The U.K.’s Foresight Project, part of the Department for Business Innovation & Skills (BIS) has issued a white paper on “The Future of Computer Trading in Financial Markets” that discusses both high frequency trading and algorithmic trading, both of which (as the Foreword says with a bit of Brit understatement), have “attracted considerable controversy and opposition.”
The message of the Foresight Project on HFT and AT is mixed. On the one hand, (as the government’s chief science adviser, Sir John Beddington puts it in a Foreword) certain “of the commonly held negative perceptions surrounding HFT are not supported by the available evidence.” On the other hand, there is good reason for policy makers to concern themselves that HFT may contribute to instability in financial markets.
The project entailed the assistance of 150 academic authorities and other experts from more than 20 countries, and peer reviews of more than 50 commissioned scientific papers.
As to ongoing technological developments, the paper presumes the following:
- Computer power will continue to become cheaper and more widely available, in part through the use of the ‘cloud’;
- Computers will become faster, and their ability to simulate and analyze real world events will improve;
- The algorithms that drive some robots in their trading will themselves over time come to be designed and even tweaked by … other robots, which will pose “new challenges for understanding their effects on financial markets and for their regulation”;
- Middleware technology components, which can be purchased and compiled to form trading systems that have until now been the province only of very large institutions, will open up new possibilities for small and medium sized trading firms.
All of these seem fairly safe bets, since in each case the Project is not so much predicting as simply extrapolating. What is happening will continue.
These developments will entail certain social consequences. For example: the major U.S. and European cities usually cited when one thinks about high finance will lose their prominence, because the new technologies will be open to anyone to plug in anywhere. Also, the nature of the workforce at the financial hubs will change as the carbon-based life forms that have long played a role in the on-the-spot execution of orders fade into the background.
But the report seeks to alleviate certain concerns about HFT and AT. In particular:
- “The evidence available to this Project provides no direct evidence that computer-based HFT has increased volatility in financial markets.”
- “Economic research this far, including the empirical studies commissioned by this Project, provides no direct evidence that HFT has increased market abuse.”
- In general, HFT and AT have led “to benefits to the operation of markets, notably relating to liquidity, transaction costs and the efficiency of market prices.”
At the same time, the authors of the report have their own unalleviated concerns about certain of the impacts of the technological spiral. In specific circumstances, self-reinforcing feedback loops could amplify risks “and lead to undesired interactions and outcomes.”
Further, computerization of trading may contribute to a broader social process the report calls the normalization of deviance, where extremely rapid crashes will come over time to be seen as themselves unfrightening even normal events “until a disastrous failure occurs.”
Policy Measures: Good, Bad, and Evolving
The report’s authors approve of certain proposals now under discussion in Europe that might help alleviate the unalleviated concerns with HFT and AT. Circuit breakers, they say, may be valuable in helping to deal with illiquidity brought about by temporary imbalances in the limit order books. Also, the various European trading venues might want to decide on a “coherent overall minimum tick size policy.”
But the report provides a lengthy list of policy measures that are “likely to be problematic.” It is opposed to the imposition of market maker obligations or minimum resting times. It sees order-to-execution ratios (that is, any more-or-less direct limit on cancellations) as an overly blunt instrument that could curtail beneficial strategies. Also, it urges caution on any policy maker tempted to limit internalization or “dark trading” in general.
One recent change in market procedures with which the authors of this report are unhappy is the virtual central limit order book (CLOB) created by the Markets in Financial Instruments Directive. This is “still evolving and improving, but its current structure falls short of a single integrated market.” They don’t call for its repeal, but appear to hope that the “evolving” will continue in a manner that will reduce complexity and risk.