Restraints on high frequency trading may hurt liquidity
IT IS surprising that an event that took place in the US is causing a regulatory backlash in Europe. The now infamous 2010 flash crash, in which the Dow Jones plunged by about 9 per cent, is the main justification for various European regulatory initiatives against electronic market-making firms .These initiatives may, however, cause more harm than good, by increasing costs and decreasing liquidity.
Despite the US regulator’s report, which established that electronic market-making firms did not cause the flash crash, various fanciful theories live on. They are accused of offering liquidity that “disappears at the first sign of trouble”. But there is much evidence to refute these claims. Data from Eurex and the Tokyo Stock exchange showed the continued presence of such firms during periods of severe market volatility. Research sponsored by the Financial Services Authority has shown similar results.
Nonetheless, the regulatory proposals are numerous, and have little regard for the substantial differences in market structure between the US and Europe.
To make sure that electronic market-making firms have no opportunity to leave the market, the European Commission has proposed a continuous quoting obligation, irrespective of market conditions. This is a truly unprecedented piece of legislation. We are aware of no other legal requirement for a group of market participants to continuously bear risk, without regard to proper risk management. This is like forcing a bank to lend money to anyone who walks into a branch, regardless of credit history. And, if that branch failed to open, the bank would be in contravention of the law.
Then there are proposals to counter a practice called quote stuffing, which was also found blameless by US regulators. These proposals involve a specifically designated order-to-trade ratio, and an order cancellation charge, to disincentivise market-makers from rapidly updating their quotes. And, as an extra barrier to updating quotes, there will be a minimum order resting time of 500 milliseconds.
Adding all this up, electronic market-making firms would be forced to quote continuously, they would be unable to update or withdraw their prices when their risk parameters told them to, and there would be limits on the permitted number of price updates altogether. And, if that wasn’t enough, they would need to pay extra for these same updates. There would be no other way to respond to these restrictions than to significantly widen quotes in equities and exchange-traded derivatives.
The barriers to entry would also become much higher. Many participants would simply be unable to quote continuously. It’s certainly an effective way to promote more off-exchange trading, which is itself more expensive for end users.
Unfortunately, these proposals look mostly like a knee-jerk political response to anecdotal evidence and false claims.
Remco Lenterman is chairman of FIA European Principal Traders Association, a body that represents traders in Europe.