Make or break for powerful method

Debate rages over a trading technique, with some commentators blaming it for fuelling chaos - while others highlight its contribution to technological progress and market efficiency.

Monique Melis is a member and Alison Adcock is a consultant at Kinetic Partners.

The FSA has made it clear that these types of abuse will not be tolerated and that Direct Market Access providers must introduce controls that identify and prevent these types of activity. To some extent, the London Stock Exchange has already paved the way for this, when it fined an undisclosed firm £35,000 for layering the order book in October 2008.

This year the EU is calling for layering to be explicitly defined as market abuse and in America, the scrutiny of market abuse and its possible connections to HFT strategies has been stepped up: in June 2010 the Securities and Exchange Commission implemented a temporary policy requiring exchanges to halt trading in a stock if it declined more than 10% in any five-minute interval. It is considering implementing “limit up/limit down” levels to slow big price changes without stopping trading, and is still considering a new marketwide circuit breaker to temporarily pause trading if a market is in crisis.

Among all the major regulatory bodies, there is consensus that market abuse needs to be better defined, updated in line to reflect strategies and terminology related to advances in technology and applied uniformly and globally before market abuse regulation can be effective. However, this has to be achieved in such a way that innovation and competition are not stifled, so as not to halt progress.

HFT therefore has advantages and disadvantages: while it has increased liquidity and market efficiency, it has also created regulatory debate and uncertainty. Indeed, the Markets in Financial Instruments Directive review is proposing that firms register their algorithms with their regulator: a measure that is likely to be opposed.

So what will become of HFT? It is widely suggested that HFT will run a natural course. Irrespective of regulatory reform, it is becoming harder for traders to use this method of trading profitably, as momentary price anomalies are so quickly corrected that opportunities are missed and many traders are out of pocket.

In addition, message traffic across multiple trading venues has increased over the past few years, which unabated will surely slow down systems rather than improve latency. Has HFT become a victim of its own success? Does this mean that HFT will eventually break its own market? Only time will tell.