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Conquering Fear in Trading

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October 3, 2011

On Regulation and HFTs

How A U.K. Report Could Impact U.S. Markets

By Annette Nazareth, Robert Colby and Jai Massari

Also in this article

Recently the Foresight Programme, a research arm of the United Kingdom government, published a working paper on "The Future of Computer Trading in the Financial Markets." The paper focuses on the effects and risks of computer-based trading, including algorithmic and high-frequency trading, on financial market stability and efficiency.

The paper confirms what many market participants suspected: Since the rise of computer-based trading, markets may be less tidy, but they also appear to be more efficient. But the paper also points out novel-and alarming-risks raised by computer-based trading. These include the risk of causing sharp market shocks that are difficult, if not impossible, to anticipate or address ex ante.

The topics addressed in the paper are closely related to those being examined by the U.S. Securities and Exchange Commission and Commodity Futures Trading Commission in connection with the flash crash of May 6, 2010. The paper is consistent in some respects with findings of the SEC and CFTC staff in their "Flash Crash Report," in that it emphasizes the role computer-based trading may have in causing market instability. Overall, the paper may strengthen the resolve of regulators and legislators to take action to forestall endogenous shocks from computer-based trading.

Working Paper

The working paper comprises three articles that draw conclusions from a series of academic papers commissioned by Foresight. The articles focus on separate, but closely related, aspects of computer-based trading. The first article analyzes the effects of computer-based trading on market volatility. It concludes that, to date, no evidence exists tying computer-based trading to higher market volatility. Indeed, it observes that the increased prevalence of computer-based trading has coincided with decreased market volatility under normal market conditions.

The second article reviews the effects of computer-based trading on liquidity, price efficiency, and transaction costs. Consistent with the conclusions of the first article, the second asserts that computer-based trading has coincided, in normal market conditions, with improved market quality, including increased liquidity, lower transaction costs and greater efficiency in market prices. But it emphasizes the likelihood of non-linear price movements shocking the system and undercutting investor confidence.

The third article focuses on the effects on financial markets of technological advances in trading systems, including cloud computing, customized CPUs and autonomous adaptive trading algorithms, each of which reduce the need for human traders and increase the speed of trading systems. The article concludes that the rapid pace of technological change and increasing use of computer-based trading systems will continue for the foreseeable future. Importantly, it notes that these technological advances mean that computer-based trading systems can relocate to markets anywhere in the world.