07 Nov Analysis – Foresight Committee Report on the Future of Computer Trading in Financial Markets

In the past, we’ve taken a consistent position on the need for greater control and diligence in automated trading whilst urging caution on the seemingly unstoppable HFT witch-hunt. A balanced argument requires us to face the potential dangers of HFT, but better to gather evidence first and cast judgement second – don’t you think?

We found the recent Foresight Committee findings on “The Future of Computer Trading in Financial Markets” made for a refreshing and well-researched contrast to the usual political spin.

Admittedly, there was a lack of quantitative data in some areas and I disagree with their assertion that “academic studies can only approximate market abuse as data of the quality and detail required to identify abuse are simply not available to researchers”. That data does exist for some markets, such as cash equities, is available to researchers and would have made a worthwhile, if narrow, addition to the paper.

But on the whole, we found that a range of the findings hit the mark, including:

• Engineering discipline – There is a clear need for better design methodologies as well as better testing. The need to iteratively back-testing your algo against vast quantities of historical data in a cost effective and timely manner has never been greater. We would also add that a separation is required (as with all software) between the developers and testers. HFT/AT shops should create dedicated and impartial testing teams within their risk operations to support better engineering discipline.

• Circuit breakers – Circuit breakers at the venue-level are clearly a good idea. However, the responsibility should also fall on the market participant to monitor their own order flow and pre-emptively block orders that would cause market instability if they ever reached the market. A “prevention is better than cure” mind-set is urgently required within the risk organisations responsible for automated trading.

• Consolidated tape and virtual consolidated order book – Consolidated tape and virtual consolidated order book are a must to balance the benefits of fragmentation (price competition) with the threats (inhibits price discovery). Intuitively, it feels to me like fragmentation has gone too far and the benefits are overstated but if we accept that it is a fact of life, a consolidate tape and order book are the only way ensure efficient price discovery and reduce information asymmetry.

• Off-exchange trading – Off-exchange trading represents another threat to price discovery and, as the report rightly points out, cannot go on indefinitely else there will be no price at all. It is not clear to me what the ideal ratio of dark: light traded volume is. One would assume that if price discovery is weakened by off-exchange and dark trading, then traditional directional fundamental based investors would detect that a security is under/over-priced and step in to correct – BUT that is an assumption.

Given this broad agreement, I was surprised to read that “European Union lawmakers renewed calls for tougher curbs on high-frequency trading” in the same week as the Foresight Committee findings were released – without so much as suitable time window to reflect on the outcome of the research.

I am especially surprised (or is it concerned?) at the extent the EU continues to feel it necessary to intervene in the day-to-day management of market infrastructure – such as what a suitable order to trade ratio should be for a trading venue. But maybe it’s time we just accept that this debate has ceased to be rational and has become a purely political issue. It may save us some precious column inches.

What’s your take on the findings and the EU’s concurrent recommendations?