By Terry Flanagan

OFR Cites High-Frequency Risks

The Office of Financial Research, the research arm of the U.S. Treasury’s Financial Stability Oversight Council is setting its sights on reducing systemic risk in 2014.

“OFR is beginning to deliver on our core mission: to fill critical gaps in financial data and analysis for the benefit of the Financial Stability Oversight Council and, ultimately, the public,” said OFR director Richard Berner in a letter. “Although the U.S. financial system is stronger and functioning more smoothly than it was 17 months ago, threats to financial stability remain.”

Among them are vulnerabilities in short-term, wholesale funding markets. “The current financial environment, marked by low interest rates and low volatility, has spurred risk-taking, making markets and institutions more vulnerable to a sharp increase in interest rates, volatility, or both,” Berner said. “Operational risks could also destabilize the “plumbing” of the financial system — the infrastructure for payments, clearing, and settlement. In addition, uncertainty about the U.S. fiscal outlook could threaten financial markets.”

Developing more secure internal risk controls and risk management systems remains an ongoing structural risk theme. The FSOC’s latest annual report cited technological and operational failures, natural disasters, and cyber-attacks as potential sources of
significant financial system stress.

One key source of operational risk across all markets is the growing role of automated trading systems, including high-frequency trading systems, which use sophisticated algorithms to place rapid-fire orders after analyzing large volumes of market data, the OFR said in its 2013 annual report.

Automated trading represents a significant portion of daily equity and foreign exchange volumes and a sizable portion of Treasury market volumes. Given these volumes, high-frequency trading poses several potential financial stability risks, suggesting that closer monitoring may be warranted, according to the OFR.

Liquidity is the most commonly cited concern. Some studies suggest high-frequency trading improves market liquidity in equity and foreign exchange markets by narrowing bid-ask spreads, suppressing volatility, and improving price.

But research suggests that such activity may disappear during periods of high volatility. Liquidity could decline if large losses accumulated quickly and unexpectedly, and trading controls were inadequate.

Also, liquidity provided by high-frequency trades is not the same as the liquidity provided by traditional market-makers, as it lacks depth due to the small size of quotes and the fact that high-frequency-trading firms have no market-making obligation, according to the OFR.

If there are fewer traditional market-makers because of narrower bid-offer spreads, the exit of high-frequency traders during times of market stress could reduce liquidity.

Price discovery is another concern. The proliferation of trading in private market venues such as single-dealer trading platforms and dark pools — off-exchange venues that let large institutions trade anonymously — may be tied to the rise of high-frequency trades, the OFR said.

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