A key message coming from the widely-read Foresight Report entitled The Future of Computer Trading in Financial Markets (2012), prepared by The Government Office for Science, London, indicates that high frequency trading (HFT) and algorithmic trading (AT) may have several beneficial effects on markets. However, the report continues, HFT/AT may cause instabilities in financial markets in specific circumstances. The report shows that carefully chosen regulatory measures can help to address concerns about computer based trading (CBT) in the shorter term. However, further work is needed to inform policies in the longer term, particularly in view of likely uncertainties and lack of data. This will be vital to support evidence-based regulation in this controversial and rapidly evolving field, the report concludes.
“While the effects CBT on financial markets have been the topic of some controversy in recent years, analysis of the available evidence has shown that CBT has led to benefits to the operation of markets, notably relating to liquidity, transaction costs and the efficiency of market prices. Against the background of ever greater competition between markets, it is highly desirable that any new policies or market regulation preserve these benefits.
However, this Project has also highlighted legitimate concerns that merit the close attention of policy makers, particularly relating to the possibility of instabilities occurring in certain circumstances, and also periodic illiquidity. In view of the critical importance of financial markets for global growth and prosperity, the following suggests priorities for action:
A. Limiting possible future market disturbances:
A.1 European authorities, working together, and with financial practitioners and academics, should assess (using evidence-based analysis) and introduce mechanisms for managing and modifying the potential adverse side-effects of CBT and HFT. Section 7 of this Executive Summary sets out analysis of ten individual policy options, and provides advice on which are supported most by the available evidence. It is also important that such regulatory measures are considered together, not individually, in view of important
interactions which may exist between some of them.
A.2 Coordination of regulatory measures between markets is important and needs to take place at two levels:
- Regulatory constraints involving CBT in particular need to be introduced in a coordinated manner across all markets where there are strong linkages.
- Regulatory measures for market control must also be undertaken in a systematic global fashion to achieve in full the objectives they are directed at. A joint initiative from a European Office of Financial Research and the US Office of Financial Research (OFR), with the involvement of other international markets, could be one option for delivering such global coordination.
A.3 Legislators and regulators need to encourage good practice and behaviour in the finance and software engineering industries. This clearly involves the need to discourage behaviour in which increasingly risky situations are regarded as acceptable, particularly when failure does not appear as an immediate result. These recognise that financial markets are essentially complex ‘socio-technical’ systems, in which both humans and computers interact: the behaviour of computers should not be considered in isolation.
A.4 Standards should play a larger role. Legislators and regulators should consider implementing accurate, high resolution, synchronized timestamps because this could act as a key enabling tool for analysis of financial markets. Clearly it could be useful to determine the extent to which common gateway technology standards could enable regulators and customers to connect to multiple markets more easily, making more effective market surveillance a possibility.
A.5 In the longer term, there is a strong case to learn lessons from other safety-critical industries, and to use these to inform the effective management of systemic risk in financial systems. For example, high-integrity engineering practices developed in the aerospace industry could be adopted to help create safer automated financial systems.
B. Making surveillance of financial markets easier:
B.1 The development of software for automated forensic analysis of adverse/extreme market events would provide valuable assistance for regulators engaged in surveillance of markets. This would help to address the increasing difficulty that people have in investigating events.
C. Improving understanding of the effects of CBT in both the shorter and longer term:
C.1 Unlocking the power of the research community has the potential to play a vital role in addressing the considerable challenge of developing better evidence-based regulation relating to CBT risks and benefits and also market abuse in such a complex and fast-moving field. It will also help to further address the present controversy surrounding CBT. Suggested priorities include:
- Developing an ‘operational process map’: this would detail the processes, systems and interchanges between market participants through the trade life cycle, and so help to identify areas of high systemic risk and broken or failing processes.
- Making timely and detailed data across financial markets easily available to academics, but recognizing the possible confidentiality of such data.
C.2 The above measures need to be undertaken on an integrated and coordinated international basis in order to realize the greatest added value and efficiency. One possible proposal would be to establish a European Financial Data Centre.”
Professor Dave Cliff, Professor of Computer Science at the University of Bristol and member of the lead expert group overseeing the project, will be keynote speaker at High-Frequency Trading Leaders Forum 2013 London, March 21, on the topic “What the Foresight Report Tells us About the Future of Computer Trading in Financial Markets.”