We carry out an update on the developments of High Frequency Trading with Farzine Fazel and Mohamed Radjabou who respectively senior partner and consultant at Capco. They suggest regulating this activity which holds a potential for market destabilization…

Next-Finance : Several large banks have said that they do not take part in this type of activity. Who are the main participants in High Frequency Trading?

Farzine Fazel and Mohamed Radjabou : Indeed, we do not usually come across publicly known participants in High Frequency Trading. The main ones are specialized “boutiques” or hedge funds. Among the latter are Citadel, Renaissance, Getco and others.

High Frequency Trading has been highlighted recently following the flash crash that took place in May 2010 and which saw the Dow drop by 10% When this happened, this type of activity has been heavily criticized. Do we know exactly what happened?

The responsibility of the flash crash remains undefined. The common hypothesis that is retained is that HFT has at least increased instability. On the 5th of May, Waddel & Reed Financial sold a series of futures contracts on the S&P 500 index in order to hedge it’s positions on equity markets. The order is executed by a computer through an algorithm which has apparently launched a chain reaction with other participants using the same programme. This led to the automatic selling of shares and finally the temporary disappearance of several market makers. In total, 1000 billion USD worth of market capitalization has disappeared and then brutally reappeared

The supporters of High Frequency Trading believe that this technique increases liquidity, the volume of transactions price transparency. They also claim that costs go down…is this true?

The proportion of transactions originated by machines on equity markets has reached 66% in the United States and 33% in Europe. Obviously, they are an important component of transactions and bring the required liquidity for order execution. They also participate in erasing quickly arbitrage opportunities which makes the price structure more rational.

According to Dominique Cerutti, head of Nyse Euronext, the only participants present on the markets during the month of August consisted mainly of hedge funds and high frequency traders which accounted for up to 75% of market activity. They also seem to be the only market participants when everything goes wrong. Even then, the European commission has promised to regulate high Frequency Trading since it considers that some of its actions can amount to market abuse. Does high frequency trading have a potential for market destabilization?

With stop loss mechanisms and considering the role played by machines in transactions, high frequency trading can amplify the movements of share prices. Besides, any error or operational incident from these participants can have consequences which go beyond what the markets are used to.

Is the commission in the right direction? Can it go even further and what do you suggest?

The measures proposed are carried out within the framework of the MIFID revision and include a measure on High Frequency Traders themselves (registration as a PSI as from a certain threshold) and the activities (risk control).
Besides, the ESMA requests from the trading platforms to set up procedures for a better surveillance of electronic trading. All of this is going in the right direction and must be coordinated with the regulation on laco location. This will enable a high frequency trader to physically install his servers close to an exchange. This proximity typically allows transaction time to drop by 20 milliseconds thus allowing price anomalies to be exploited very quickly.

Several observers believe that this practice to be anti-competitive since the operator benefits from an advantage which allows him so see the state of the market before anyone else. The regulation of this practice is something to explore.