The European Parliament wants high-frequency traders to hold stocks for half a second before selling to prevent a future stock market crash, but critics retort that slowing down trading is not a solution to the problem.

What is happening?

In October 2012, the European Parliament proposed curbs on algorithmic high-frequency trading (HFT), in which propriety algorithms trade thousands of orders in a thousandth or even millionth of a second. The parliament’s decision comes as part of a proposal by the European Commission to tighten rules under the Markets in Financial Instruments Directive.

The European Parliament is not alone in this. Individual governments are taking action, but there is no common approach. HFT has come under scrutiny in recent years due to faults in the algorithms that have caused sharp stock price fluctuations and multimillion-dollar losses. Critics point to the fact that trading occurs with little or no human intervention.

“Curbing HFT would result in greater stability and price predictability, prevent further ‘flash crashes’ and eliminate pure speculation,” says Martin Schulz, president of the European Parliament.

What’s the problem?

Critics see HFT as speculative and manipulative. HFT not only trades stocks at astonishing speeds, it also breaks up orders and sends out quotes into the market to see how much investors will pay. The HFT systems then outbid other investors and sell the stock at a slightly higher price.

“HFT produces a huge number of orders, [though] many are cancelled as soon as the amount originally intended to be bought has been filled or the target price undergoes significant change. [Traders] do so in the expectation that their algorithms are intelligent enough to make a small profit per operation. The profit per operation is small, but large when you look at the cumulative amount,” says Rik Turner, senior analyst in financial services technology at consultancy Ovum.

In unstable market conditions, HFT exploits sharp price movements specifically to spur on volatility, so that the value of options increases. This happened during the infamous ‘flash crash’ in May 2010, when the Dow Jones Industrial Average lost 9.2%, then regained some ground within 20 minutes and finished the trading day down 3.2%. Although HFT was not the original culprit – the Greek debt crisis was putting strain on markets – the crash spiralled into a selling frenzy as different algorithms started trading until the exchange was shut down.

More recent casualties include market-maker Knight Capital, which lost $461m in August as soon as it opened for trade on the New York Stock Exchange with an upgraded version of its system. The Indian National Stock Exchange lost $60bn when a brokerage placed 59 wrong orders, prompting a sell-off.

Will it work?

Market practitioners emphasise that the common feature of the recent failures was not that someone traded too fast, but that algorithms were wrongly operated.

“Slowing down or stopping HFT altogether is not a solution to the problem. The market is evolving and it is the control mechanisms and policies that need to be adjusted accordingly. It should be remembered that HFT and electronic trading are also used as a service to clients to transact efficiently and transparently with other market participants,” says Svante Hedin, JPMorgan’s global head of automated trading strategies and foreign exchange trading.

Low tolerance for high-frequency trading

Ralf Roth, global head of equities, feeds and platform at data provider Thomson Reuters, suggests that exchanges should jointly enforce more testing for those wanting to use their platforms to reduce the incidents of errors and potentially make stricter regulation less necessary. But, says Mr Hedin, there are inconsistencies between platforms, partly because they all have different views on participation.

Will it happen?

There is no consensus in the EU. Germany has approved its own draft bill to restrict the speed of HFT and France has proposed a tax on HFT. But after a two-year study into HFT, the UK government’s Foresight Project published a report in October 2012 that contradicted the European Parliament’s proposal. The report argued that, since the arrival of HFT, “liquidity has improved, transaction costs have fallen for both retail and institutional traders, and market prices have become more efficient”.

For Mr Schulz, this is “a false liquidity, an illusion”. His view is that true liquidity is provided by real investors building their portfolios for a longer period of time and by market-makers who are there to help match selling and buying. “High-frequency traders do no such thing. They just exploit certain technical features of current trading systems,” he says.

The European Parliament is negotiating with its member countries on the final legislation, although “it is difficult to say how long the negotiations will last”, says Mr Schulz. The parliament is keen for rapid approval of any legislation that could thwart a future financial crisis. But with no common position on HFT among EU member states, “they are not ready to start negotiations”, says Mr Schulz

Other governments are starting to respond. The Australian Securities and Investment Commission is considering in-built ‘kill switches’ that activate when algorithms malfunction. In the US, the Securities and Exchange Commission has deployed technology firm Tradeworx to track real-time data from the 13 US exchanges. .

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