There is no doubt that 2011 was the year of high frequency trading, the practise of using computers to analyse real time market information such as stock prices to implement proprietary trading activity in milliseconds.

According to a recent study carried out by the Bank of England, HFT's share of the UK equity market has grown considerably since 2005, rising from a tiny portion of the UK equity market to now represent more than 35%. In the current economic climate, HFT is attractive because it can deliver profit with lower margins.

Now an established trading method, HFT has had two main effects on the markets. Firstly, there are larger volumes of trades than ever before. A recent report from Thomson Reuters and the London Stock Exchange said that more than £1.9 trillion was traded in the first half of 2011 - representing more than one trillion trades. Secondly, this growth has resulted in a large jump in the volume of data moving between exchanges which has increased the networking and storage resources required to deliver the information between exchanges. This has in turn led to the practise of locating servers in close proximity to the data centre of the exchange, the most effective way of limiting latency, to enable traders to provide pricing bids faster than their competitors.

Moving to other asset classes

Moving forward, we expect to see more and more asset classes, such as energy and commodities, catching the high-speed trading bug. No asset class is out of bounds: if there is liquidity available, it is likely that someone will come up with a complex algorithm to exploit it. While traditionally, high-speed traders have exploited the listed derivatives markets such as those of CME, Eurex and LIFFE, we are now witnessing HFT trading models emerging in foreign exchange, specifically in key liquidity centres in Secacus, New Jersey. The new US Dodd-Frank Act and the forthcoming European Union MiFIR legislation will create new brand OTF and SEF ‘exchanges‘ to trade what were once over-the-counter instruments, such as credit default and interest rate swaps, and all potentially at low latency.

It is interesting to note that this activity is not just limited to derivatives. High-speed trading is also moving into the commodities market, specifically metals, with traders looking to arbitrage the physical commodity against the futures market. Foreign exchange has also been a target for high-speed traders this year. This is supported by recent analysis from the Aite Group, confirming that over 20% of high frequency firms are now moving into FX, following the growing popularity of commodity derivatives.

It is easy to understand why this trend is occurring. The potential for more assets to be sold without causing a significant movement in the price and no real loss to its original value is an attractive proposition to any trader, regardless of the market. This year, we have already seen the Latour trading group, a small New York-based proprietary trading house based in New York that is purely electronic, overtaking investment banking giants such as Goldman Sachs and Morgan Stanley in trading volumes. Brokers are making money by trading the firm's own assets and not those of their clients. The group has traded 484.6 million shares in principal strategies over the past quarter - an attractive place to be.

For organisations such as Latour to continue their successful high-speed trading model, the issue of regulation has to be addressed in the coming year. In spite of the UBS scandal and the mini FX flash crash in Japan that saw liquidity grind to a halt back in March, a global agreement addressing how markets are monitored has yet to be reached. The question for 2012 is how can markets be kept secure as the complexity and speed of trades continues to increase? There are many different theories, some point towards circuit breakers, a limit put in place to reduce market volatility and panic selling by program trading computers. UBS recently found that pre-trade risk checks are very important. However, an over emphasis on "the dangers" can hold the benefits of high-speed trading back.

The new EU Markets in Financial Instruments Regulation (MiFIR) regulations from Brussels are aimed at forcing OTC trading in derivatives, such as credit default swaps (CDS), onto new "exchange like facilities." This is long overdue. Until recently, reporting of OTC was almost impossible because trades could occur in private, without activity being visible on any exchange. New regulation means that new pools of liquidity will be created. With these new pools available, it is only a question of when, not if, high-speed traders will follow, demanding connectivity to these pools.

At the same time that confidence in the fairness of markets is being put to the test under new regulatory measures, a combination of general public anger towards financial services and negative press has created a mood of distrust around high-speed trading. As we move into 2012, it is imperative that both governments and regulators introduce smarter rules to try and prevent further high-speed market abuse, without restricting the practice.

In summary, increased levels of regulation will only restrict the benefits of HFT. When new laws such as MiFIR come into play, it is imperative the aforementioned benefits around HFT are not lost, particularly as the practice begins to grow in new asset classes such as energy. A balanced approach of smarter regulation and greater connectivity is what regulators and financial institutions should be striving for in 2012.

Tony Moulange is business development manager at Colt.