U.K. Study Rejects EU Plans to Curb HFT

Terry Flanagan

A new U.K. study into high-frequency trading has largely come to the defense of the practice and has poured scorn on some of the European parliament’s recent proposals to clamp down on it.

The Foresight Project, a much-anticipated two-year study commissioned by the U.K. government, gathered evidence from 150 academics and experts from 20 countries and has come to the conclusion that if HFT was seriously curbed then liquidity and market efficiency could disappear faster than the blink of an eye. However, the report, which was released today, did caution that HFT, which the report says now accounts for 30% of U.K. equity trading volume, can make markets more unstable, especially in times of stress.

“HFT firms have been widely vilified in recent months, though the reasons most typically given are, in fact, based on popular misconceptions,” said Dr Christian Voigt, business solutions architect at trading and technology company Fidessa.

The Foresight study has found that computer-based trading has “allowed new participants to enter, new trading methods to arise and even new market structures to evolve”. It added that “liquidity has been enhanced, transactions costs have been lowered and market efficiency appears to be better, or certainly no worse”.

It also urged regulators to “catch up to the new realities of trading in asset markets”. Many market participants, across all sections of the market, are horrified at the potential consequences of some of the rules targeting HFT proposed by the European parliament in its latest draft of MiFID II, which promises sweeping reforms to Europe’s financial markets, most notably the introduction of a minimum resting time for orders to remain valid on an exchange for at least 500 milliseconds.

The Foresight Report said it was “doubtful that minimum resting times would be a step in the right direction” and it was also worried about other anti-HFT MiFID II proposals such as the impact of imposing market making obligations, proposed measures to require the notification of algorithms and minimum order-to-execution ratios. The report did, though, back the use of circuit breakers and a coherent tick size policy.

“The project has found that some of the commonly held negative perceptions surrounding HFT are not supported by the available evidence and, indeed, that HFT may have modestly improved the functioning of markets in some respects,” said Sir John Beddington, the U.K. government’s chief scientific officer who headed up the study.

“However, it is believed that policy makers are justified in being concerned about the possible effects of HFT on instability in financial markets.”

These concerns, according to the Foresight study, were “fears that, under stressed conditions, the liquidity provided by HFT may evaporate and lead to greater volatility and more market crashes, which provides the main driving force for new regulatory measures to manage and to modify computer-based trading”. It also highlighted the risks to market stability due to “errant algorithms or excessive message traffic that must be addressed”.

It did, though, add a caveat to this. “Caution must be exercised to avoid undoing the many advantages that the high frequency world has brought,” said the Foresight study. “Technology will continue to affect asset markets in the future, particularly as it relates to the ultra-fast processing of news into asset prices.”

Voigt at Fidessa concurred: “We are beginning to see politicians interfering in the technology enabling existing business models. Intraday trading is not new. Market making is not new. These are the models that technology has effectively speeded up with HFT.”

The Foresight report also touched on the issues facing the buy side in today’s high-speed trading environment. Buy-side institutional investors, who generally trade in big blocks of shares and want to invest in the long term, have become disillusioned by not being able to properly execute their orders on the lit exchanges and instead see their orders instantly picked off by the algorithms of HFT firms.

“The bulk of the evidence suggests that, in normal circumstances, HFT enhances the quality of the operation of markets, though the returns to HFT may come in some significant part from buy-side investors, who are concerned that HFT may have the effect of moving prices against them,” said the report.

However, Voigt at Fidessa argued that restricting HFT could actually hinder the buy side in the long run. “Measures to reduce HFT would also reduce liquidity in the market, forcing up execution costs for the buy side,” he said.

Foresight’s conclusions come after several well-publicized market blow-ups that have been linked to HFT—such as the ‘flash crash’ in May 2010 and this year’s Knight Capital debacle and the botched IPOs of Facebook and Bats Global Markets—as well as the big increases in market volatility in recent times, but it suggested that this volatility was due to wider economic issues.

“The main conclusion from this study is that the macroeconomic crises of the past five years have been the main driving force for the liquidity and volatility of UK equity markets,” said the Foresight study. “If HFT has a role to play in the large swings in market conditions, it is relatively small and insignificant in comparison with the huge negative effects of the banking and sovereign debt crises that happened during this period.”

Some, though, have criticized the study, saying that the majority of the make-up of one of Foresight’s two advisory panels was heavily linked to the HFT industry.

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