LONDON, Aug 31 (Reuters) - 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 paper said.
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 unfair disadvantage.
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 reduce liquidity.
"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 paper's findings.
"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.