Government should not overregulate the HFT market.

AuthorBell, Holly A.
PositionStock Market - High frequency trading - Essay

HIGH Frequency Trading (HFT) is a form of algorithmic trading where firms use high-speed market data and analytics to look for short-term supply and demand trading opportunities that often are the product of predictable behavioral or mechanical characteristics of financial markets. It often is referred to as "equity market making." HFT firms usually hold their positions for less than a minute while perpetually looking for opportunities to buy and sell. These transactions happen thousands of times a day, take microseconds, and often net less than a penny in profit per share traded.

Concerns have been raised in recent years about the potential market risks associated with HFT and algorithmic trading in general. Some opponents have argued that these practices create risk and require aggressive regulation. Purported risks to the stability and integrity of financial markets created by HFT include the creation of a two-tiered market system as a result of asymmetric information, potential volatility, "noise" and informational distortions, out-of-control algorithms, and "flash crashes." However, many of these concerns are neither new nor exclusively related to HFT.

HFT is, quite simply, a contemporary tool that facilitates informational market efficiency and, as such, is capable of being regulated by the market and market participants--indeed, there is significant evidence to indicate HFT activity already is being regulated by the market. At the same time, HFT improves market efficiency by lowering the costs to investors, controlling volatility, and improving liquidity. Many of the concerns raised by those calling for increased regulation predate the emergence of HFT, and thus those concerns are not particular to HFT. There are, however, opportunities for regulators, HFT firms, and exchanges to continue to work together to monitor and develop internal and external "circuit breakers" and consolidated audit trails to ensure continued market stability and integrity.

This is an important time to discuss the role, if any, for U.S. regulators in monitoring or controlling HFT. Countries such as France and Germany recently have taken significant steps to curtail or even ban HFT activities. In the U.S., the Securities and Exchange Commission (SEC) has proposed additional regulation under a new rule called Regulation Systems Compliance and Integrity ("Regulation SCI"). This seeks to "formalize and make mandatory many of the provisions of the SEC's Automation Review Policy that have developed during the last two decades."

Fortunately for HFT traders, according to Andrei Kirilinenko, former chief economist at the Commodities Futures and Trading Commission, the current proposal by the SEC aims "to take existing practices and make them Federal regulations" rather than attempting to curtail HFT market activity significantly. Yet, the move does signal a desire by U.S. regulators for an increased and more formalized regulation of HFT.

Financial markets are believed to be "informationally efficient." This term comes from the efficient market hypothesis developed by economist Eugene Fama. The underlying concept of the efficient market hypothesis is that "no simple rule based on already published and available information can generate above-normal rates of return."

Fama describes the conditions facilitating market efficiency as "markets where there are a large number of rational profit-maximizers actively competing with each other, trying to predict future market values of individual securities, and where current information is almost freely available to all participants." He describes an informationally efficient financial market as "a market in which prices always 'hilly reflect' available information." High frequency waders create a base of rational, profit-maximizing competitors that use available high-speed information to help determine the market value of individual securities.

When the efficient market hypothesis was developed, information was passed on relatively slowly as professional investors gathered around tables and examined quarterly and annual reports and painstakingly created hand-drawn charts of stock and market activity. HFT is a contemporary application of the same process that takes advantage of the increasing speed and quantity of data and the availability of computer algorithms that can sort through and analyze data quickly.

Efficient markets rely on the efficient distribution of information. This information resides inside and outside the market. Within the market, information is contained and reflected in the price of securities. Once outside information is known to at least one person, it begins to be reflected in the price of a security or the market as a whole. Microeconomic information influences the value of a security relative to another security, whereas macroeconomic information can influence the market value as a whole.

The movement and symmetry of internal and external market information are not assumed to be perfect. As Fama states, it is "almost freely available." One of the early notable contributions to the field of market efficiency includes a paper published in 1921 by economist F.W. Taussig, in which he observed that financial markets seem to diverge from the ordinary reasoning of supply and demand as they are subject to manipulation based on information that may not be widely known.

He observed that technical information--such as whether a position is oversold or undersold--and insider information and rumors all led to fluctuations not anticipated by supply and demand alone. In other words, information (and anticipated information)...

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