The introduction of electronic and online trading has led to the development of automated trading systems and eventually the growth in popularity of algorithmic forex trading throughout the years. If you’re just tuning in, make sure you review the first couple of articles on this topic:
Algorithmic forex trading has been on the rise, as the appeal of automated trade signals and quick execution with minimal human supervision boosted interest and demand for “black box” systems. According to the “FX Electronic Trading 2014 – Global Trends and Competitive Analysis” report from Greenwich Associates, the usage of algorithmic trading has grown from 7% of forex market participants in 2012 to 11% last year.
The adoption of algo FX trading systems among hedge funds and institutional trading firms is projected to be significantly higher, as these market participants enjoy larger capital and can be able to make the most out of higher trading volumes. Industry experts estimate that high-frequency trading systems account for roughly 75% of volume among larger funds.
Of course the development of algo systems throughout the years and across various financial markets has been riddled with a few problems here and there. A couple of years back, the opening of the BATS (Better Alternative Trading System) Global Markets exchange – an ECN stock exchange with trading systems based on trade bot, a computer program performing algorithmic trading – set off a market glitch among several equities.
“Black box” systems have also been blamed for a flash crash that occurred in May 2010 when Waddell & Reed Financial, Inc. implemented an algorithm that triggered a feedback loop among its high-frequency trades. No need to go into the nitty-gritty of this blunder, but you should know that it sparked the largest intraday dip in the Dow to the tune of 998.50 points!
Back in 1998, a highly-leveraged quant hedge fund trading in the fixed-income market got instantly blown out when Russia announced a default on its bonds. The government had to scramble for a bailout plan for this firm in order to prevent contagion and a full-scale debt crisis from happening.
In the forex market, several firms have already been placed under scrutiny for being suspected of using algorithmic systems that are designed to manipulate WM/Reuters exchange rates. Industry watchdogs are also looking into the possibility that traders may have colluded with dealers in order to push forex rates in their favor during the 60-second windows before the benchmark rate are set.
Because of that, this part of the financial industry has merited closer regulation as well. There have been some instances where system glitches have disrupted financial activity, leading to calls for stricter regulation even in other financial markets.
The CME Group has already started discussions on algo trading regulation in the futures market. In addition, the issue on the tightening of spreads in the forex market has been raised, with various options on how to ensure efficient order execution even in highly volatile market situations also discussed. This stems from the New York Federal Reserve’s research paper on how high-frequency algorithmic trading impacts market liquidity.
Some rules proposed by European regulators include limits on the ratio of unexecuted orders to open transactions and license requirements for algo trading service providers. Time limits in between trades executed were also suggested. Apart from that, provisions on flagging trades executed by algorithmic systems could also be added, as this would allow regulators to keep track of strategies that might be abusive or pose a threat to financial markets.
Last year, the German Parliament already voted to adopt the High Frequency Trading Act, which covers licensing and documentation for algorithmic trading practices in the country. Regulators expect this rule to be incorporated in the European Commission’s MiFID (Markets in Financial Instruments Directive), which would pave the way for implementation among all countries in the region.
U.S. regulators appear to be more open to algorithmic trading activity though, as many officials believe that the market benefits outweigh its risks. In the same New York Federal Reserve paper on high-frequency algo trading, research officer Ernst Schaumburg asserted that these strategies enhance electronic trading efficiency and market liquidity, with strict restrictions likely to limit these advantages.