The Foresight Project takes issue with EC proposals to limit HFT

Market participants have applauded the UK government’s Foresight Project, which finally published its long-awaited report into the effects of high-frequency trading earlier this week. The report rejects European Union proposals to curb high-frequency trading.

The two-year study, headed by professor Sir John Beddington, found “no evidence” that HFT adversely affected market quality or stability. However, it did support the introduction of circuit breakers to help reduce the impact of extreme stock movements such as the ‘flash crash’ of May 2010, in which $1 trillion was briefly wiped from the value of the US stock market. Proposals to introduce minimum order resting times, which were included in the European Commission’s MiFID II document, were rejected by the Foresight paper on the grounds that such a measure would expose liquidity providers to increased ‘pick-off risk’ if they cannot cancel stale orders.

“Earlier this year, MiFID rapporteur Markus Ferber took great delight in amending the MiFID II text to slow the market 100 times – from an estimated 5 milliseconds to 500 milliseconds,” said Paul Squires, head of trading at AXA Investment Managers. “That is surprising, because most market participants would argue minimum order resting times are pointless and arbitrary. I am glad to see that the Foresight report agrees with the market participants.”

The Foresight document also rejects MiFID II proposals requiring trading firms to notify regulators of their algorithms. The idea behind the original proposal was to improve transparency and regulatory oversight, enabling regulators to better understand and control what trading tools are being used in the market. However, Foresight’s research suggests that the proposed guidelines are too vague and would likely impose excessive costs for capital markets firms and regulators. That is a view shared by other market observers, including Anna Pajor, senior consultant at capital markets consultancy GreySpark Partners.

“We do need standards for trading algorithms – and not just HFT algos,” she said. “Without these, poorly managed algos may cause problems. But the industry is able to create a solution for itself, with a little encouragement from regulators, and I think that is the best answer rather than the MiFID II proposal on notification of algos.”

Concerns over excessive order cancellation by HFT firms have also been prevalent in recent months. Last year, broker CA Cheuvreux presented research which found that HFTs create enormous levels of “market noise” that makes it difficult for long-term investors to discern genuine liquidity. They do this by sending out high volumes of orders and then cancel the majority – sometimes transacting less than one order for every hundred they send out. Following discussions with Italian securities regulator Consob, Italy’s Borsa Italiana moved to control the practice by introducing a charging system based on order to cancel ratios. The new fee took effect in April 2012, and charged market participants that cancelled more than 100 orders for every one they transacted.

The Foresight paper expressed support for fees introduced at the exchange level, especially if this is coupled with greater regulatory surveillance to detect manipulative trading practices. However, it stopped short of recommending it as a policy for regulators, on the grounds that if imposed at the regulatory level such a limit could become too blunt and therefore curtail beneficial strategies. Market participants however were more enthusiastic about order to cancel ratio limits.

“Order to execution ratios should be introduced here in the UK,” said Squires. “HFT order cancels are what annoys traders. The problem for us is that is illusory liquidity. You think you can buy 100,000 at a certain price, but actually all you can do is buy 20,000. That is not helpful and it’s very close to being market manipulation.”

The effects of HFT on market volatility have also been extensively debated. The Foresight Project concludes that there is no evidence that HFT increases volatility overall.  However, it acknowledges that during periods of market stress, HFTs may contribute to volatility by suddenly withdrawing from the market. For Squires, it is a question of market structure.

“The characteristics of HFT are very different to historical market makers,” he said. “HFT is opportunistic. There’s no obligation for them to continue to make markets, which is why during periods of market crisis, they disappear and flash crashes arise. HFT does bring volatility at those times, which is an issue.”

The Foresight Project’s conclusions about HFT stand in contrast to research published earlier this year by Brussels-based public interest body Finance Watch. The organisation published a paper in April, Investing not betting, agruing that even if HFTs do help reduce spreads, the value gained is not enough to offset the negative effects of aggressive, predatory HFT strategies that prey on institutional order flows. According to Finance Watch, HFT does not contribute to the real economy, but simply deters long-term investors from participating in equity markets. The conflict of views has led some other observers to call for moderation from regulators over HFT legislation.

“While we should not be complacent about the potential for market abuse or manipulation, or the introduction of unnecessary or unwelcome volatility, I would advocate dealing with these issues on a case by case basis, rather than taking the ‘sledgehammer to crack a nut’ approach,” said Hugh Cumberland, solution manager, payment and settlement services at technology provider Colt Enterprise Services. “Let’s eliminate or mitigate the negatives, and retain the important advantages in terms of higher liquidity, lower volatility and more efficiency in the cost of trading.”

Notably, the Foresight Project also stressed that international cooperation and coordination in securities markets regulation was important; the document suggests a join initiative from a European Office of Financial Research and its US equivalent as a means to achieve more effectively harmonised and monitored markets.

The Foresight Programme, which also covers other topics in areas such as science and manufacturing, was created in 1994 to help the UK government plan for the future and is funded by the Department for Business Innovation and Skills.