Whilst liquidity plays a central role in the functioning of financial markets, it is volatility that can be truly detrimental. Despite almost universal agreement among academics that HFT improves prices for investors and dampens volatility in equity markets, since the 6th of May 2010 the sector has come under intense scrutiny from regulators.
On a day described as the ‘Flash Crash’, the U.S stock market experienced one of the most severe price drops in its history. In the matter of five minutes, the Dow Jones Industrial Index declined by 900 points, and then recouped the balk of those losses within the next 15 minutes. This unprecedented and unexplained volatility has fired public debate ever since.
In the aftermath of the US ‘Flash Crash’, regulators were quick to pin blame on HFT. Within a week the chairman of the US Securities and Exchange Commission determined there was evidence that “professional liquidity providers” pulled out of the market when shares started declining exacerbating the fall. Perhaps irrationally, policymakers without any significant evidence believe HFTs pull out of markets at signs of stress, contributing to a sudden loss of liquidity and promoting volatility (Grant, 2011).Moreover, Andrew Haldane points to the ‘flash crash’ whens he determines that the ever increasing speed of trading is amplifying volatility.
In my opinion, in the aftermath of the financial crisis when regulators received so much criticism, I believe they feel they must act immediately, even if they don’t know the true problem. I consider this evident from calls for increased HFT regulation from US Senator Charles Schumer, who bases his opinion on recent news reports (Zerohedge. 2010), rather than academic research or scientific research. Subsequently, this has led the European Commission to propose that HFT firms will be required to be market makers throughout the trading day, regardless of market conditions.
Market participant Getco, one of the largest HFT firms, argues in a letter to the SEC that the firm actually commits more capital and provides more liquidity during volatile periods, thus supporting market stability when it is most needed (Grant, 2010). On top of this, an independent study (Makan, 2011) led by Andrei Kirilenko, chief economist at the Commodity Futures Trading Commission, found HFTs were actually less likely to exit the market during the US ‘Flash Crash’ than traditional market-makers. Furthermore, a study commissioned by the UK government concluded “Economic research thus far provides no direct evidence that high frequency computer based trading had increased volatility” (BIS, 2011).
However, against this tide of academic consensus, Professor Frank Zhang of Yale University (2011) concludes “Events can move markets, but high-frequency trading increased the volatility in the overall market”. Regardless of being commonplace among academics and experts that HFT provides some extra liquidity for the market, Zhang suggests that...