Market fears grow as fettering of high-frequency trading draws closer

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Five years on from the financial crisis, high-frequency trading remains under an intense spotlight, with regulators on both sides of the Atlantic determined to crack down on alleged manipulation of markets, triggering an inevitable backlash from market players that claim illiquidity, price distortions and regulatory arbitrage will come to the fore if regulators make good on draconian threats.

In a two-pronged onslaught, 11 EU states are negotiating a financial transaction tax (FTT) that would include the transactions of high-frequency trading firms and could cover cancelled high-frequency trading (HFT) orders; and possibly impose mandatory minimum resting periods during which trades must remain in place before being cancelled. The EU is still thrashing out its wide-ranging Mifid II directive and Mifir regulation and deciding whether it should include speed limits, or pauses, designed to slow down automated trades to prevent abuse as well as meltdowns such as the infamous flash crash that rocked US markets in 2010. Other proposals include licensing of high-frequency algorithmic trading and trading facilities being required to limit the ratio of unexecuted orders to transactions in their systems. Algorithm-generated traders might also be flagged and tagged with an algorithm identifier so regulators can trace and crack down on trading strategies that are deemed abusive or pose risks to the market. The legislation – which the EU estimates will cost more than €700 million to implement – is expected to become law in 2016 in spite of widespread recognition that trading technology has boosted liquidity and market participation and narrowed spreads. In the wake of last year’s Kay Review into equity trading, UK legislators have urged the government to consider a transaction tax that would apply specifically to HFT. Members of the US Congress have proposed a 0.03% tax on almost every trade across most markets and a flat fee for HFT trades including cancelled orders. The controversial moves come as the industry is under increasing pressure from plummeting volumes, margin-crushing competition, and probes by regulators including the high-profile prosecution of a US high-frequency trader. Michael Coscia and his company Panther Energy were fined more than $3 million in July by the UK's Financial Conduct Authority, the US Commodity Futures Trading Commission and CME for creating false orders for oil and gas using high-speed algorithmic programs. The firm allegedly used a computer algorithm to place and then cancel trades at lightning speed in order to manipulate prices, an illegal activity called ‘layering’ or ‘spoofing’. The action was the first the FCA has taken against a high-frequency trader. But the high-frequency trading industry is fighting back with the unlikely support of firms that trade at more prosaic velocities. “The European Parliament’s amendment of the FTT also covers cancelled trades. This could be quite harmful for price discovery and for competition within Europe because it will hurt liquidity providers significantly,’’ says Christian Voigt, business solutions architect at Fidessa, which provides support and software to trading firms. “Firms and institutions that are willing to provide liquidity to other market participants provide constantly two-sided quotes to the market so that whenever someone wants to trade they can do it immediately. “Quotes have to be as up to date as possible and high-frequency trading technology is a good way of achieving this. The idea that you will all be taxed, effectively punished, for providing very recent quotes is not the way forward.’’ Voigt argues that the justification for the tax in the legislation – that the financial sector should be made to finance some of the cost of the financial crisis – does not stand up because the cost of the tax will ultimately be carried by end investors such as pension funds. Like it or not; the FTT is no longer just a populist rhetorical stick with which to beat the industry: Italy and France introduced their own FTTs last year, setting a precedent for the rest of the EU. Italy levies a tax on firms that exceed a pre-defined order-to-cancel ratio of 1:100. Volume in France’s equity markets has tumbled despite the country’s two largest market makers being exempt from the tax in order to mitigate possible negative impact on liquidity. A proposed 500 millisecond resting period for all high-frequency trades might be losing traction, with critics, including the European Central Bank, warning that it might negatively impact market efficiency and liquidity, and lead to wider spreads. With the underlying price of some assets changing thousands of times a second, but updates of quotes only permissible twice a second, traders will have to quote conservatively to allow for underlying price volatility. HFT firms might also respond by focusing on the final millisecond of the resting period to make money. In other words, the high-frequency traders are mainly arbitraging prices in different markets or between the cash and futures markets. If all orders are forced to 'rest' on the order book for 500 milliseconds, they can be seen by other traders who can time their trade as close as they can get to the end of the 500 milliseconds and position themselves to capitalize on, say, gold long at $1,299 and short gold futures at $1,300 in a bid to make $1 profit. Were this the outcome, a resting period would do nothing to solve inefficiency resulting from participants placing limit orders with little likelihood of their being executed. There are also fears that if implemented in Europe alone, trading will simply migrate to jurisdictions without taxes and speed limits. Jason Rolf, manager of the Amati Systematic Trend Fund, which executes using non-high-frequency algorithmic trading models, says while HFT sometimes creates problems for firms such as his, it is a positive force for good in markets. “These measures could kill off high-frequency trading were it just to stay in these jurisdictions where taxes are planned. It’s short-sighted, but I think they’ll go ahead and put the taxes on, but all the high-frequency traders will just move to where they don’t exist,’’ says Rolf. “Regulating HFT will only work if rules are in place worldwide because there will be other exchanges without taxes and resting periods and business will migrate very quickly to those exchanges. There’s nothing stopping a copycat exchange opening up in Asia, say China, or somewhere like that. Once the volume goes to those exchanges the end users will follow. “The fact that price discovery is so liquid across the world is largely due to HFT, but there’s a minority of bad apples engaging in predatory practices and the politicians are using that as an excuse for blanket punishment.’’ Rolf dismisses resting periods as unworkable but says that ever higher speeds need to be addressed. “The risk is of another flash crash, a major one, because with no curb on speed, traders will find faster and faster methods. We need to slow down that speed arms race until the risk management and oversight are able to keep pace.’’

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