Evidence is reviewed in ‘Economic impact assessments on MiFID II policy measures related to computer trading in financial markets’, a working paper by Foresight. The paper shows support for the use of some measures currently under consideration in the EU under MiFID II. Other measures are likely to entail costs that exceed potential benefits. This paper has been developed within Foresight’s forthcoming study of computer trading in financial markets.
The working paper was written by leading, independent academic experts and does not represent the position of the UK or any other government. It draws on the work and advice of 35 leading independent academics from 9 countries.
The policy measures assessed in the research include:
- circuit breakers
- tick sizes
- market-maker obligations
- minimum order-to-execution ratios
- minimum resting times
- notification of algorithms
Overall, there is general support from the evidence for the use of circuit breakers, particularly for those designed to limit periodic illiquidity induced by temporary imbalances in limit order books. Different markets may find different circuit breaker policies optimal, but in times of overall market stress there is a need for coordination of circuit breakers across markets.
There is also support for a coherent tick size policy across similar markets; given the diversity of trading markets in Europe, a uniform policy is unlikely to be optimal, but a coordinated policy across competing venues may limit excessive competition and incentivise limit order provision.
The evidence offers less support for policies imposing market maker obligations. For less actively traded stocks, designated market makers have proven beneficial, albeit often expensive. For other securities, however, market maker obligations run into complications arising from the nature of high frequency market making across markets, which differs from traditional market making within markets. Many high frequency strategies post bids and offers across correlated contracts. A requirement to post a continuous bid-offer spread is not consistent with this strategy and, if binding, could force high frequency traders out of the business of liquidity provision. Voluntary programmes whereby liquidity supply is incentivised by the exchanges and/ or the issuers can improve market quality.
Similarly, minimum resting times, while conceptually attractive, can impinge upon hedging strategies which operate by placing orders across markets and expose liquidity providers to increased ‘pick-off risk’ if they are unable to cancel stale orders.
The effectiveness of proposed measures to require notification of algorithms or minimum order-to-execution ratios are also not supported by the evidence. The proposed notification policy is too vague, and its implementation, even if feasible, would require excessive costs for both firms and regulators. It is also doubtful that it would substantially reduce the risk of market instability due to errant algorithmic behaviour, although it may help regulators understand the way the trading strategy should work.
An order-to-execution ratio is a blunt policy instrument to reduce excessive message traffic and cancellation rates. While it could potentially reduce undesirable manipulative trading strategies, beneficial strategies may also be curtailed. There is insufficient evidence to ascertain these effects, and so caution is warranted. Explicit fees charged by exchanges on excessive messaging and greater regulatory surveillance geared to detect manipulative trading practices may be more effective approaches to deal with these problems.
Government Chief Scientific Adviser Sir John Beddington said:
With financial markets evolving at a rapid pace, it is essential we develop a better understanding of the critical issues which affect the health of this sector and the wider economies in serves.
I believe this evidence and analysis will be valuable to policy makers and regulators wanting to maximise the opportunities from computer-based trading while managing the risks. This kind of analysis is vital if a resilient regulatory framework is to be put in place.
Computer-based financial trading has grown substantially in recent years. It now accounts for around 70% of equity trading in the US, and 30% in Europe.
Such trading has attracted controversy and has been implicated by some, as a contributory factor in the so called May 6 (2010) ‘flash crash’ in which $1 trillion temporarily evaporated from US markets.
A key aim of the Foresight study into computer-based trading is to use the available science and evidence to evaluate the benefits and risks of this technology and to assess options for policy.
Notes to editors
‘Economic impact assessments on MiFID II policy measures’ by Professor Maureen O’Hara, Professor Oliver Linton, Dr Jean Pierre Zigrand can be found here: www.bis.gov.uk/assets/foresight/docs/computer-trading/12-1088-economic-impact-mifid-2-measures-computer-trading.
It will inform a 2-year study into computer trading and the financial markets, to be published by Foresight in the autumn.
The working paper is being published now to make this review of emerging evidence available to policy-makers around the world.
MiFID (the Markets in Financial Instruments Directive II) is a major part of the European Union’s Financial Services Action Plan (FSAP), which is designed to help integrate Europe’s financial markets. For more information see: www.fsa.gov.uk/about/what/international/mifid/background.
The UK government’s Foresight Programme helps government think systematically about the future. Foresight uses the latest scientific and other evidence to provide advice for policymakers in addressing future challenges.