Preserving Capital Markets Efficiency in the High-Frequency Trading Era
Due to technological innovation and automation, trading on equity markets has changed dramatically during the past twenty years. Algorithmic and High-Frequency Trading (HFT) have come to equally characterize U.S. and European financial markets, while relevant regulation remains slow to adapt. Despite increasing liquidity, narrowing spreads, and reducing short-term volatility, HFT can negatively impact market quality and stability, and render marketplaces more vulnerable, especially during crisis periods or under uncertain market conditions.
In both the U.S. and Europe, regulatory action directly or indirectly targeting HFT prioritized constraining market disruption and manipulation, while giving insufficient consideration to how HFT-related informational inequalities interact with the allocative function of price discovery.
The current financial markets settings offer many ways to gain early access to inside information and trade data. Low-latency news wires and market data feeds, along with co-location, are available to any investor willing to pay for these services. But, as a matter of fact, selling these services gives rise to information asymmetries among investors to the advantage of those, such as high-frequency traders (HFTs), who actually find themselves in the position of profiting from faster access to market-moving information, due to their superior capacity to process information and trade upon new information before it reaches other investors. The resulting two-tiered system of information dissemination contrasts the principle of equal access to information underlying financial regulation in the U.S., as well as the EU. In addition, HFTs’ structural advantage in processing information can affect disclosure-based market efficiency, as theorized in the Efficient Capital Markets Hypothesis (ECMH).
Despite the fact that news wires’ early access arrangements violate the prohibition against insider trading, and Regulation Fair Disclosure (Reg FD), where corporate information is disseminated (as is often the case), the SEC seems to tolerate this type of information inequality. On the other hand, insider trading rules seem not to apply to early access to trade data, and subscribing to direct market data feeds from the exchanges does not violate Rule 10b-5, or Reg FD. In the EU, too, where the principle of equal access to information is explicitly embraced by Regulation No. 96/2014/EU concerning market abuse (MAR), the sale of faster access to exchanges’ proprietary feeds equally falls outside the scope of application of insider trading rules.
Information inequalities tolerated or admitted under the current insider trading and issuer disclosure rules affect financial market efficiency and challenge the theoretical framework underlying the ECMH. Due to reduced latency, 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 long-term price discovery, since trades are only marginally based upon information concerning securities and their issuers, and fundamental analysis thereof.
Against this backdrop, in a recent article we develop an analytical framework for possible regulatory strategies to limit the negative effects of HFT on allocative market efficiency by reducing HFTs’ speed advantage or incentivizing fundamental informed traders to enter markets where they face costs to compete with HFTs. Given that the current insider trading regime is—if adequately enforced—suitable for restricting 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. Minimizing information advance to prevent HFTs from exploiting aggressive trading strategies that ultimately micro-front-run slower investors, may be achieved by either restricting the sale of market data feeds, or slowing down HFT. Unlike replacing the current continuous trading regime with a discrete-time trading regime based on frequent batched auctions, restricting the sale of trade data feeds or mandating speed bumps would not demand radical change in current equity markets regulation. But, either of these measures may discourage HFT, and weaken its positive effects in terms of increased liquidity and better short-term price discovery. Importantly, they would not definitively curb HFT-related risks concerning long-term price accuracy.
If future empirical evidence was found to more strongly support HFT’s negative impact on real resource allocation, regulators might consider taking action aimed at alleviating the 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 might be pursued via 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 potentially discouraging effect deriving from the risk of being faced with insider trading liability for trading upon selectively disclosed information, the SEC may consider widening the reach of public companies’ mandatory disclosure obligations in a way similar to the EU, and therefore introduce a continuous, event-driven, and timelier, disclosure regime. This solution would ask for limited adjustments in the regulation, and seems not to present major drawbacks when compared to the current SEC rules concerning issuers’ disclosures.
Gaia Balp is Assistant Professor of Commercial Law at Bocconi University, Milan, and a guest contributor to the Oxford Business Law Blog.
Giovanni Strampelli is Associate Professor of Commercial Law at Bocconi University, Milan, and a guest contributor to the Oxford Business Law Blog.
This post first appeared on the Columbia Law School Blue Sky blog here.
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