Global Regulators Scrutinize High-Frequency Trading

(October 20, 2011) — Global regulators have released guidelines on how to better monitor high-frequency trading, which has attracted increasing concern among asset managers and others in the industry.

In May 2010, the “flash crash” on Wall Street pushed investors to reevaluate the algorithms they use. Previously, in July 2009, a former Goldman Sachs computer programmer was arrested for allegedly stealing proprietary high-frequency computer codes.

Consequently, the International Organization of Securities Commissions (IOSCO) has published a new report that asserts that flow order on venues should have controls. Furthermore, the group warns that authorities should monitor unregulated members of trading venues to lessen risks posed by high-frequency and algorithmic trading.

Masamichi Kono, Chairman of IOSCO’s Technical Committee, says in the report: “Markets are evolving rapidly and it is important for regulators not only to monitor developments in technology and market structure, but also to continue to assess the impact of these changes on market integrity and efficiency and to address any risks identified.”

The specific recommendations outlined in the report by the watchdog group include:

1) Regulators should require that trading venue operators provide fair, transparent and non-discriminatory access to their markets and to associated products and services,

2) Regulators should seek to ensure that trading venues have in place suitable trading control mechanisms (such as trading halts, volatility interruptions, limit-up-limit-down controls) to deal with volatile market conditions,

3) All order flow of trading participants, irrespective of whether they are direct venue members or otherwise, must be subject to appropriate controls, including automated pre-trade controls,

4) Regulators should continue to assess the impact on market integrity and efficiency of technological developments and market structure changes, including algorithmic and high-frequency trading,

5) Market authorities should monitor for novel forms or variations of market abuse that may arise as a result of technological developments and take action as necessary,

IOSCO’s recommendations were developed in response to the G20 leaders’ request in November 2010 that the group should “develop recommendations to promote markets’ integrity and efficiency to mitigate the risks posed to the financial system by the latest technological developments.”

The recommendations follow worries expressed by asset managers in a September study that analyzed the impact of high-frequency trading on financial markets. The study consisted of responses from 630 institutional asset management firms collectively managing equity assets of more than $13 trillion.

“The survey reveals that there is strong conviction among the vast majority of long-only traders that high-frequency trading is a negative for institutional investors trading in large size, adding some hard facts to what’s previously been speculation about institutional attitudes,” said Seth Merrin, founder and CEO of Liquidnet, in a statement. “Investors are clearly concerned that their long-term investment styles are at odds with the speculative, nano-second profit taking approach utilized by high-frequency traders.”

Merrin added, “Institutional investors who manage trillions of dollars on behalf of Main Street investors need to be able to get in and out of positions in a safe and efficient manner away from the retail markets and internalization engines where high-frequency trading thrives, particularly in the volatile markets like we have been seeing recently.”

Liquidnet’s research revealed that at the top five global institutions, 73% of the traders said they regarded high-frequency trading as a high-priority market-structure issue. Traders’ concerns around high-frequency trading ran the highest among those based in North America. Almost 60% of European respondents and more than half in Asia Pacific expressed concern regarding high-frequency trading’s impact on trading performance.