Interesting to read the venerable Leo Melamed's open letter in the FT this week on HFT and regulators. The CME's chairman emeritus certainly makes a good point when he says that trying to stifle innovation is both wrong and inevitably doomed to failure, but I am not sure he's completely right in a couple of areas.
First, whilst it's true that algorithmic or HFT players have indeed had the effect of narrowing spreads, this is not always the best thing for the trading community as tighter spreads are nearly always associated with smaller trade sizes. This is a particular problem for the institutional buy-sides wishing to trade in size. A colleague at one such buy-side firm compared HFT to a waiter who, rather than serve a meal in three sensible courses, insists on bringing it to you in small spoonfuls and stays at your table waiting for a tip before he will go back to the kitchen for your next morsel.
Second, I imagine that most regulators would see themselves as gamekeepers rather than poachers but this does help highlight the fundamental problem our industry faces. The minute you interfere in any ecosystem and try to protect one species or another you invariably invoke the law of unintended consequences. This is especially true in financial markets that are going through a rapid period of evolution driven by a technology-inspired natural selection process. The tendency then is to try and adjust for these consequences with yet more regulation and so the vicious cycle continues. This is confirmed by the fact that it was the regulators themselves that inadvertently fuelled the HFT boom by breaking up the national (natural?) monopolies of stock exchanges in the first place.
We begin 2012 much as we left 2011 with fear, uncertainty and doubt being the prevailing sentiments, so maybe regulators on both sides of the Atlantic should take a second look at their groaning inboxes. Perhaps a return to lighter touch regulation is the lesser of two evils.
Why not let the natural evolution of financial markets play itself out. Of course, there will be individual winners and losers but the overall ecosystem will emerge stronger to the benefit of everybody who is either directly or indirectly affected by capital markets. The alternative will be ever-growing mountains of retrospective regulation that will be arbitraged, hidden behind or simply never understood.