Abstract
Regulators and policy makers are concerned that high frequency trading strategies may hamper the integrity of markets. Some participants in the debate about high frequency trading (HFT) consider that such trading provides liquidity to markets, reduces bid/offer spreads and corrects anomalies. Others believe that the liquidity produced is artificial, that such trading facilitates market manipulation, and that it may lead to “flash cracks.” (A flash crack (or flash crash) is a rapid and sudden drop and recovery in securities or financial instruments prices. The most famous is the one which occurred on may, the 6th, 2010 on the US stock market (the Dow Jones plummeted about 1000 points and recovered a few minutes later).) The purpose of this article is to shed some light on the various factors explaining the development of high frequency trading (including the end of the concentration rule, competition and technological innovation) as well as on the pros and cons of regulatory measures which are being considered, in particular in the revision of the Market In Financial Instruments Directive (MIFID 2) and the Market Abuse Directive (MAD2).
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Notes
« L’intérêt, toujours ingénieux, à s’affranchir de ce qui le capture, a trouvé moyen d’éluder le règlement qui interdit tout marché d’effets royaux ou publics, sans livraison ou dépôt ; des reconnaissances concertées, des déclarations annulées par des contre-lettres et des dépôts fictifs voilent aujourd’hui les contraventions et rendent fort difficile d’en découvrir la trame », Hilaire [11], p. 77.
Also see the creation of “initial margin“ technique by exchange agents. Hilaire [11], p. 117, « Ainsi se dessinait une sorte de spirale dans le développement du droit en la matière : l’interdiction suscitait l’innovation, cette dernière menait à son tour à la légalisation de l’usage ».
Regulation (EC) No 1060/2009 of the European Parliament and the Council on credit rating agencies, modified by Regulation (EC) No 513/2011. This regulation is currently under revision.
Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers.
See in particular the different initiatives of European regulators (UK, Netherlands, France, Belgium) to regulate, even to ban, commercialisation of complex structured products.
Definition proposed in the preliminary revision project of Regulation (CE) No 2004/36 on Market in Financial Instruments (MiFiD).
de Boissieu [4].
Of course there were exceptions, like block trades or complex trades. In practice, the bond market and the derivatives market escaped this obligation.
For a same level of market volatility.
CFTC, SEC [3].
Economic research shows that HFT firms base their investment decisions (new IT tools, calculation power, etc.) on the behaviour of their competitors (herd behaviour). There are strategic similarities, which lead to a situation where the more you invest the bigger return on investment you receive (the yield from information asymmetry decreases in proportion with the degree of equipment of other players). Biais [2].
Akerlof [1]. On the used cars market, only the seller knows products quality and the buyer has a suspicious attitude. G. Akerlof calls it the “non-selection” risk.
Decision of the AMF (French market regulator) Disciplinary Commission concerning Kay Trading Company of May 12, 2011.
Case C-445/09 IMC Securities BV v Stichting Autoriteit Financiële Markten, judgement of 7 July 2011 (not yet reported)
In Europe, volumes steadily increased prior to the recent financial crisis, mirroring the development of high frequency trading. This is a quite low margin activity (less than 1 bp/transaction). Its development has been encouraged by lower execution fees, due to the competition between markets which was made possible by the MIF Directive. This trend lasted until 2008 and the financial crisis. Since then, volumes decreased globally which led some to believe that high frequency trading liquidity was artificial. Furthermore because of the crisis, liquidity figures have become more volatile, which may have increased this impression of shrinkage. But in reality, the proportion of high frequency has remained globally stable (at 50 % to 80 % depending on the market). Thus, the increase liquidity was not artificial, but was a consequence of the MIF Directive. It is even possible that if market competition continues with lower execution fees, high frequency volumes could increase yet more.
Les Echos, 9 June 2011, p. 32.
Droit, Henrot [5], « Tout cadre règlementaire dans le domaine financier – souligne-t-il avec justesse – est par nature précaire en ce qu’il s’applique à une réalité en perpétuel changement, qui sécrète en permanence des innovations, c’est à dire des transgressions ».
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This article is based on a presentation given at the Conference The MIFID II Legislative Proposal, organised by ERA on 28–29 June 2012 in Trier. The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Société Générale. The author retains all rights to the material in any form, including oral presentation.
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Bréhier, B. High frequency trading: should technological developments be considered a potential threat to financial markets and be subject to specific regulation?. ERA Forum 14, 69–80 (2013). https://doi.org/10.1007/s12027-013-0293-0
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DOI: https://doi.org/10.1007/s12027-013-0293-0