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Should High Frequency Trading be Regulated?

By Esteban Medina


It takes 500 milliseconds for the brain of the average person to process external information. Meanwhile, in less than one millisecond, high frequency trading (HFT) can process market data and execute orders in extreme volumes. The world’s financial markets are increasingly being dominated by this high-speed form of trading. In fact, about 50% of total equity trading in the U.S. is currently attributed to this method.

High frequency trading, also known as algorithmic trading, is a market activity that uses powerful algorithms to automate a large volume of trades at extremely high speeds. Because computer-based HFTs have only begun implementing execution times in the milliseconds within the last two decades, the impacts of high frequency strategies on financial markets are often debated by economists. Critics have demanded aggressive regulation, often citing harsh observations, including unfair advantages over retail investors and sudden major market moves due to the algorithms used.

A number of different regulations have been proposed. For instance, some critics support the use of a stricter financial transaction tax (FTT) on algorithmic trading. An FTT is a tax on buying and selling a financial asset. This type of tax would affect firms dealing with HFT since it results in them paying the tax rate twice due to buying and selling actions occurring in rapid succession. This limits the amount of market activity HFT would have done otherwise. Other supporters of regulating HFT propose limiting speeds, sanctioning firms that violate order-to-transaction ratios, or even eliminating the action altogether.

However, high frequency trading seems to be far from rigging the markets— instead, HFT seems to make markets more efficient for all investors, making the case for stringent regulation unwarranted.

One of the most important advantages of high frequency trading is its enhancement of liquidity in financial markets. Research conducted by the U.S. Securities and Exchange Commission (SEC) further highlights the positive impact of this, as it appears to “[increase] the accuracy of prices and lower transaction costs.” The improved liquidity as a result of the increasingly competitive nature of HFT has narrowed bid-ask spreads dramatically over recent decades. From 1994 to 2011, bid-ask spreads fell from around 0.17 to 0.002 percentage points, with several empirical studies suggestingthat algorithmic trading is, at the very least, partially responsible for this. All else equal, smaller spreads indicate a better cost structure for investors. Shorter time-lags in clearing orders between buyers and sellers are also often attributed to the rise in high frequency trading. Economists have additionally found HFTs to facilitate efficiency in asset pricing by “trading in the direction of permanent price changes and in the opposite direction of transitory pricing errors, both on average and on the highest volatility days.” On these metrics, market efficiency appears to have improved immensely.

Although, of course, there are general risks associated with high frequency trading, implementing regulations hoping to curb or entirely eliminate it could have devastating impacts on the efficiency, liquidity, and stability of a secondary market that has already become accustomed to the benefits of this technological development. Robert Greifeld, the chief executive officer of NASDAQ OMX Group, has gone as far as stating “U.S. regulators are unlikely to put rules in place that would harm high frequency trading, as doing so would make trading more difficult and expensive for all investors.” Any policy enacted that hopes to limit high frequency trading could ultimately lead to removing liquidity from financial markets, and thus, increasing transaction costs and making it more difficult for investors’ trades to be filled.

Countries that have already implemented regulation on high frequency trading are now experiencing these consequences. The combination of diminished liquidity and tighter regulations has further shown to then drive investors out of these developed markets and into emerging ones instead. This is particularly true in member states of the European Union, which have carried out many regulations expected to increase firms’ compliance costs and lower trading volume. Emerging markets in HFT, such as Russia and Singapore, have witnessed a surge in algorithmic activity due to low levels of regulation.

This is of particular concern for a few reasons. First, offshoring high frequency trading activities has the possibility of putting domestic markets at risk of lost capital. The loss of HFT also reduces a domestic government’s ability to interfere in cases of serious malpractices in the global marketplace, in the case of an emerging market not having sufficient infrastructure or legal structure in place to halt unethical practices.

Some oversight of high frequency trading is, of course, warranted. For example, spoofing, once an area of serious concern for regulators, has since been made illegal following the Dodd-Frank Act. Spoofing is essentially a strategy in which investors make fake trades in order to influence competition into making faulty trades. Algorithm failures are also of particular concern for regulators, especially following Knight Capital Group’s error which resulted in losses of $440million.

However, with the banning of spoofing and an increase in algorithm productivity due to heightened competition, there is currently no evidence of market failures or abuses that would require any means of intervention in the name of market integrity. Any further regulation on HFT activity would be redundant and hurt financial markets.

Critics of high frequency trading often argue the tactic is an example of rent-seeking—where an individual or entity seeks to gain a greater share of existing wealth without creating new wealth; however, evidence supports HFT as being much more efficiency-enhancing. Regulation of HFT instead seems to have a larger chance of reducing economic efficiency as it could lower liquidity, increase costs, and transfer wealth to governments and competitors that have failed to improve their productivity in a highly automated market environment. Additionally, developed markets imposing strict regulations could have more harmful consequences than erasing the market efficiencies created over the last two decades.

With these considerations in mind, countries considering implementing regulations on HFT, such as using fees and taxes—including financial transaction taxes (FTTs)—or limits and bans on the activity, should reconsider their policy in order to ensure market efficiency and stability. High frequency trading has the ability to benefit all investors and innovate financial markets.

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