“Taken together, the different behaviours of active and passive high-frequency trading firms indicate a heightened risk of periods of short-term excessive volatility, which could encourage market upheavals as far as flash events,” the Bundesbank wrote.
Regulators in Europe and the US have been considering new rules for high-frequency traders, who have become some of the largest players on major exchanges around the world in recent years, accounting for around half of all trades in US and European Union equity markets, according to Tabb Group and the European Securities and Markets Authority.
In its study, the Bundesbank examined trading in some of the most liquid German stock and bond futures contracts, in which high-frequency firms accounted for about 44% of trades.
The Bundesbank divided high-frequency firms into two broad types: those that trade actively on news, and those that act as market-makers, or intermediaries between buyers and sellers of assets.
It found that the first type of traders were particularly active during periods of high market volatility, and therefore contributed to that volatility. The second group, by contrast, tended to withdraw from financial markets during periods of high market stress, just when they might be needed most to provide additional liquidity.
“Around the time of the publication of important news, the liquidity provided by HFT [firms] falls significantly,” the Bundesbank wrote.
Supporters of high-frequency trading claim that they boost liquidity on financial markets, making it easier for investors to buy or sell an asset.
However, regulators believe that such firms could cause market distortions, including by aggravating events such as the 2010 flash crash, in which the Dow Jones Industrial Average plunged about 9% within minutes before rebounding.
European Union regulators have agreed on new rules due to enter into force next year, known as Mifid II, which introduce closer regulation and monitoring of algorithmic and high-frequency trading firms.
One additional rule under discussion is enforcing minimum resting times for orders, a step that has been fiercely opposed by some traders.
Such a rule would help reduce the incentives for a technological “arms race” on stock markets, which has questionable social value, the Bundesbank said.
Write to Tom Fairless at email@example.com
This story was first published by The Wall Street Journal