Regulators Wrestle with HFT

Terry Flanagan

CFTC’s O’Malia proposes seven-part definition of high-frequency trading.

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 paces of development or technology innovations in the financial markets, and the speed of their adoption, are likely to increase in the future.

“Computer-designed and computer-optimized robot traders are likely to be increasingly viewed as routine, and in time could potentially come to replace current algorithms designed and refined by humans,” the report said.

This week, Scott O’Malia, a commissioner on the Commodity Futures Trading Commission, suggested that before the CFTC recommend rules for HFTs, it develop “a precise and reasoned definition of who is and who is not an HFT,” according to a letter he wrote to the CFTC’s Technology Advisory Committee (TAC).

The CFTC needs to collect reliable data so it can define HFT trading activity before imposing regulations.

“Without a principled definition of what constitutes an HFT, any oversight scheme may inadvertently extend either too narrowly or too broadly,” he said.

O’Malia proposed a multi -part test to determine what constitutes an HFT, such as the use of extraordinarily high-speed order submission systems with speed in excess of five milliseconds; the use of computer programs or algos for automated decision making, without human direction for individual trades or orders, and very short time-frames for establishing and liquidating positions.

O’Malia proposed that the TAC engage in “a fulsome debate on the issues surrounding HFTs” at its next meeting in December.

“I congratulate Commissioner Scott O’Malia for taking the bull by the horns to define high frequency trading,” John Bates, chief technology officer of Progress Software, told Markets Media.

“The CFTC and the Technology Advisory Committee, of which I am a member, has a difficult task ahead in proposing a definition and rules for HFT,” said Bates. “Commissioner’s O’Malia’s definitions will accelerate these discussions. While I agree with a number of the parameters of his proposed HFT test, I would like to add some provisos.”

High frequency trading can be simply defined, according to Bates.

“In my mind HFT is defined as using algorithms to take in real-time market data, analyze it and look for patterns upon which to trade,” he said. “Then the algorithm places the trades and manages the orders.”

Large order volumes, numerous cancellations, short position-holding periods and ending the day with largely flat positions are all by-products of HFT, although they have come to be associated with it, according to Bates.

“I do not believe that these practices define HFT, but they do require careful policing to in order to prevent market abuse,” he said. “I look forward to the TAC meeting discussions in December.”

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.

The U.K. government late last year commissioned a study, known as the Foresight project, into the impact of high frequency trading on market stability and the U.K. economy.

The Foresight project, sponsored by HM Treasury and led by the Government’s chief scientific adviser, Professor Sir John Beddington, explores how computer generated trading in financial markets might evolve over the next decade or more, and how this will affect financial stability and the integrity of financial markets, including price information and liquidity.

The study found that liquidity has improved, transactions costs lowered, and market efficiency has not been harmed by HFT during regulator market conditions. HFTs now provide the bulk of liquidity, but their use of limited capital combined with ultra-fast speed creates the potential for periodic illiquidity.

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