As European law-makers close in on a deal to tighten rules on high-frequency trading, a new paper from the ECB warns that curbing the practice could make markets less efficient.
HFT has caused consternation thanks to several high-profile incidents - most infamously the May 2010 flash crash which saw the Dow Jones Industrial Average plummet - which have raised concerns about its effect on the stability and price efficiency of markets.
Last month the European Parliament hammered out a preliminary deal with EU member states on how to regulate the practice as part of negotiations for MiFID II, which is expected to come into effect in 2016.
However, despite its largely negative reputation, HFT may actually make price more efficient, says the paper from academics Jonathan Brogaard, Terrence Hendershott and Ryan Riordan.
Examining transactional level data from 120 stocks traded on Nasdaq between 2008 and 2009, the team found that high-frequency traders "reduce the noise component of prices and acquire and trade on different types of information, making prices more efficient overall".
Therefore, any moves to curb HFT will make markets less efficient unless additional measures are brought on to support price discovery, warns the paper.
It concludes: "When considering the best way to organise securities markets and particularly the intermediation sector, the current one with HFT more resembles a highly competitive environment than a traditional market structure.
"A central question is whether there were possible benefits from the old more highly regulated intermediation sector, e.g., requiring continuous liquidity supply and limiting liquidity demand that outweigh lower innovation and monopolistic pricing typically associated with regulation."
Despite being published by the ECB, the paper is the opinion of the authors, not the bank, and Europe is still on course to bring in several HFT curbs, including circuit breakers, official testing of traders' algorithms, harmonisation of tick sizes and synchronisation of business clocks.
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