AFM evaluates use of high-frequency trading (HFT) in European financial markets

The Netherlands Authority for the Financial Markets [Autoriteit Financiële Markten, or “AFM”] sees no grounds for restricting the use of ”high-frequency trading” (HFT). The AFM sees HFT not as a separate strategy, but as a technique for applying short-term trading strategies that have been in use for years. This assessment changes if HFT were to be used to implement an illegal trading strategy, but in this respect as well HFT is no different from other trading strategies. The AFM reaches this conclusion in its study on the role of HFT in the European financial markets published today.

The fragmentation of the European securities markets as a result of changes to the market structure has contributed to the growth of HFT. Using HFT, trading strategies can be implemented that provide liquidity on various trading platforms and that contribute to more efficient price formation for securities.

The AFM takes the view that automated trading methods like HFT have increased dependency on complex technical systems. It therefore argues that additional requirements should be set in the European context with regard to operational and risk management systems used by market participants throughout the trading chain.

In general, the internationalisation of the financial markets has resulted in increased complexity. The AFM therefore argues for a more intensive exchange of information between international regulators and further harmonisation of European supervision.

The AFM also invites market participants to respond to its report and to debate the benefits and potential risks of HFT both with the AFM and with their peers.

High-frequency trading: a technique, not a strategy
HFT uses advanced information technology that allows market participants to trade at a rate and in volumes that until recently would have been impossible. The AFM takes the view that HFT cannot be held responsible for the occurrence or exacerbation of recent financial crises. However, it is the case that complex technological innovations in the financial markets require careful analysis of the impact and (systemic) risks that may be involved. This was the reason for the AFM to conduct a review of HFT.
High-frequency trading is not a trading strategy in itself; it is a means of automatically executing certain short-term trading strategies by means of arithmetical algorithms. HFT is used in market making and arbitrage. The profit model for high-frequency traders consists of transactions that individually involve very small profit margins, but which are executed in very large volumes. In many cases, HFT is used by proprietary traders. The AFM estimates the market share of HFT in the European financial markets to be between 30 and 40 percent.

New market structure promotes growth of HFT
Since the introduction of the Markets in Financial Instruments Directive (MiFID) in 2007, trading in securities takes place simultaneously on various different trading platforms. This has created new market making and arbitrage potential for HFT traders. The AFM attributes the recent growth of HFT in Europe to the fact that high-frequency traders recognised the potential offered by the new market structure. HFT strategies that add liquidity and assist the process of price formation make a positive contribution to reducing fragmentation and therefore, in the opinion of the AFM, on balance have a positive function in the market.

HFT is not market abuse
The strategies used in HFT are nothing new. As long as people pursue legitimate strategies, the AFM sees no grounds for treating high-frequency traders any differently from other market participants. If however the strategies are designed to abuse the market, the AFM will take action. In itself, HFT cannot be equated with market abuse.

To be able to act effectively against possible illegal and/or undesirable behaviour by market participants, it is essential that regulators make additional investments in technological know-how, expertise and resources. The information systems currently available in Europe are not adequate for supervisors to obtain a coherent and complete picture of the behaviour of individual players in the European capital markets. In the opinion of the AFM, a more intensive exchange of information between international regulators and further harmonisation of European supervision are needed.

Further improvement to operational and risk management systems
The AFM does not consider it appropriate to prescribe the time horizon or technology with which market participants may trade. It does however consider that the growth of automated trading has further increased the dependence of the financial markets on technology, as was shown during the
“flash crash” in the United States on 6 May 2010. The systems and processes of traders, brokers, trading platforms, and clearing and settlement firms have to be able to cope with the effects of HFT and other automated trading. One market participant’s problems must not be allowed to result in a crash of an entire system.

The AFM’s aim in publishing today’s report is to provide information on the phenomenon of HFT and the trading strategies this involves. The report is also intended to list the effect and risks associated with HFT. Lastly, the report identifies a number of points for consideration and puts forward recommendations to regulators and market participants for improving the present situation.

AFM report on high-frequency trading (HFT)

The link next to this page is to a speech that AFM board member René Maatman gave on October 7 at the Amsterdam Derivatives Day. This speech is based on the AFM report and provides a summary of its contents.

The AFM is committed to promoting fair and transparent financial markets.

As an independent market conduct authority, we contribute to a sustainable financial system and prosperity in the Netherlands.

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