UK-Backed Study Supports High-Frequency Trading

Initial findings of a high-profile study funded by the U.K. government are threatening to bust a couple of myths about high-frequency trading (HFT).

What the heck are HFTs and why are they so controversial?

High-frequency traders (HFTs) are characterized by the use of algorithms and incredibly fast computers to trade securities like stocks, options, and even currencies. HFTs profit from their speed and small but consistent profits; we’re talking trades that are open for nanoseconds and profits in the range of a fraction of a penny.

HFTs have a bad rep with some market participants as their trading method allegedly encourages “quote stuffing,” “flash trading,” and statistical arbitrage. HFTs were even blamed for the “flash crash” in 2010 when the Dow Jones Industrial Average plunged 1,000 points before leveling off 20 minutes later.

Opponents of high-frequency trading argue that the strategies used by high-frequency traders, as well as the uncertainty that it inspires, increase volatility in markets and reduce the reliability of the trading industry.

Today, around 30% of the U.K.’s equity trading volume comes from HFTs. The figure is higher in the U.S. at around 75%. This is probably why governments are stepping up their game in regulating HFTs.

France has already introduced a levy (small fee) on HFT while Germany is also pushing for tighter HFT regulations. Even the European Commission is also tightening its belt, as it is expected to include measures to curb HFTs in its second version of the Markets in Financial Instruments Directive (Mifid II).

Before you read the next part, you should know that though the study is funded by the U.K.’s HM Treasury, Foresight’s project is a product of 35 academic experts across nine countries and does not represent any government.

What has the study found so far?

Markus Ferber, the lawmaker spearheading HFT-related rules in the European Parliament, wanted to include proposals for a so-called “minimum resting time” for orders.

In his proposal, market makers would be required to keep orders in the market for, say, at least 500 milliseconds before cancelling them. If this “minimum resting time” proposal is legislated, it might end up forcing most HFTs out of business as it could interfere with their strategies.

The study also seemed to be against proposals on putting a cap on the order-to-execution ratio, which is the number of orders that a trader or firm could cancel relative to the number of trades executed.

Last but certainly not least, the study also questioned the proposed notification policies, which would require algorithmic trading firms to submit a thorough description of their strategies to their regulators.

This policy is intended to prevent “unsound algorithms” from wreaking havoc in the markets as regulators would be able to study the trading parameters and risk controls of algorithmic trading systems. According to the Foresight paper, this proposal is still too vague and might end up being too costly to implement.

How will the report impact the trading industry?

As you’ve probably noticed, high-frequency traders are already growing in number and in support from the industry. Once the final copy of Foresight’s study is published later this year and if its conclusions build from its initial findings, high-frequency trading could garner much more support from the trading community.

Take note that an important vote on the Mifid II’s provisions will take place in the European Parliament on September 26. If majority of the votes favor MifidII and the legislation is passed, it would set forth stricter regulation in the financial markets, particularly for high-frequency trading. I’ll definitely keep you posted on how it turns out!