September 25, 2012

Germany is set to approve a new bill this week that aims to rein in high-frequency trading and the risk associated with the practice. The move has financial industry observers already fearing that it could open up a path for tougher rules across Europe that could seriously hamper the growth of high frequency trading in the old continent.

Up to 40% of trading sales in Germany are currently driven by high frequency trading, the German finance minister says. While high frequency trading has taken off to an even greater extent in other European countries – in the UK for example, it accounts for 77 percent of transactions according to a 2011 Tabb Group report – Germany will be one of the first EU countries to move on the issue, the Wall Street Journal notes .

Still, the UK is also considering legislation, France and Belgium have been pushing high-frequency legislation too, and Germany hopes its bill will put pressure on other European governments to support EU-wide regulation on high-frequency trading, according to the WSJ.

So what will happen if the German legislation on HFT goes into effect? According to the WSJ, excessive use of trading systems would come with added fees and traders would have to keep a balance between orders and executed transactions. New rules would also introduce a minimum amount that prices can change on each transaction, which could in turn increase costs for traders.

Of course, the high frequency debate continues to rage in the U.S. too. Detractors are concerned about the increasing number of incidents, such as the 2010 Flash Crash and the Knight Capital debacle last month that have been set off by high frequency trading, have caused chaos in financial markets, and have seriously damaged investor confidence.

But high-frequency trading supporters say regulation would harm the market by preventing traders from reacting quickly to market shifts and managing risk.

From the WSJ:

Imposing caps on the number of trades or instituting order-to-trade ratios, as proposed in the bill, could restrict traders from being able to revise their quotes, the price at which they buy or sell stocks, based on new information, they say. Installing a minimum price change can lead to larger market spreads, which equals higher costs for traders.

"We think a one-size-fits-all approach would be very harmful. These order-to-trade ratios could be harmful if not set on the right level," said Remco Lenterman, chairman of the FIA European Principal Traders Association, which represents firms that trade their own capital in the exchange-traded markets. Mr. Lenterman did praise Germany for allowing exchanges to play a strong role in regulating the market, adding that "our goal is to make sure the markets are not disrupted."

Perhaps most importantly, experts suggest the issue at stake isn't high-frequency trading itself and the need for the practice to be regulated, but the fact that firms are failing at their core competencies – such as when Knight Capital glaringly failed to test its software leading to its August 1 market disaster.

As such, regulators should ensure adequate controls and tests on the part of market participants, rather than trying to put a stop to high-frequency trading itself, experts argue.

On October 2, the SEC will be holding a market technology roundtable to discuss how market participants can prevent and respond to technology errors in real-time. After the roundtable, Wall Street & Technology and Advanced Trading will hold a live video webcast with industry experts to analyze the various points of view raised during the SEC’s discussion. Join us for the webcast, and let us know your thoughts on the issue.

Melanie Rodier has worked as a print and broadcast journalist for over 10 years, covering business and finance, general news, and film trade news. Prior to joining Wall Street & Technology in ...