NO 235 – SEPTEMBER 2012
52nd WFE Annual Meeting

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WFE Focus September 2012
EXCERPTS FROM ECONOMIC IMPACT ASSESSMENTS ON MIFID II POLICY MEASURES RELATED TO COMPUTER TRADING IN FINANCIAL MARKETS
Oliver Linton
Cambridge University
Maureen O'Hara    
Cornell University
J.P. Zigrand
London School of Economics


Introduction by Professor Sir John Beddington

This working paper presents important interim findings of the international Foresight project: The Future of Computer Trading in Financial Markets. In particular, it considers the costs, risks and benefits of six possible regulatory measures which are currently being considered within the European Union’s Markets in Financial Instruments Directive 2 (MiFID II). It precedes the final project report which will be published later in 2012, and which will consider a broader set of issues surrounding computer-based trading (CBT) over the next ten years.

Algorithmic trading (AT) and high frequency trading (HFT) have grown rapidly in use in recent years. As such, they have also fuelled increases in complexity as well as new system dynamics, making markets ever harder to understand and to regulate. In particular, there is continuing controversy concerning the extent to which they improve or degrade the functioning of financial markets, and also influence market volatility and the risk of instabilities. For example, such trading has been implicated by some as a contributory factor in the May 6th 2010 Flash Crash.

For such reasons, computer-based trading is now attracting the close attention of policy makers and regulators worldwide.

However, the debate on high frequency and algorithmic trading has been hampered by the availability of evidence and analysis. This is of significant concern since regulation that is not soundly based risks being ineffective, or worse, could lead to unhelpful and unforeseen consequences. By drawing upon the available science and evidence from across the world, the Foresight project seeks to provide independent advice to policy makers. More specifically, this working paper has involved some 35 leading academics from nine countries and presents analysis that has been subject to independent peer review. As such, it does not represent the views of the UK or any other government. In view of the rapid pace of the MiFID II regulatory process, I have pleasure in making this paper freely available now, in advance of the full Foresight report.

Professor Sir John Beddington CMG, FRS

Chief Scientific Adviser to HM Government and Head of the Government Office for Science

 

Foresight project team

Professor Sandy Thomas (Head of Foresight)

Derek Flynn (Deputy Head of Foresight)

Lucas Pedace (Project Leader – Senior Economist)

Alexander Burgerman (Project Manager – Assistant Economist)

Gary Cook (Project Manager)

Jorge Lazaro (Analyst)

Christopher Griffin (Higher Executive Officer)

Piers Davenport (Executive Officer)

Zubin Siganporia (Research Assistant)

Yasmin Hossain (Research Assistant)

Louise Pakseresht (Intern)

Jennifer Towers (Intern)

For further information about the project please visit:

http://www.bis.gov.uk/foresight/our-work/projects/current-projects/computertrading

 

 

A requirement to post a continuous bid-offer spread is not consistent with this strategy and, if binding, could force high frequency traders out of the business of liquidity provision.

Economic impact assessments on MiFID II policy measures related to computer trading in financial markets.

Key findings

Computer trading has changed markets in fundamental ways, not the least of which is the speed at which trading now occurs. There are a variety of policies proposed to address this new world of trading with the goals of improving market performance and reducing the risks of market failure. These policies include notification of algorithms, circuit breakers, minimum tick size requirements, market maker obligations, minimum resting times and minimum order-to-execution ratios. The Foresight Project has commissioned a variety of studies to evaluate these policies, with a particular focus on their economic costs and benefits, implementation issues and empirical evidence on effectiveness. This working paper summarises those findings.

The key findings relating to the different policies are as follows, starting with those which were most strongly supported by the evidence:

  • Overall, there is general support from the evidence for the use of circuit breakers, particularly for those designed to limit periodic illiquidity induced by temporary imbalances in limit order books. Different markets may find different circuit breaker policies optimal, but in times of overall market stress there is a need for coordination of circuit breakers across markets.
  • There is also support for a coherent tick size policy across similar markets. Given the diversity of trading markets in Europe, a uniform policy is unlikely to be optimal, but a coordinated policy across competing venues may limit excessive competition and incentivise limit order provision.
  • The evidence offers less support for policies imposing market maker obligations. For less actively traded stocks, designated market makers have proven beneficial, albeit often expensive. For other securities, however, market maker obligations run into complications arising from the nature of high frequency market making across markets, which differs from traditional market making within markets. Many high frequency strategies post bids and offers across correlated contracts. A requirement to post a continuous bid-offer spread is not consistent with this strategy and, if binding, could force high frequency traders out of the business of liquidity provision. Voluntary programmes whereby liquidity supply is incentivised by the exchanges and/or the issuers can improve market quality.
  • Similarly, minimum resting times, while conceptually attractive, can impinge upon hedging strategies which operate by placing orders across markets and expose liquidity providers to increased ‘pick-off risk’ if they are unable to cancel stale orders.
  • The effectiveness of proposed measures to require notification of algorithms or minimum order-to-execution ratios are also not supported by the evidence. The proposed notification policy is too vague, and its implementation, even if feasible, would require excessive costs for both firms and regulators. It is also doubtful that it would substantially reduce the risk of market instability due to errant algorithmic behaviour, although it may help regulators understand the way the trading strategy should work.
  • An order-to-execution ratio is a blunt policy instrument to reduce excessive message traffic and cancellation rates. While it could potentially reduce undesirable manipulative trading strategies, beneficial strategies may also be curtailed. There is insufficient evidence to ascertain these effects, and so caution is warranted. Explicit fees charged by exchanges on excessive messaging and greater regulatory surveillance geared to detect manipulative trading practices may be more effective approaches to deal with these problems.

Conclusions

We have considered a variety of proposals to deal with the new world of computerised trading in markets. In this working paper, we have summarised the views of studies directed toward understanding the impact of these proposed changes. We further summarise our position below.

The desirability of understanding algorithmic trading strategies and their impact on the market is laudable but achieving this through notification requirements, as, for example, currently envisioned in MiFID II, may not be feasible given the complexity of algorithms and their interactions in the market.

The current system of exchanges determining how to structure market maker obligations and pay for them seems to be working well for most markets.

Circuit breakers have a role to play in high frequency markets, and they are found in virtually all major exchanges. Because of the inter-connected nature of markets, however, there may be need for coordination across exchanges, and this provides a mandate for regulatory involvement at least in times of acute market stress. New types of circuit breakers triggered as problems loom rather than after they have emerged may be particularly effective in dealing with periodic illiquidity.

Tick size policy can have a large influence on transaction costs, market depth, and the willingness to provide liquidity. The current approach of allowing each European1 trading venue to choose its own minimum tick size has merits, but can result in unhealthy competition between venues and a race to the bottom. A uniform policy applied across all European trading venues is unlikely to be optimal, but a coherent overall policy for minimum tick size that applies to subsets of trading venues may be desirable. This coordinated policy could be industry-based such the one agreed to by FESE members. The current system of exchanges determining how to structure market maker obligations and pay for them seems to be working well for most markets. Extending those obligations more broadly across markets and to the market making function more generally is problematic.

The aim of a more stable limit order book is laudable, and minimum resting times seem a possible device to achieve that aim. Many of the independent academic authors have submitted studies which are very favourable to a slowing of the markets. Nevertheless, they are unanimously doubtful that minimum resting times would be a step in the right direction, in large part because such requirements favour aggressive traders over passive traders and so are likely to diminish liquidity provision.

It is unlikely that a uniform order-to-execution ratio across markets would be optimal because it depends upon the type of securities traded and the trader clientele in the market.

An order-to-execution ratio is a blunt measure that catches both abusive and beneficial strategies. It may not do too much harm if the upper limit is large enough not to hinder market making and intermediation, but to the extent that it is binding on those activities it may be detrimental to both spreads and liquidity. It is unlikely that a uniform order-to-execution ratio across markets would be optimal because it depends upon the type of securities traded and the trader clientele in the market. If a ratio could be structured to target those quotes that are considered socially detrimental directly, then it might be a useful tool for combating market manipulation. The absence of research investigating costs and benefits, as well as the difficulty of actually setting this measure optimally, suggest caution in adopting this approach for the market.

© Crown copyright 2012

Foresight
1 Victoria Street
London SW1H 0ET
www.bis.gov.uk
URN: 12/1088

This includes countries in the European Union (EU), the European Economic Area (EEA) and Switzerland.