The International Organisation of Securities Commissions (IOSCO) and the Bank of International Settlements (BIS) have called for strict monitoring of high frequency trading (HFT) across global currency and securities markets to ward off ‘flash' crashes.

Citing the recent Japanese Yen crash of 300 pips in 25 minutes on March 17, 2011 (see box) against the US dollar and the 5-6 per cent Dow Jones index collapse within minutes on May 6, 2010 (flash crash), the agencies said this was due to the unfair advantage HFT commanded.

Both the agencies said that providers of HFT liquidity could distort market prices away from fundamental values and impair the price discovery process due to their high volume and speed of execution.

Hence, HFT liquidity was actually a mirage, said BIS.

In India, the Securities and Exchange Board of India (SEBI) set up a Technology Advisory Committee in March 2010 to advise on issues relating to HFT, co-location and security issues related to internet based trading.

Both IOSCO and BIS concerns are that traditional market makers (those who provide liquidity) could either reduce or stop market making and move to less transparent venues.

There was no guarantee on the quality of the bid-ask quotation as drying up of liquidity could result in widening of spreads (difference between buying and selling prices) even by designated market makers.

BIS was concerned over the increasing similarity between the currency (Fx) and equity markets as Fx was increasingly becoming a more order driven market than quote driven.

Though participants were unsure whether this was necessarily bad, order driven markets have the potential to be more vulnerable to issues associated with insufficient liquidity whereas a quote driven market provides a clearer and more continuous indication of market pricing, said BIS.

Recommendations

IOSCO said that regulators should ensure that trading venues do not use fees, incentive schemes, rebates and inducements for providing liquidity as a tool that results in unfair, non-transparent and /or discriminatory access to a trading venue.

It said regulators should require trading venue operators to be nimble to the demands of the nature, scale and speed of trading activity and have adequate control mechanisms to throttle market disruptions due to sudden volatile price movements.

Regulators should not allow trading venue operators to offer direct electronic access without proper checks and balances with regard to creditworthiness, legally binding client intermediary agreement, KYC for better surveillance, access to pre- and post-trade information and controls at all market and intermediary levels, said IOSCO.

Regulators should continuously ensure that risks to market integrity and efficiency by the use of technology (especially algorithmic and HFT) does not occur by taking suitable measures to mitigate risks to price formation or to the resiliency and stability of markets.

Market authorities should monitor for novel forms or variations of market abuse that may arise as a result of technological developments and take necessary action.

(This article was published on November 3, 2011)
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