01.20.2012
By Terry Flanagan

HFTs and Algos Pose Quandary

Eighteen months after flash crash, industry mulls market-make obligations.

More than 18 months after the May 6, 2010 flash crash brought algorithmic and high-frequency trading into the headlines, regulators and market participants have yet to agree on the meaning of the terms, much less what regulatory steps, if any, are needed.

The issue of market maker obligations for HFTs is conflicted. One the one hand, imposing obligations could prevent the disappearance of liquidity that triggered the flash crash. On the other hand, a heavy-handed regulatory regime could distort market making activity and create the very conditions it was intended to prevent.

“There are few things that create fear and loathing for regulators as much as the difficulty in solving obligations for liquidity provisioning,”  Louis Lovas, director of solutions at OneMarketData, a provider of historical tick data and complex-event processing (CEP) technology, told Markets Media. “Regulators have to eventually face this difficult issue.”

Incentive rebates to keep participants in market during stressed market conditions are a potential remedy, although not without drawbacks.

“This is not an easy problem to solve with a good chance of backfiring,” Lovas said. “Firms could simply move to more regulation friendly markets, resulting in thinner liquidity and creating the very drought-like conditions regulators want to avoid.”

Regulators on both sides of the Atlantic appear to be conflicted over high-frequency and algorithm trading, on the one hand saying that it needs to be controlled while on the other recognizing that it represents the wave of the future.

This ambivalence is reflected by the fact that the new MiFID directive calls for market-making obligations to be imposed on high-frequency traders.

Yet only a few weeks prior to the MiFID release in October, the U.K. government released a report on HFT that concluded that the pace of development or technology innovations in the financial markets, and the speed of their adoption, are likely to increase in the future.

Regulators have floated the prospect of subjecting algorithms to inspection, but opponents say this is unnecessary given the ban on unfiltered, or naked, sponsored access, and other measures already in place.

“The Market Access Rule, exchange-monitored risk checks and the multitude of watchful counterparties will prevent anything but minor Infinium Capital-style skirmishes from occurring,” Lovas said.

Any additional proposed regulations for algos (i.e. controls and/or source code inspection) are unnecessary, said Lovas.

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