29 May 2014

Financial News: High-speed traders face slowing effects of regulatory hurdles

The European Commission’s working document “European Financial Stability and Integration Report 2013” proposes changes that would mean a major shake-up for high-frequency trading (HFT) in Europe, if implemented.

Asking HFT firms to come to a gentleman’s agreement not to trade too quickly? It may seem incredible but that’s one idea floated. Or changing the deep structure of how stock markets work? Again, this is a measure that is analysed. These ideas are not yet EU policy. But the paper makes it clear that there’s support within the Commission for the idea that HFT firms are engaged in an expensive technological arms race that can generate risk-free profits but creates no economic value. The report cites studies that say that all the cash HFT firms spend on ever-faster trading systems in their “speed arms race” comes out of the pockets of ordinary investors. Some of the proposals include:

• Limiting the speed of trading and data feeds: Applying limits on just how fast firms are able to trade was a measure considered for Mifid II but one that faced fierce opposition. It was eventually dropped. Some high-speed trading firms act as marketmakers, ready to provide liquidity to buyers and sellers of stocks as soon as they need it. Part of the marketmaking process requires orders to be cancelled and repriced in line with market activity. The paper notes that “liquidity providers will suffer losses if they cannot cancel orders when the market moves against them. As a result they may simply widen spreads or exit the market entirely”. An alternative method of speed control mentioned in the paper is to decrease the importance of speed below the millisecond level. Currently, most markets work on a price-time priority, whereby the orders that arrive first are executed first.
• Private agreements on speed activities: One solution proposed in the paper is for market participants to agree not to engage in mutually offsetting investment or activities related to speed. While such an agreement sounds good in theory, making it work in practice might be too challenging. Joe Saluzzi at Themis said: “Limiting the arms race is an interesting concept but I seriously doubt it would be possible, mainly because it would be considered as anti-free market.” Moreover, such an agreement would be hard to monitor and it would require fierce competitors to have faith in each other.
• Use of batch auctions: A more subtle proposal to rein in high-speed traders is to introduce “batch auctions” – share auctions throughout the day modelled on the auctions that exchanges use to set opening and closing prices. This would require exchanges to replace the continuous central limit order book model with a series of uniform-price, sealed-bid auctions. The Commission paper suggests that auctions could be at “discrete time intervals, such as every one second, or 100 milliseconds”.

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