Circuit Breakers Adequate for Flash-Crash Prevention

High-Frequency Trading: The Fast and the Furious is the first of a two-part report that examines the regulatory landscape around high-frequency trading (HFT), defining the activity and analyzing recent events that have garnered widespread media attention for the perceived effects of the practice. Although various measures to curb HFT have been suggested by regulators and politicians alike─minimum resting periods, order messaging ratios, market-maker obligations and more─GreySpark suggests that these responses are not necessarily beneficial to a sober analysis of the situation.

"The Flash Crash is the obvious, newsworthy item that stimulated a lot of debate around this, and it has caused certain camps within Washington or here in the UK to react on a political basis and legislate for it," says Bradley Wood, a partner at the consultancy. "What we've seen, with some governments or regulators who are not experts in this sector, is a knee-jerk reaction and a tendency to become heavy-handed in this area of financial regulation. There are areas where regulatory responses are needed, but there are some aspects where we've had suggestions from regulators that, frankly, aren't workable, like time delays."

Simple Steps
Rather than potentially harmful measures such as forcing orders to be held for a minimum period of time, which have been routinely dismissed by market participants and studies such as the UK Government's Foresight report as inappropriate, GreySpark suggests that venue-level controls such as limiting trading in a volatile instrument, or withdrawing rogue algorithms are a more elegant and efficient solution.

"If you have a circuit breaker in place, it can shut off a certain algorithm, and it's not a particularly technical implementation to make it limit trading in an instrument for a period of time, That's the correct way to handle it," Wood explains. "So even if there are other algorithms that are well behaved in normal conditions, but are reacting to a rogue algorithm, then that should be fine. It should simply be a matter of pulling the offending algorithm, or if that's not clear, then just halt trading on that instrument until it can be determined what exactly is going on. That's sufficient, and that's what we're trying to articulate in the paper."

Notification and Certification
A recurrent topic of discussion around algorithmic controls─that of strategies being certified in some way─has also been dismissed as unworkable in its current form, mainly due to the difficulties in presenting criteria by which it should be examined and the technical resources needed to dig into the guts of an algorithm. However, a blend of market-maker obligations and algorithmic notification could lead to the buy side stepping into roles traditionally occupied by investment banks, at a time when capital adequacy requirements and other measures are forcing them to reconsider balance sheet-intensive activities such as market making.

"If you have a circuit breaker in place, it can shut off a certain algorithm, and it's not a particularly technical implementation to make it limit trading in an instrument for a period of time, That's the correct way to handle it.

"It would not be surprising to see alternative investment houses, hedge funds and so on, beginning to take up the market-making slack, if you will, as banks exit. And actually, managing your balance sheet and the risks associated with market making may be better placed in a hedge fund, where there's no bailout required if they fail, and they can make money by bringing liquidity to markets," Wood says. "Then when you bring an algorithm on board, you should inform [the relevant authority] whether it's an arbitrage algorithm, or a liquidity provision algorithm, so there's some sense of classification. And if you are a liquidity provision algorithm operator, then the venue may elect to rebate you for that in a way that's attractive. But with that rebate should come an obligation to provide liquidity at all times, and not just when the markets aren't crashing."

Fragmentation
However, regardless of whether the free market is empowered to find solutions that enable HFT shops or hedge funds using algorithmic strategies to become liquidity suppliers, the fragmented landscape of regulation still provides challenges.

"I suspect it'll be some time yet before we see a consolidated, or settled, global view around regulating HFT," says Wood, pointing out the disparity of approach even inside the EU regarding issues such as the financial transaction tax, and the enormity of difference between regulatory regimes in Asian nations. That in itself, he warns, may lead to regulatory arbitrage.

The Bottom Line

• GreySpark's report essentially states that circuit breakers should be adequate to solve issues such as the Flash Crash, without a need for further legislative action.
• While the industry debates market-maker obligations, algorithmic notification and the like with regulators, elements may be practical but as a whole, existing proposals are unworkable.
• The fragmented regulatory landscape surrounding HFT and algorithmic trading is complex, and potentially of concern.