Towards protection of swaps user margin and more scrutiny on high frequency trading

The SEC is considering whether new requirements should be imposed on high frequency trading and what benefits market makers should get for meeting those obligations. In the meantime the CFTC moves forward to protect swaps user margin from peer default.

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High-frequency trading is a style of buying and selling, via automated trading systems, based on momentum or statistical arbitrage signals on relatively short time windows of about one second to several hours. Under normal conditions, it contributes to narrow bid-ask spreads, to lower brokerage fees, to improve the speed of execution as well as market efficiency and liquidity.

The volume of transactions is constantly growing and accounts for more than half of U.S. equities trading according to the SEC. Mainly used by experts in quantitative trading, it started facing Securities and Exchange Commission (SEC) scrutiny early in the summer of 2007 and more recently following the rout on May 6, 2010, that erased $862 billion in value in less than 20 minutes before rebounding!

According to Bloomberg, the SEC is considering whether new requirements should be imposed on market makers and what if any benefits they should get for meeting those obligations. Citing Mary Shapiro, chairman of the SEC, a reassessment of the “entire regulatory structure” surrounding the firms is needed, in part to determine whether the algorithms or strategies used to generate and send orders are “programmed to operate properly in stressed market conditions. Somehow, it will mean to define the bounds of volatility that would "officially invalidate" this type of trading.

On the swap market, the Commodity Futures Trading Commission (CFTC) is gradually moving towards the establishment of a protection of collateral and margin calls. We all remember the earthquake caused by the default of Lehman Brothers,one of the largest swaps dealers. Many institutions have lost huge amounts of money because their margin wasn’t segregated within the bank. BlackRock Inc., the world’s largest asset manager, advocated for this approach because it allow swaps users who post collateral to a clearinghouse to have their margin protected against another investor’s bankruptcy.

This move may increase trading costs as clearinghouses will require more money from swaps users to compensate for the reduction of the amount of funds available to them to fund a default. The project is still at an early-stage and more details on the protection has not yet been given. The CFTC is still asking for comments on other margin protection proposals. Today swaps clearing is still voluntary.

Next Finance May 2011

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