is now in the sights of regulators around the world. HFT involves automatic trading strategies with high volume and extremely short holding periods. Dramatic growth over the last five years means new potential for systemic risk. Last year, HFT strategies represented 36% of EU trading volumes, and possibly twice that in the US. Evidence is accumulating of unhealthy practices; regulators realise they currently lack detailed information. Wash trades, quote stuffing, disruptive algos and momentum ignition are all areas that could represent market abuse if only the analysis was available. There is an urgent need for regulatory action on this – collecting the facts that are needed to implement current legislation and protect markets.

Some studies have suggested that the arrival of HFT has cut costs and not harmed market efficiency. It seems to be adding to volume. But, not all trading volume really increases market liquidity; a portion of HFT activity seems designed to subvert the price discovery function of the market. The problem is that some of this behaviour takes place in milliseconds, and can easily be overlooked by conventional analysis. Liquidity can be illusory if prices are not reliable; a quote that can be almost instantaneously withdrawn is useless as a source of liquidity. It is hard to see why existing legislation cannot deal with this type of behaviour. HFT traders should not be able to game market structure. Overwhelming an exchange, targeting a specific stock, can undermine market integrity. The systemic risk comes from the potential for HFT to provide liquidity at times, but withdraw it just when it is most needed. Regulators are concerned about behaviour at times of market stress.

The danger of HFT exacerbating markets sell-offs has already been noted. Indeed, while HFT did not initiate the US flash crash of 2010 – which saw the Dow plunge and then rebound 1000 points – its role was not helpful. Studies showed a high level of toxic order flow- effectively business that adversely selects market makers who are still unaware that they are providing liquidity at their own loss. Toxic order flow induces a herding response that quickly becomes a dangerous downward spiral. It is HFTs limited capital, ultra-fast speed and periodic illiquidity that poses the danger to markets. While HFT can dampen short term volatility, research points to the strategies on average taking as much liquidity as they supply.

While many institutions make some use of algorithmic trading and other computer-based methods, the specific risks from HFT come from aggressive and predatory practices. Institutions demonstrating any type of persistent order flow can quickly become a target. Computers would view as “dumb flow” anything that involves orders in round numbers or targeting a specific share of market volume. HFT strategies can detect when there is a human in the trading room and take advantage. Prices can be pushed into cascades in dark pools, triggering stop losses. Unfortunately, many conventional market participants are blissfully unaware of how HFT might be hurting them.

For example, wash trades involve firms using multiple algorithms actually dealing with themselves – possibly outside market spreads. Yet these are not readily identified. Any conventional institution doing this would be well aware that it risks scrutiny for potential market abuse. Institutions need to be able to demonstrate that any such cross –trading was within market spreads, and not misleading others.

The most predatory behaviour appears to be quote stuffing, where huge numbers of orders are issued by an HFT trader and cancelled. Essentially the market is flooded with quotes that competitors have to process. It needs a direct link to the exchange in order to be effective, and would be viewed by many as simply a denial of service attack.

The problem with market abuse in computer-based trading is how transient it is. Only examination of behaviour in milliseconds, and the nature of cancelled orders can really spot something wrong. Regulators may need to join the jots, connecting up the different elements of an HFT strategy, as the benefit of a pattern of cancelled orders might be achieved through an entirely different stock or index. Orders that are pulled in a fraction of a second might create a profit in a position in a separate but related stock or ETF.

The difficulty is that computers lack motive, and so detailed analysis of the algorithms and strategies themselves is what is needed. Regulators need the resource to do this.

Revisions to the EU Market Abuse Directive will come, requiring risk controls within algorothmic trades, but full use is not being made of current legislation. There are new forms of market manipulation arising from any predictability in order flows. The very fact that such a high proportion of orders are quickly cancelled means that the market can be nudged in a direction, even in milliseconds, with little transparency.

While the risks point to the need for regulatory action, there is a danger of unintended consequences from conflicting intervention. Transaction taxes and forcing a minimum quote period may not be helpful. But there are signs that setting limits on order to trade ratios can bring some control. One size fits all intervention, could damage markets when it is simply the potential for abuse that is the target. It is necessary to differentiate strategies, separating the good from the bad.

The UK Foresight Project examined HFT, but this UK report did not propose a credible alternative regulatory approach. The UK needs to recognise that other centres may intervene and should engage more actively with the debate on HFT control. There is political pressure, and HFT still has an image of social uselessness.

Intervention should focus on the behaviours that undermine market integrity, rather than simply frequency of order entry. There are benefits from computer-based trading, but the same regulatory principles should apply. A clear statement by regulators on what practices are deemed to be a breach of existing legislation would also be helpful and force industry self-improvement.

Disclosure: The views set forth in this article and website are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. Data and content provided are for information, education, and non-commercial purposes only. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent personalised investment advice and are limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of investment services.

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