Preserving Capital Markets Efficiency in the High-Frequency Trading Era

Automation and new technology have dramatically changed trading on equity markets over  the past 20 years, and algorithmic and High-Frequency Trading (HFT) have become prominent in U.S. and European financial markets, while regulation has been slow to adapt. Despite increasing liquidity, narrowing spreads, and diminishing short-term volatility, HFT can lower market quality and stability and render marketplaces more vulnerable, especially during crises or periods of uncertainty.

Regulations affecting HFT have prioritized, in both the U.S. and Europe, preventing market disruption and manipulation, while failing to closely consider how HFT-related inequalities in information interact with the allocative function of price discovery. Financial markets offer many ways to gain early access to inside information and trade data. High-speed news wires and market data feeds, along with “co-location” – positioning a trader’s computers close to those of a trading venue’s, are available to any investor for a price. But these services create information asymmetries that favor investors, such as high-frequency traders (HFTs), who profit from faster access to market-moving information, because they can process information and trade on it before it reaches other investors. The resulting two-tiered system of information dissemination and HFTs’ advantage in processing information can affect disclosure-based market efficiency, as theorized in the Efficient Capital Markets Hypothesis (ECMH).

What’s more, though there’s an argument that news wires can violate insider trading laws and Regulation Fair Disclosure (Reg FD[1]) when they prematurely disseminate corporate information, the Securities and Exchange Commission seems to tolerate this type of information inequality. By contrast, insider trading rules do not to apply to early access to trade data, and paying for a subscription to direct market-data feeds from securities exchanges does not violate Rule 10b-5, or Reg FD. In the European Union, where the principle of equal access to information is explicitly embraced by Regulation No. 96/2014/EU concerning market abuse[2], the sale of faster access to exchanges’ proprietary feeds also falls outside insider trading rules.

Nonetheless, even lawful information inequalities affect financial markets’ efficiency and challenge the theoretical framework underlying the ECMH. Early access to trade data allows HFTs to anticipate order flow and trade ahead of slower investors. HFTs reduce informed traders’ incentives to perform (costly) fundamental analysis, since they erode the possibility to profit from the first-mover advantage gained through investing in fundamental research and analysis. As a result, market prices may become less informative in the longer run, and negatively affect allocative efficiency. Importantly, HFT is structurally unable to contribute to long-term price discovery, since HFTs’ trades are only marginally based on information about securities, issuers, or financial analysis.

Against this backdrop, we develop a conceptual framework for possible regulatory strategies aimed at limiting the negative effects of HFT on allocative market efficiency. The framework would aim to reduce HFTs’ speed advantage and give informed traders more incentive to enter markets where they face costly pressures to compete with HFTs. Given that the current insider trading regime can—if adequately enforced— restrict the sale of news wire services that provide early access to corporate information, reducing HFT-related informational inequalities requires focusing on data feeds that grant subscribers faster access to trade information. A possible key is to either restrict the sale of market data feeds or slow down HFT.

To reduce information inequalities between HFTs and slow traders, a prohibition against selling private trade data feeds seems unnecessary. First, equal access to market data could be restored if the SEC adopted the interpretation of Rule 603(a)(2), according to which distributed data cannot be made available to private clients sooner than core data is made available to a network processor. Second, speed advantages could be significantly limited, if not eliminated, if speed bumps were mandated, or if the current continuous-trading system was replaced with an alternative market structure, e.g. a discrete-time trading regime based on frequent batched auctions. While not affecting private data feeds, these measures would largely prevent HFTs from micro-front-running other investors, which would bear a limited risk to transact upon stale information.

Either of these measures may, however, discourage HFT and weaken its ability to increase liquidity and promote short-term price discovery. Importantly, they would not clearly curb HFT-related risks concerning long-term price accuracy. Although the regulatory approaches illustrated above can alleviate the impact of two-tiered access to trading data, they still remain problematic and raise unresolved questions that illustrate the need for additional empirical studies.

As a consequence, regardless of the adoption of measures aimed at reducing HFTs’ speed advantage, if future empirical evidence confirmed HFT’s negative impact on real resource allocation, regulators could consider actions aimed at alleviating pressures suffered by fundamental informed traders. Supporting allocative efficiency within HFT-dominated equity markets by providing fundamental traders with more frequent and cheaper access to information may be taken into consideration pursuant to two different, and to some extent opposite, strategies. Subject to a confidentiality agreement, selective disclosure of material non-public information is a means already available to reduce fundamental traders’ information research costs. But, given the disincentive of potential insider trading liability for trading upon selectively disclosed information, legislators and the SEC may consider widening the reach of public companies’ mandatory disclosure obligations in a way similar to what the EU has done, and introduce a continuous, event-driven, and timelier, disclosure regime.

ENDNOTES

[1] https://www.sec.gov/rules/final/33-7881.htm.

[2] http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32014R0596.

This post comes to us from professors Gaia Balp at Bocconi University, Milan, and Giovanni Strampelli at Bocconi University, Milan. It is based on their recent paper, “Preserving Capital Markets Efficiency in the High-Frequency Trading Era,” available here.

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