U.K. Study Critical of Europe’s Plans to Tackle HFT

Terry Flanagan

Proposed European regulation aimed at curbing high-frequency trading could significantly reduce liquidity in financial markets, according to a new U.K. government commissioned paper.

The Foresight working paper, which draws on the work and advice of 35 independent academics from nine countries, flagged up serious concerns over the updated Markets in Financial Instruments Directive (MiFID II), a key piece of securities reform looking to tighten up regulation in the wake of the 2007 original.

There are many contentious issues within MiFID II that have yet to be decided upon with the European parliament’s Economics and Monetary Affairs Committee (Econ) postponing a vote on MiFID II in July due to political wrangling after over 2,000 amendments were tabled. The long-awaited reforms, which are currently at the draft law stage after the European Commission’s initial MiFID II proposals kickstarted the process almost a year ago, are not likely to be rubber-stamped by Econ for another month at least with final adoption now probably being pushed back to 2015 at the earliest.

Markus Ferber, a German center-right MEP responsible for guiding MiFID II through parliament, has adopted a tough stance on anything that resembles algorithmic trading, despite opposition from some other MEPs as well as many in the industry, and, in the latest amendments to MiFID II, Ferber, based on feedback from MEPs, has called for the introduction of a minimum resting time for orders to remain valid on an exchange for at least 500 milliseconds as well as penalties for excessive order cancellations. While HFT firms that deal on their own account will also, in effect, be forced to become market makers and provide continuous liquidity to the market.

The Foresight project said that there were benefits to be derived from some of the MiFID II proposals, but cast doubt over market-making obligations, order-to-trade ratios and minimum order resting times.

“With financial markets evolving at a rapid pace, it is essential we develop a better understanding of the critical issues which affect the health of this sector and the wider economies it serves,” said Sir John Beddington, the U.K. government’s chief scientific adviser. “I believe this evidence and analysis will be valuable to policy makers and regulators wanting to maximize the opportunities from computer-based trading while managing the risks. This kind of analysis is vital if a resilient regulatory framework is to be put in place.”

The interim findings from Foresight, which do not represent the views of the U.K. government, have been released almost two months ahead of schedule so that European policymakers returning to work after their summer breaks can see the report ahead of any MiFID II vote.

The study was most explicit about forcing HFT firms, in effect, to become market makers within markets as it said that market maker obligations run into complications arising from the nature of high-frequency market making across markets, which differs from traditional market making within markets

It said: “A requirement to post a continuous bid-offer spread is not consistent with this strategy and, if binding, could force high-frequency traders out of the business of liquidity provision. With upwards of 50% of liquidity coming from high-frequency traders, this could be disastrous.”

Computer-based financial trading has grown substantially in recent years and now accounts for roughly 70% of equity trading in the U.S. and over 30% in Europe. Such trading has attracted controversy and has been implicated, by some, as a contributory factor to the so-called May 2010 ‘Flash Crash’ in which $1 trillion temporarily evaporated from U.S. markets.

“We are encouraged to see such a rational and evidence-based assessment of the benefits of automated trading [by Foresight] and we hope that these findings will have a positive impact on the European regulatory debate,” said Remco Lenterman, chairman of the FIA European Principal Traders Association, a Brussels-based lobbyist which represents firms that trade their own capital on European exchange-traded markets such as Knight Capital, Optiver, Getco, Citadel Securities and Quantlab Financial.

“We are continuing to engage constructively with regulators and policymakers, as we too want to ensure that markets are safe, robust and transparent. At the same time, we do not want investors to lose the positive gains made through technological progress.” 

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