Europe targets HFT traders

Terry Flanagan

European regulators have high-frequency traders firmly in their crosshairs, much to the relief of buy-side institutional investors who believe that the practice impacts on their profits.

Moves are afoot in France, Italy and Sweden, as well as the European Union, to curb these high-speed strategies that aim to benefit from arbitrage opportunities using sophisticated computer algorithms to interpret or anticipate market signals – generating trades in fractions of a second.

However, high-frequency trading affects institutional investors, who generally operate on behalf of large clients such as pension funds, and who are less reliant on speed, leaving buy-side desks to pay more for stocks or earn less on sales due to the presence of this high-speed order flow.

Buy-side orders on regulated exchanges also run the risk of seeing their sizable trades suffer from market impact as buy-side firms are forced to break up their trades over time in a bid to mask their size and intent. This causes ‘information leakage’ as the market, spurred by high-frequency trades, then moves against the order. This has pushed some institutional investors into off-exchange trading venues such as dark pools where such orders can be masked.

A survey last year conducted by Liquidnet, an operator of alternative trading platforms, found that over two-thirds of global asset managers, out of a sample of 300 firms, said that trading costs had increased due to high-frequency traders.

High-speed trading has blossomed in Europe since 2007 with the introduction by the European Commission of the Markets in Financial Instruments Directive, known as Mifid. Competition among exchanges and other platforms has soared, fragmenting trading and creating arbitrage opportunities.

Proponents of high-frequency traders say that more liquidity is pumped into the market, benefiting all investors.

But France’s securities regulator, the Autorité des Marchés Financiers, believes that proposals in Mifid II, a new version of Mifid that is working its way through Brussels and aimed at cracking down on market abuse by high-frequency traders, do not go far enough and it has suggested that a new pan-European watchdog run by the Paris-based European Securities and Markets Authority is given more power to monitor such trades.

In December, ESMA, an independent European Union authority, published guidelines about the automated trading environment, encompassing high-frequency trades. In issuing these rules, ESMA rolled out a regime governing the operation of electronic trading systems by EU regulated markets, multilateral trading facilities or investment firms. The guidelines cover trading in an automated environment on any financial instruments, as defined in Mifid. However, some regulators in Europe are disappointed that ESMA has not been given extra authority to govern the practice.

Reemt Seibel, communications officer for ESMA, said: “HFT can be a valid trading strategy. But there may, however, be risks in terms of orderly market functioning. This is why those traders have to put in place proper risk and control procedures.

“ESMA’s guidelines are an important step towards improving the oversight of automated trading. ESMA is committed to ensure that technological innovation does not pose a risk to the orderly functioning of the markets and will continue to monitor closely the developments in financial markets, including those which could impact on the resilience of market infrastructures.

Maintaining the orderly functioning of the markets is one of the aims in defining rules for algorithmic trading.”

ESMA’s guidelines focus on adequate pre-trade controls, ensuring participants’ IT systems are compatible with the trading platforms’ electronic trading systems, automatic and discretionary mechanisms to constrain trading or to halt trading in response to significant variations in price to prevent trading becoming disorderly and rules and procedures designed to prevent market abuse and market manipulation.

Seibel added: “These guidelines will help contribute to the stability and robustness of European electronic trading systems, which is why ESMA is implementing these guidelines now without waiting for the completion of the Mifid review. In so doing, ESMA advances in establishing consistent, efficient and effective supervisory practices in this important area of European regulation.

“This sets out ESMA’s view of how EU law should be applied. ESMA therefore expects all EU relevant competent authorities and financial market participants to comply with these guidelines unless otherwise stated.”

The guidelines will take effect from May 1.

Meanwhile, French president Nicolas Sarkozy is also intent on bringing into force by August a financial transaction tax of 0.1% on all share purchases. He hopes that the France-only scheme will be rolled out across the rest of the European Union in time, but David Cameron, the British prime minister, has grave concerns about the project – saying it will cost 500,000 jobs in the UK alone.

This 0.1% tax on all transactions would, in all likelihood, put an end to high-frequency strategies as a trading approach as the levy would wipe out most, if not all, of the margin made by microsecond trading.

A report last week by Finansinspektionen, the Swedish markets authority, also expressed concern that high-frequency trading was being used to manipulate the market.

And Italy’s stock exchange is considering plans to charge traders who send high volumes of orders into its system to crack down on high-frequency trading.

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