A study on high-frequency trading (HFT) commissioned by the UK government has dismissed a number of measures in MiFID II designed to curb the practice but recognises the danger it poses to market stability.
Overall, the Foresight project, a two-year investigation led by the UK’s Government Office for Science, found that HFT was beneficial to liquidity and price formation and helped to lower transaction costs, but noted that it created the “potential for periodic illiquidity”.
The report also assessed the rules in MiFID II to control HFT – which were signed off by the European Parliament’s Economic and Monetary Affairs Committee (ECON) last month – labelling many as problematic.
In particular, the Foresight report said market making obligations, whereby HFT firms would be obligated to provide two-sided markets, could lead some liquidity providers to exit the market because the risk of losses would be too great.
It also noted many HFT strategies rely on posting bids and offers in correlated instruments, so a requirement to constantly provide liquidity would not be consistent with this strategy.
A similar conclusion was reached for minimum resting times. In its version of MiFID II, ECON voted that all orders should be valid for 500 milliseconds before they can be cancelled. Specifically, limit orders would be in danger of going stale and could be subject to front-running practices for aggressive high-frequency traders.
“Moreover, to the extent that minimum resting times inhibit arbitrage between markets, which is essentially at the heart of many HFT strategies, the efficiency of price determination may be diminished,” added the report.
A ban of maker-taker pricing, which was also included in ECON’s revised version of MiFID, would not have the desired effect of reducing HFT and making order routing more transparent, according to Foresight. The report said the practice, which pays rebates to posters of liquidity and charges liquidity takers, improves depth and trading volume, without negatively affecting spreads.
"Blunt instrument"
Foresight also concluded that order-to-execution ratios (OTRs), typically a charge levied on firms that cancel an excessive number of orders compared to actual executions, are a “blunt instrument” that could “curtail beneficial strategies”. OTRs are gaining traction among markets globally, including Deutsche Börse, which implemented the fee to ease the loads on its trading platform.
Proposed policy measures supported by the research included a standardisation of tick sizes and circuit breakers.
“Because of the inter-connected nature of markets there may be need for coordination across exchanges, and this provides a mandate for regulatory involvement,” read the report. “New types of circuit breakers which are triggered before problems emerge rather than afterwards may be particularly effective in dealing with periodic illiquidity.”
Noting that the use of computers and information technology in financial systems will lead to more complex markets in the future, the report also urged regulators take an integrated approach to better understand the nature of HFT. This could be achieved by improved post-trade transparency and analysis that better allows for the identification of market abuse. The use of standards, such as synchronised timestamps, would also help to improve surveillance.
The review of MiFID is currently at the halfway stage and is expected to be completed by 2014. A plenary meeting of MEPs will meet on 26 October to vote on the version of MiFID II approved by ECON. After the Council of the European Union has proposed its version of the directive, both European legislative bodies will be required to agree on a final text.