Banking StandardsWritten evidence from FIA European Principal Traders Association

High-Frequency Trading Point of View

FIA EPTA appreciates the opportunity to provide its views on High Frequency Trading to the Parliamentary Commission on Banking Standards. Below, we have provided responses to the Commission’s specific questions.

In addition, we would lilke to comment on a recent discussion between the Parliamentary Commission on Banking Standards and the CEO of HSBC, Mr. Stuart Gulliver. High Frequency Trading was described as an “ethical and culture free zone” by one of the Commission members, an opinion with which Mr. Gulliver agreed with. FIA EPTA was disappointed to hear this view. We do not quite understand where this perception around High Frequency Trading Firms in the Commission originates from and would be interested to learn more about it.

As we will explain in this paper HFT firms only operate on highly regulated, transparent and public exchanges. Their electronic and quotes and trades are based purely on public information and are completely transparent and continuously monitored by regulators and exchanges. This transparency makes any wrongdoing significantly easier to detect than in many of the non-electronic, non-public markets. In addition, the advanced automation of exchange traded markets has significantly reduced the opportunities for collusion. In FIA EPTA’s position paper published last year in relation to MiFID II, we included a section specifically aimed at dispelling a number of these types of popular myths surrounding HFT1.

The UK Treasury’s Government Office for Science’s project on the Future of Computer Trading in Financial Markets (commonly referred to as the “Foresight Project”) came to the conclusion that, while HFT activity had surged in recent years,2 the concerns around its impact on market integrity were unfounded. The Project commissioned three separate empirical studies that found no link between HFT and market abuse. One of those studies found that the increase in HFT over the five-year period had actually reduced the likelihood of market manipulation. We would strongly argue that automation is a very effective means of limiting the incidence of market abuse. Electronic trading makes markets more transparent and wrongdoers easier to trace. The recent LIBOR scandal is a case in point. Manipulation by human traders at several banks went undiscovered for years. Had this measure been electronically generated in our opinion it would not have been subject to the same risks of manipulation and it would have made uncovering wrongdoing substantially more straightforward. It should also be noted that the manually determined LIBOR benchmark is where the manipulation took place, not in the electronically traded Eurodollar futures contract, which is a related benchmark.

We were also surprised to learn that Mr. Gulliver assumed that the boards of many of these HFT firms would have little knowledge of what was actually going on in their own firms. Nothing could be further from the truth. These firms are most often owner-managed, highly entrepreneurial and innovative partnerships. These firms do not rely on clients or shareholders’ funds (nor taxpayers’ funds) to run their operations and are therefore highly skilled in the area of risk management. Because it is their personal capital that is at stake, the owners and managers have the strongest possible incentive to keep a very close watch on how trading is being conducted and to minimise the risk of any losses. Furthermore, HFT firms are relatively small in the context of the financial industry and as a result there is a very good understanding by the boards of trading firms of the various strategies that are being deployed. More often than not these senior managers are the originators of these same strategies.

Lastly, the vast majority of these firms are authorised and regulated by their relevant regulatory authority which means they are required to have adequate systems and controls in place in relation to their trading activities and operations. Given that many HFT firms are UK based the FSA has taken the lead in rendering its supervisory activities with respect to HFT firms more effective. FIA EPTA and many of its UK based members have been working very closely with the FSA in this regard. This cooperation has included from participating in thematic reviews to aid FSA’s understanding of HFT, and informal and formal dialogue following these reviews and in relation to the implementation of the ESMA Guidelines and the on-going review of MiFID.

The Nature of HFT/AT and the Extent to which Banks are Involved

Despite continued attempts a common definition of HFT is yet to be found. FIA EPTA believes too much commentary and media reporting has focused on supposed “high-frequency trading strategies”. High-frequency trading is simply a new means, or tool, used to implement age-old trading strategies such as arbitrage and market-making.3 The members of FIA EPTA are the electronic versions of the floor-based jobbers, market makers or specialists in the equity markets or “locals” in the futures markets. New technologies such as co-location and high speed data lines are, in some shape or form, used by all actors in the financial industry, including banks, hedge funds, proprietary traders and brokers.

The members of FIA EPTA act as electronic liquidity providers and are major source of liquidity on public exchanges, across a variety of asset classes. By providing prices at which other market participants may choose to trade, electronic liquidity providers bridge the time gap at which natural buyers and sellers come to the market. In fact, several exchange-traded markets, such as options, futures and ETFs, would simply cease to exist and other markets such as the equity markets would become severely illiquid if it were not for these participants. We note that the Foresight Report has found that “high frequency traders now provide the bulk of liquidity”.4

Apart from providing liquidity, there are other strategies that can be implemented by means of HFT tools.5 For example, arbitrage ensures that participants can trade at the right price across fragmented markets in the same or related products. For example, a US investor that buys ADRs listed in New York that are economically equivalent to more liquid ordinary shares traded in London wants to pay a price economically equivalent to the ordinary share price. If no market participants provided liquidity in the ADRs through arbitrage between the ADR and the ordinary shares, the US investor would pay a substantially higher price than the price at which ordinary shares are trading.

The Impact of HFT/AT on Long-Term Investors

The HM Government led Foresight Project has found that “the commonly held negative perceptions surrounding HFT are not supported by the available evidence”.6 The Foresight report came to the conclusion that “computer-based trading has improved liquidity, contributed to falling transaction costs, including specifically those of institutional investors, and has not harmed market efficiency”.7

The biggest impact of AT/HFT has been the decrease of transaction costs for institutional and retail investors. Increased automation in trading technology has enabled many institutions to access the markets through algorithms. Compared to the voice-based brokerage of ten years ago at tariffs of 25–40 basis points, institutions now access the markets through algorithms at rates as low as 1–3 basis points. Data compiled by Oxera shows a decrease of 21% in trading costs between 2006 and 2009.8 These results are supported by some of the largest asset management institutions such as BlackRock and Vanguard, who have publically stated that transaction costs have fallen as a result of automation and high-frequency trading. Vanguard for example calculates that, as a result of lower transactions costs, the average pensioner will have 30% more funds in his or her investment account over a lifetime.

In addition, using a methodology commonly known as execution shortfall—which measures the difference between the price of a security before an order is entered and the final price paid by the institution—both ITG and Elkins/McSherry, which track this data for scores of institutional investors around the world, show that costs have dropped over the past decade.

Some critics of HFT contend that HFT firms have an unfair advantage over institutional investors because HFT firms have better technology and are faster than these institutions. This notion would only be valid if institutional investors were competing with HFT liquidity providers by pursing a strategy based on the same intra-day time horizon in which many the HFT liquidity providers operate. That is clearly not the case. Instead, institutional investors make trading decisions by meeting company management and conducting research of companies. This information gives these long term investors an insight into fundamental valuations that are not accessible, and also not of relevance, to those market participants pursuing intra-day strategies. It is no more true that these institutional investors have an unfair advantage over HFT firms because HFT firms do not have the same access to company management and broker research, as it is to claim that these HFT firms have an unfair advantage over long-term investors. Because these two types of market participants pursue different trading strategies, on entirely different investment time horizons, they typically do not compete with each other and act as each other’s counterparties as a result.

How Values Consistent with High Standards can be Embedded in Automated Systems

Exchange traded markets have in a relatively short period of time become increasingly automated. Many participants that used to rely on traders to manually execute orders have now replaced many of these traders with substantially more efficient computers. The benefits of these developments, in terms of increased transparency, less opportunity for collusion and in particular vastly lower transaction costs, are unquestionable. At the same time, regulations have not kept up with these developments. These markets require harmonization of risk controls, high standards of software development and a better understanding of trading parameters.

FIA EPTA members purely trade their own capital and are reliant on their own risk controls to preserve this capital. FIA EPTA, therefore, believes that trading venues and market participants should have robust risk controls in place to address risks inherent in electronic markets and is fully supportive of the risk control requirements in the ESMA’s guidelines on systems and controls in an automated trading environment.9

Electronic systems enable the users to implement a wide range of risk management techniques and safeguards. These include, amongst others pre and post-trade checks, maximum exposure thresholds and kill switches. Risk controls are incorporated in algorithms and monitored by traders and risk managers in each firm. The execution of trading strategies is carried out by computers; but the design and monitoring of these strategies remain in human hands.

Additionally, FIA EPTA has developed internal best practices to emphasise the importance of the preservation of market integrity.10 These best practices build upon existing European regulation in general and ESMA’s guidelines on systems and controls in an automated trading environment in particular. They act as a set of recommendations from FIA EPTA to trading firms and provide guidance to firms in establishing their internal policies and procedures and/or Codes of Conduct. They reflect the commitment of FIA EPTA members to actively prevent, detect and report market abuse and to manage the risks related to their trading activities.

How HFT and AT can be Regulated and Overseen given its Complexity and Pace of Change

There are many complex questions facing regulators, policy makers and indeed market participants on risk management. It is our collective responsibility to answer these questions in an objective and dispassionate fashion, reaching conclusions based on careful analysis of empirical data.

FIA EPTA members believe that markets should strive for full transparency. High frequency trading by definition takes place on automated exchanges and MTFs. All quotes and all trades that are sent into these markets are completely transparent. FIA EPTA members base their activities fully on publicly available information and all trades and quotes can be monitored by exchanges and regulators. There is a permanent record of all these orders and trades.

FIA EPTA is committed to the minimisation of risk and the optimisation of controls related to the safe operation of electronic systems in today’s financial markets. As noted elsewhere, FIA EPTA fully supports the work of ESMA to establish guidelines relating to these specific areas. Also, to this effect, FIA EPTA has issued a set of recommendations for software development and change management.

Any Links between HFT/AT and (a) Market Abuse and (b) Market Instability and Periodic Illiquidity

Research conducted for the Foresight project (Capital Markets Cooperative Research Centre (CMCRC) in Sydney) found that while HFT activity had surged in recent years, the concerns around its impact on market integrity were unfounded. The study found that there was a “negative correlation” between HFT and end-of-day price dislocation—meaning the increase in HFT over the five-year period had actually reduced the likelihood of market manipulation.

Market abuse is not only morally reprehensible; it also comes with a hefty price tag for the market. A large part of the cost of these practices is borne by those firms that provide liquidity to the screen based markets, ie many of our members. FIA EPTA members depend on fair, orderly and honest markets to enable them to properly value the securities in which they provide liquidity. A Market participant that trades on inside knowledge will more often than not find our members as counterparty to their illicit behavior. It is also for these reasons why we have taken such a firm stance on abusive behavior.

Contrary to public opinion HFT is not more susceptible to abusive practices than other types of trading. FIA EPTA is fully supportive of measures proposed to monitor markets more effectively but emphasize the need for these same rules to apply to all market participants. In this regard, FIA EPTA fully supports the proposed changes to MAD designed to provide well-defined and clear regulation to detect, deter and enforce actions to counter fraudulent and manipulative behaviour.

Regarding market instability, much academic evidence concludes that HFT either has no effect or reduces volatility.11 The one research report that concludes otherwise12 is linking HFT activity to volatility but fail to provide evidence supporting the causal link between the two. The liquidity provided by HFTs actually counters excessive volatility and helps to bridge short term imbalances between buyers and sellers. They generally do not hold positions for longer periods of time and can therefore not influence longer termed price developments.

Periodic illiquidity

The popular notion that the liquidity provided by these firms is fleeting is anecdotal at best and not supported by data. Recent data provided by Eurex and the Tokyo Stock Exchange around severe market dislocations showed that these firms stayed in the market during these very volatile periods. Financial Services Authority-sponsored research on other markets by the University of Sydney has shown precisely the same results. These firms provide much needed liquidity around very volatile periods.

The flash crash is often used as the prime example of this fleeting liquidity. It should be noted that even in this cataclysmic event many of these HFT firms continued to trade. The problem was that the demand for liquidity vastly outstripped supply in a very short period of time.

High-frequency trading did not cause the Flash Crash and in fact absorbed the initial sell orders according to a report released by the CME as well as the CFTC/SEC report. In contrast to some media references to high-frequency traders exacerbating illiquidity, the CME review of the trading activity during the period of the flash crash found that most high-frequency traders did not leave the futures markets during the market break and continued to provide liquidity under extreme market conditions. “Based on our review, there is no evidence to support the proposition that high-frequency trading exacerbated the volatility in the markets on 6 May.”13

Additionally, the CFTC has found in their market study following the flash crash that “although some HFTs exited the market for reasons similar to other market participants… other HFTs continued to trade actively”.14

It should be noted that HFTs must execute trades in order to make profits. As such they have strong incentives to quote very close to or even at market prices. Trading firms sign-up to market-marker and liquidity programs developed and enforced by the trading venues. These programs provide incentives to market makers and liquidity providers in return for meeting certain obligations, such as providing liquidity at the best bid and offer, assuring successful price formation and market stability.

Lessons from the Flash Crash

High frequency trading did not cause the flash crash according to a joint report by the CFTC and the SEC. The staffs of the two agencies concluded that a large long term investor’s order to quickly sell 75,000 CME S&P 500 mini contracts (with a notional value of over $4 billion) created a “liquidity crisis” in the CME E-Mini futures that caused the price to drop more than 5% in four-and-one-half minutes during the most intense part of the episode. This long term investor’s order resulted in the largest net change in daily position of any participant in the S&P E-Mini contract since the beginning of that year, ie it was exceptionally large. At the same time, this long term investor decided to enter this sell order in an algorithm with no regard to price or time limits. In a market that was already extremely nervous because of the European debt crisis (there were riots in the streets of Greece at the time) this order caused the events witnessed that day. The report carried out by the CFTC found that “this sell pressure was initially absorbed by high frequency traders (‘HFTs’) and other intermediaries in the futures market”.15 The sell-off, however, created high levels of insecurity in the markets as other investors thought they had missed critical information. As a result other market prices started to rapidly drop as well.

The market events of 6th May in the U.S. exposed shortcomings of the current U.S. securities and futures market structure, most notably the absence of circuit breakers. In addition, these events exposed the need for robust risks and controls to be implemented on all algorithms. Had the long term investor used a price limit in the algorithm that they used that day than this event probably would not have taken place. It is important to note that there are meaningful differences between the European and US market structures. For example, European markets are not linked, unlike in the US where the National Market System operates (under Reg NMS). In addition, most European exchanges have circuit breaker type mechanisms in the form of intraday auctions triggered by high volatility and allow market participants to digest information and bring in additional liquidity. FIA EPTA supports robust requirements for regulated markets’ systems resilience, circuit breakers and electronic trading.

The Adequacy of Controls and Regulation

The members of FIA EPTA are committed to a sound regulatory framework. We welcome, and actively engage with EU and national policy makers regarding, the design and implementation of appropriate regulation which serves to increase transparency on markets and reduce risks.

As outlined above, FIA EPTA fully supports of the risk control requirements in the ESMA’s Guidelines on automated trading and developed the FIA EPTA Market Integrity Framework; Best Practices to Preserve Market Integrity.

Future direction

HFT will continue to develop as an industry and will play an important role over the coming years in asset classes that are currently still largely OTC traded. In accordance with the stated objectives of the G20, high frequency trading firms will play a key role in enabling this development. In fact this objective can simply not be achieved without the active participation of these firms.

The increasing amount of experience with automated and high frequency trading will help to improve risk management practices and error prevention systems both within trading firms and exchanges. Mechanisms such as circuit breakers and kill switches have already seen considerable risk reductions. These systems will become more sophisticated over time thereby further improving market stability. Increasing competitive pressure amongst HFT firms will not only see further reductions in trading cost but will also compel firms to implement improved risk management.

Meanwhile regulators and trading venues will continue to upgrade and refine their supervisory systems and processes. This will enable them to monitor market activity more effectively. In the EU it will also be particularly important to improve cross-border co-operation between regulatory authorities as well as with the US where HFT trading has a considerably larger footprint.

28 February 2013

1 FIA EPTA MiFID Position Paper [http://www.futuresindustry.org/epta/downloads/FIA-EPTA-MiFID-PositionPaper050412.pdf]

2 Foresight: The Future of Computer Trading in Financial Markets (2012), Final Project Report, The Government Office for Science, London [link]

3 We note that our position is in line with the conclusions reached by ESMA”s Task Force established in February 2011 to consider micro-structural issues in an automated trading environment and which resulted in the publication in December 2011 of Guidelines on systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities.

4 Foresight Report, p.41

5 Foresight Report, p.41

6 Ibid., p.5

7 Ibid., p.41

8 “Monitoring prices, Costs and volumes of trading and post-trading services”, Oxera, May 2011

9 ESMA, “ESMA Guidelines on Systems and controls in an automated trading environment for trading platforms, investment firms and competent authorities”, 22/12/2011, http://www.esma.europa.eu/content/Final-report-Guidelines-systems-and-controls-automated-trading-environment-trading-platforms

10 FIA EPTA Market Intergity Framework; Best Practices to Preserve Market Integrity, July 2012, http://www.futuresindustry.org/epta/downloads/EPTA-Market-Integrity-Framework_072012.pdf

11 CME Group July 2010; Jarnecic, Snape, June 2010; Hendershott, Rioirdan, Brogaard, 2009; Chaboud, Hjalmarsson, Vega and Chiquoine, October 2009; Hasbrouck, Saar, May 2011; Credit Suisse, April 2010; Frino and Zheng, 2011; UK foresight committee

12 Frank Zhang, Yale University, November 2010.

13 Comments by Bryan Durkin, Managing Director and Chief Operating Officer, CME Group, to CFTC Technology Advisory Committee, July 14, 2010, page 4 [http://www.cmegroup.com/trading/equity-index/files/CFTC_techadvisory_durkin.pdf]

14 CFTC Market Event Findings, p.45

15 CFTC Market Event Findings, p.3

Prepared 19th June 2013