08.19.2011
By Terry Flanagan

Prop Traders Defend HFT and Algo Trading

Prop trading firms are urging regulators to step back from imposing limitations on trading technology that aren’t backed up by academic research or empirical evidence.

Regulators have been stepping up their scrutiny of high-frequency and algorithmic trading in the wake of last year’s flash crash, but traders who employ such tools say that a heavy-handed regulatory approach would squash initiative and be counterproductive to creating a level playing field.

A consultation report issued in July by the International Organization of Securities Commissions (IOSCO) examined regulatory issues raised by the impact of technological changes on market integrity and efficiency.

The report noted that while algorithms and HFT technology have been used by market participants to mange trading and risk, their usage was a contributing factor in the flash crash of May 6, 2010.

A similar finding had been reached by the joint SEC/CFTC advisory committee appointed to issue recommendations to prevent a recurrence of the flash crash.

Regulators in the U.S. and Europe have been wrestling with how to treat HFT and automated trading in general. In the United States, the SEC and CFTC are considering whether to impose requirements on HFTs to function as market makers.

“Forcing rules like introducing a minimum resting time on HFTs (or any other market participants) will increase the risk for traders, resulting in increased spreads and fewer that will be willing to provide good liquidity to the market,” Markus Kämpe, senior product manager at Orc Sofware, told Markets Media.

Prohibiting a new flash crash should be a common effort among trading firms, software providers and exchanges.

“Trading firms employing automated trading need thorough testing mechanism for their algorithms,” said Kämpe. “In addition, they need a solid risk layer in the trading system they are using to prevent algorithms from going wild.”

On the exchange side, safety precautions like a circuit breaker at unusually large moves in the market is another contribution that is a natural part of a common effort among financial market participants to prohibit events like the flash crash, he said.

“Market makers should get the benefits they deserve by complying with market making obligations,” said Kämpe. “Other market participants, not bound by obligations and not getting the marektbenefits, should be allowed to bring liquidity to the market. All market participants, regardless of being a market maker or not, should be stopped from bad trading behavior.”

The European Securities and Markets Authority (ESMA) has published guidelines that seek to clarify obligations of trading platforms and investment firms under the existing EU legislative framework, in particular Markets in Financial Instruments Directive (MiFID).

The ESMA guidelines don’t explicitly call for the imposition of market making requirements on HFTs. However, the European Commission, in its 2010 consultation paper on the review of MiFID (MiFID II), proposed that market operators be required to ensure that HFTs continue to provide liquidity on an ongoing basis subject to similar conditions that apply to market makers, and that orders would rest on an order book for a minimum period before being cancelled.

“Market makers should get the benefits they deserve by complying with market making obligations,” said Kämpe. “Other market participants, not bound by obligations and not getting the marektbenefits, should be allowed to bring liquidity to the market. All market participants, regardless of being a market maker or not, should be stopped from bad trading behavior.”

The guidelines call for extensive regulations on the use of algorithmic trading. According to ESMA, MiFID provides the legal authority relevant to investment firms’ operation of electronic trading systems, including algorithmic trading.

The guidelines require that prior to deploying an electronic trading system or algorithm, firms make use of clearly delineated development and testing methodologies to ensure that the trading system or algorithm is compatible with the firm’s obligations under MiFID as well as national laws.

The IOSCO report solicited comments on whether prop trading firms, including HFT firms, should be subject to regulatory requirements, and whether regulations should be introduced that relate specifically to risks posed by algorithmic trading and HFT.

In its response to the IOSCO report, the Futures Industry Association (FIA) Principal Traders Group, said that technology has leveled the playing field for market participants and provides a much higher degree of transparency that when the execution venue was a trading floor.

Although certain market structure refinements may be appropriate, the benefits of electronic trading—increased transparency, greater liquidity, tighter spreads, and reduced costs—should be recognized, according to the FIA PTG.

The FIA PTG cited academic and industry research that “overwhelmingly support the important role of electronic liquidity providers in today’s marketplace.”

While supporting such reforms as the elimination of stub quotes, the FIA PTG is opposed to regulatory interference in the functioning of markets, such as depending on market-maker obligations as a guarantee of market liquidity.

“We view this as a competitive issue, not a regulatory issue,” it said.

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