Home' Policy Magazine : Policy Vol 31 - No 4 Contents 13
POLICY • Vol. 31 No. 4 • Summer 2015-2016
profits between market participants is not in itself a
cause for concern from a public policy standpoint.
The relevant public policy question is the net
economic benefits of HFT to society as a whole.
HFT can be both a supplier and demander of
market liquidity. HFT demands liquidity when
it takes the active rather than the passive side of a
trade. However, HFT still serves a stabilising role,
by consuming liquidity when spreads are tight and
supplying liquidity when spreads are wide, limiting
the extent of spread widening.
find that HFT is generally a net supplier of liquidity,
even during episodes of market volatility.
The costs of upgrading market infrastructure to
accommodate HFT are sometimes cited as a cost
to other market participants. However, technology-
driven upgrades to market infrastructure are
essential to the long-run declines in the cost of
trading flowing from automation already discussed.
The fact that HFT drives upgrades in financial
market infrastructure to enable it to take advantage
of new technologies should be seen as a benefit to
the market rather than a cost.
Has HFT caused ‘flash crashes’?
So-called ‘flash crashes’ (or rallies) are sharp, short-
term movements in prices that do not have a readily
apparent fundamental basis. Flash crashes are not
a modern development and have always been a
feature of financial markets. On 28 May 1962, well
before the advent of electronic trading, some major
US equities listed on the New York Stock Exchange
fell 9% in 12 minutes.
Official and unofficial studies of flash crash (or
rally) episodes have found that not only is HFT
not the cause of these episodes, but that HFT firms
generally continued to supply liquidity through
these events and acted as a stabilising rather than
destabilising force for market prices.
24 To the extent
that HFT profits from market volatility, it does so
by smoothing that volatility, giving HFT firms an
incentive to trade in volatile markets.
There is evidence that HFT firms may sometimes
step aside and fail to provide liquidity during extreme
volatility episodes. This is generally in response to
internal risk controls or capital constraints and is no
different in motivation from other intermediaries
who are also constrained in their ability to manage
extreme volatility. Traditional market makers
engaged in manual trading simply failed or refused
to answer the phone during such episodes.
Faulty or poorly designed trade execution and
other algorithms have been implicated in some
volatility episodes, but this problem is not unique to
HFT. Human error (for example, ‘fat finger’ trades)
has also been implicated in market disruptions.
Any technology for trading is potentially prone to
malfunction or errors.
Market trading curbs and circuit breakers can
be used to manage volatility episodes and provide
opportunities for market participants to correct
problems with algorithmic trading and have been
effective regulatory tools for managing previous
episodes of market volatility.
Is HFT predatory or manipulative?
Market manipulation is as old as financial markets.
Like any technology, HFT can be abused. Market
manipulation is illegal in most jurisdictions. HFT
firms have just as much interest in promoting fair
and orderly markets as other market participants.
Allegations of market abuse through HFT
are asserted more frequently than they are
demonstrated. The UK Government Office for
Science commissioned three empirical studies as
part of a much wider investigation into computer-
based trading found ‘no direct evidence of a link
between HFT and market abuse.’
There are a number of potential forms of market
abuse that could be executed via HFT. So-called
‘layering’ and ‘spoofing’ strategies involving placing
orders without an intent to trade are illegal in many
jurisdictions. These strategies are not confined
to HFT, although associated technologies may
facilitate such strategies. ‘Quote stuffing’ involves
overwhelming computer systems with a large
number of order updates to slow other firms’ price
adjustment, but this is not a common practice
because it is not easy to do. These strategies constitute
market abuse under ASIC’s Market Integrity Rules
Technology-driven upgrades to market
infrastructure are essential to the long-run
declines in the cost of trading.
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