High-Frequency Trading: How Should Regulations Develop in Response to Modern Trading Techniques?
Best-selling author Michael Lewis’ unflattering portrayal of algorithmic “front-running” has made high-frequency trading (HFT) a household word. The U.S. Justice Department has launched an investigation. The Securities and Exchange Commission has reported that it has been studying the implications of HFT for some time. And the New York Attorney General’s office recently subpoenaed several high-frequency trading firms.
However, industry insiders have been pondering the pros and cons of high-frequency trading since 2010, when the 6 May stock market “flash crash” put automated trading in the crosshairs of regulators and investors alike.
CFA Institute staff have tracked the evolution of high-frequency trading in global capital markets over the last five years, with a view toward understanding potential impacts on market integrity and efficiency, to avoid potential unintended consequences, and to inform our perspectives on public policy and regulatory initiatives. Here are our views on high-frequency trading, as outlined in a recently released policy brief:
- HFT improves price discovery across multiple platforms and enhances the informational efficiency of markets. The weight of academic evidence suggests a benign to positive effect on markets.
- HFT firms should be well capitalized in line with other market-making firms to support the proprietary nature of their activities and should be subject to the same sorts of registration/authorization requirements that apply to other regulated investment firms.
- There is a need for robust internal risk management procedures and controls over the algorithms and strategies employed by HFT firms. Controls also are needed at the broker/dealer level (to prohibit unfiltered sponsored access) and at exchanges (circuit breakers/harmonized trading halts).
- HFT firms are not to be provided privileged access to exchange servers or other mechanisms that allow them to see order flow before other participants, unless such access is available to other market participants as well on a non-discriminatory basis and on reasonable commercial terms. We do not support minimum resting times or maximum order-to-trade ratios as we feel that such limits might cause adverse effects to investors engaged in statistical arbitrage (a significant source of liquidity) who seek to adjust their orders as new information becomes available. Limit orders provide a free trading option to liquidity takers. Measures to extend the time length of that free trading option, or to restrict the ability to modify that option, imply a higher cost to providing the option. To compensate, liquidity suppliers would likely incorporate this cost into their limit order quotes, resulting in wider spreads and higher transaction costs for investors. Exchanges should be left to determine whether order-to-trade ratios should be restricted or taxed to reflect bandwidth consumption.
- Co-location is a legitimate commercial arrangement between trading firms and exchanges/market centers — provided that the service is made available to all market participants wishing to pay for it and that the service is offered on non-discriminatory commercial terms.
- Trading venues should disclose their fee structure to all market participants.
CFA Institute believes that trying to curb HFT activity through direct, targeted, and punitive regulation is inappropriate and would likely have unintended consequences. In our view, it would be more effective for regulators to address market manipulation and other threats to the integrity of markets, regardless of the underlying mechanism and focus on risk management (pre- and post-trade risk controls), rather than try to intervene in the trading process or to restrict certain types of trading activities via fees or charges.
What are your views regarding regulation of the high-frequency trading sector?
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