Fed Extends Arm To HFT Recognizing Contribution To Market Efficiency

Federal Reserve of New York Researcher Ernst Schaumburg Considers HFT Vital For Efficient FX Order Flow

As the somewhat draconian steps being taken by the European Commission toward high frequency trading (HFT) continue to take shape, the viewpoint of senior officials across the pond denote a contrasting perspective.

The New York Federal Reserve has released a report which states that the research which it conducted, indicating that that HFT and the ongoing predilection among industry participants for algorithmic trading makes the electronic trading environment more efficient, and creates a fairer market for all concerned, especially in liquid markets such as FX.

The report, published by Ernst Schaumburg, a research officer at the Federal Reserve Bank of New York’s Research and Statistics Group had concluded that the practice within financial markets exercised by users of algorithmic trading strategies and HFT serves to enhance the efficiency, rather than creates toxic order flow.

Mr. Schaumburg’s research asserts that “The FX spot market is an over-the-counter market and differs importantly from other liquid markets like equities or futures, which are exchange traded and therefore feature a centralized counterparty.”

It is the view of the Federal Reserve of New York’s research department that FX spot trades, in contrast to transactions among other asset classes, are bilateral transactions that rely on credit arrangements between the two parties involved, which means that each participant only sees, and can act on, quotes posted by counterparties with whom a bilateral credit arrangement is in place.

Accordingly, there is no concept of a universal best bid and offer price, as is the case with U.S. equity markets.

A report issued by the Bank For International Settlements (BIS) on high-frequency trading in FX from 2011 estimates the share of FX global spot activity that was automated to be roughly 25 percent (compared with common estimates of up to 70 percent in equities) according to Mr. Schaumburger’s report.

Other sources estimate higher shares, particularly for FX spot trading in the major currencies. While much of the attention on algorithmic and high-frequency trading after the flash crash has focused on liquidity issues, another important aspect is the role of this type of trading in the rapid impounding of new information in market prices.

Mr. Schaumburg continues to bolster this case by ascertaining that “in the FX spot market, the impediments to enforcing no arbitrage are greater than they are for exchange-traded products since the would-be arbitrageur would need to have a credit arrangement in place (possibly indirectly through a dealer) with all three market participants that posted relevant quotes.”

Whilst North America, home to the lion’s share of the world’s proprietary trading companies and some of the most advanced infrastructure, continues to embrace HFT and algorithmic trading, European efforts to stem order flow generated by such means continue to run counter to American ethos.

“While there’s a broad diversity of players in the FX spot market—including corporations, official institutions, and pension funds—the latest data show that activity is most concentrated among the large FX dealers and other financial institutions,” is Mr. Schaumburg’s synopsis, which is certainly concurrent with figures reported by LeapRate recently relating to the dominant market share held by the largest banking giants globally in terms of FX order flow.

In April last year, LeapRate reported that ICAP subsidiary EBS had embarked on making changes to the means by which it handles incoming orders by eschewing its previous first-in-first-out (FIFO) method in favor of batching the orders and executing them in a random manner in an attempt to conduct what the company viewed as a leveling of the playing field in favor of non-HFT participants.

During this time, ParFX arrived on the market, supported by a number of banks as the new platform from Tradition, aiming to attract some of the order flow which moved away from EBS in what had become something of a technological arms race. European Commission’s Michel Barnier issued a document on January 14 this year, detailing that MiFID II will introduce a series of controls for algorithmic trading activities and HFT, insisting that they must provide liquidity when pursuing a market-making strategy.

Additionally, the European Commission insists that firms which provide direct electronic access to a trading venue will be required to have in place systems and risk controls to prevent trading that may contribute to what the governmental authorities view as a disorderly market or practices that involve market abuse.

Independently to regulatory requirements, EBS had considered imposing a latency floor to its execution, which would implement a mandatory delay before executing a trade, therefore discouraging HFT and users of algorithms from processing trades on its ECN.

With this recent publication by the New York Federal Reserve, along with the Commodity Futures Trading Commission’s verdict last year that the Volcker Rule segment of the Dodd-Frank Act aimed at outlawing proprietary trading should not apply to FX when it was implemented across other areas of the financial sector, it is certainly becoming apparent that the trading desks of North America remain steadfast.

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