Regulating the Velocities of Dark Pools. Thought of the Day 72.0

hft-robots630

On 22 September 2010 the SEC chair Mary Schapiro signaled US authorities were considering the introduction of regulations targeted at HFT:

…High frequency trading firms have a tremendous capacity to affect the stability and integrity of the equity markets. Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility.

However regulating an industry working towards moving as fast as the speed of light is no ordinary administrative task: – Modern finance is undergoing a fundamental transformation. Artificial intelligence, mathematical models, and supercomputers have replaced human intelligence, human deliberation, and human execution…. Modern finance is becoming cyborg finance – an industry that is faster, larger, more complex, more global, more interconnected, and less human. C W Lin proposes a number of principles for regulating this cyber finance industry:

  1. Update antiquated paradigms of reasonable investors and compartmentalised institutions, and confront the emerging institutional realities, and realise the old paradigms of governance of markets may be ill-suited for the new finance industry;
  2. Enhance disclosure which recognises the complexity and technological capacities of the new finance industry;
  3. Adopt regulations to moderate the velocities of finance realising that as these approach the speed of light they may contain more risks than rewards for the new financial industry;
  4. Introduce smarter coordination harmonising financial regulation beyond traditional spaces of jurisdiction.

Electronic markets will require international coordination, surveillance and regulation. The high-frequency trading environment has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment… Moreover, issues related to risk management of these technology-dependent trading systems are numerous and complex and cannot be addressed in isolation within domestic financial markets. For example, placing limits on high-frequency algorithmic trading or restricting Un-filtered sponsored access and co-location within one jurisdiction might only drive trading firms to another jurisdiction where controls are less stringent.

In these regulatory endeavours it will be vital to remember that all innovation is not intrinsically good and might be inherently dangerous, and the objective is to make a more efficient and equitable financial system, not simply a faster system: Despite its fast computers and credit derivatives, the current financial system does not seem better at transferring funds from savers to borrowers than the financial system of 1910. Furthermore as Thomas Piketty‘s Capital in the Twenty-First Century amply demonstrates any thought of the democratisation of finance induced by the huge expansion of superannuation funds together with the increased access to finance afforded by credit cards and ATM machines, is something of a fantasy, since levels of structural inequality have endured through these technological transformations. The tragedy is that under the guise of technological advance and sophistication we could be destroying the capacity of financial markets to fulfil their essential purpose, as Haldane eloquently states:

An efficient capital market transfers savings today into investment tomorrow and growth the day after. In that way, it boosts welfare. Short-termism in capital markets could interrupt this transfer. If promised returns the day after tomorrow fail to induce saving today, there will be no investment tomorrow. If so, long-term growth and welfare would be the casualty.

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