LONDON Aug 31 European regulations designed to
crack down on so-called high- frequency trading (HFT) could end
up reducing the number of buyers and sellers in financial
markets rather than boosting it, a UK-government commissioned
The European Union's draft law MiFID II, a reform of
Brussels' earlier Markets in Financial Instruments Directive
(MiFID), will introduce tougher regulation of financial markets
including for HFT.
Speed traders use powerful computers to churn out thousands
of trades in fractions of a second to profit from tiny price
discrepancies, sparking criticism that they increase market
volatility and instability.
The HFT industry hit the headlines in May 2010, when it was
blamed for the "flash crash" in the United States, when the
stock market plummeted more than 1,000 points, or nearly 10
percent, in a matter of minutes.
The fall was initially caused by one large erroneous trade
from a funds firm, but the losses were rapidly magnified when
computer-driven high-frequency traders followed the move down.
Among MiFID's more controversial proposals, speed traders
who increasingly function as market makers will be forced to
post prices to buy and sell at all times, to stop them from
pulling out when markets get choppy.
The hope is that this will boost liquidity and support
orderly markets, but speed traders say this would put them at an
The Foresight working paper, which brings together some 35
academics from nine countries to examine the MiFID proposals,
said the requirement could end up having the reverse effect and
"Many high-frequency strategies post bids and offers across
correlated contracts. A requirement to post a continuous bid-
offer spread is not consistent with this strategy and, if
binding, could force high-frequency traders out of the business
of liquidity provision," it said.
"With upwards of 50 percent of liquidity coming from high-
frequency traders, this could be disastrous."
The paper also questioned "notification" policies, which
would require all firms engaged in algorithmic trading to
provide the regulator with a description of their strategies,
trading parameters and key risk controls annually, to stop
unsound algorithms from damaging orderly markets.
The Foresight working paper said the proposed policy was too
vague, while its implementation would require excessive costs
for both firms and regulators.
"It is also doubtful that it would substantially reduce the
risk of market instability due to errant algorithmic behaviour,
although it may help regulators understand the way the trading
strategy should work."
The HFT's trade body reacted positively to the working
"We are encouraged to see such a rational and evidence-based
assessment of the benefits of automated trading and we hope that
these findings will have a positive impact on the European
regulatory debate," FIA EPTA Chairman Remco Lenterman said.
Foresight's final report is due out later this year.