HFT Regulation Requires Attention to Motives and Consequences

While there are several empirically demonstrated benefits of high-frequency trading, including improved liquidity and reduced transaction costs, the current arguments against HFT are largely qualitative in nature. With that in mind, what are the drivers behind global HFT regulation, and do they suggest a market failure attributable to HFT?

There are two sides to the high-frequency trading (HFT) debate that have emerged recently. The first is the quantitative argument that HFT is good for markets because it improves liquidity, lowers transaction costs, and improves price synchronization and efficient price discovery. This argument is often difficult for individuals outside the field of finance to perceive. The second is the simplistic and easy-to-understand qualitative argument that markets are “rigged.” Whether an argument is right or wrong, human nature and the desire for sound bites generally focuses attention toward the easier-to-understand assertion. This often leads to calls for additional regulation, and the current debate is no exception.

Globally, not all countries agree that HFT has a negative impact on market quality. While the European Union has proposed aggressive regulation, countries including Japan, Singapore, Russia, and Mexico are embracing HFT. These countries are seeking to create regulatory and market infrastructure environments conducive to a growing HFT presence in their markets to attract capital and improve liquidity.

[Related: “Best-Practice Risk Controls in Asia Offer Guide for Global HFT Regulation”]

So what motivates a country to seek to discourage HFT? To answer this question Harrison Searles, an MA Fellow at the Mercatus Center at George Mason University, and I looked at the qualitative concerns that have been raised by the global legislators and regulators themselves in their proposed regulation. We found two broad sets of goals associated with regulatory intervention: 1) Shared (or Market Integrity) goals; and 2) Divergent (or “Fairness”) goals.

Shared (or “Market Integrity”) goals seek to ensure that markets are secure, reliable and orderly, and that market manipulation and abuses are limited. We call these “shared” goals because no market participant ultimately has anything to gain in an unstable or chaotic market. Because most market participants share these goals, there are significant incentives for traders and exchanges to self-regulate through internal controls. For example, the large financial losses a trader would incur by executing a faulty algorithm provide significant financial incentives to implement quality controls and testing.

On a global basis most of the proposed “market integrity” regulations are designed to turn practices traders and exchanges already engage in voluntarily into federal regulations. In the U.S. the SEC’s proposed Regulation SCI and the CFTC’s Concept Release are good examples of this effort.

This is problematic for several reasons. First, trading systems and exchanges are complex, and creating one-size-fits-all regulation may not meet the needs of all market participants. Second, it implies a desire to impose sanctions when there are unintentional technological or other trading problems. This diminishes the incentive to publicly self-report problems, as firms may try to evade detection to avoid fines. And finally, it discourages private investment in system and risk-mitigation innovations and creates significant implementation delays, as changes would require new regulation or exceptions.

The second group of regulatory motivations comprises Divergent (or “Fairness”) goals. Like the assertion that markets are “rigged,” market critics often cite concerns about the need to level the playing field or improve fairness as reasons to impose market regulation. For example, the words ‘fair,’ ‘unfair,’ or ‘fairness’ are mentioned 130 times in the Dodd-Frank Wall Street Reform and Consumer Protection Act. However, it is important to note that many of these fairness goals are not new or exclusively related to HFT, which raises concerns about the desire to regulate market outcomes more broadly.

Attempts to curb or eradicated HFT on the grounds of fairness have resulted in some undesirable market outcomes. In France, the share of European equity turnover was reduced from 23% in 2011 to 12.85% in 2013. Italy’s market share dropped from 101 billion Euros in 2012 to 50 billion for the same time period in 2013. In Canada, a financial transaction tax resulted in a 30% drop in trades, quotes, and order cancellations, while bid-ask spreads increased by 9% market-wide.

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