Impact of HFT regulation on markets

Financial Times today:

EBS, one of the two dominant trading platforms in the foreign exchange market, is suggesting scrapping the principle of “first in, first out” trading, which it says gives an unfair advantage to the fastest computers and has led to an arms race of spending on technology.

Instead, under the plan, incoming orders would be batched together and dealt with in a random order.

For now, let’s ignore the question whether any regulation is necessary, and discuss the impact this particular change of rules will have for the market microstructure if they were accepted universally.

Liquidity providers, i.e. market makers, will have a harder time figuring out their priority in the order book and may be exposed to pick-offs of resting orders in the case of a news event – depending on whether cancellation messages are prioritised over trade messages by the exchange. Bid/ask quotes can only widen based on these new regulations.

Trade agressors, i.e. market takers, will have less benefit of an advantage in speed. Any self-respecting trading firm can get their orders to the exchange in milliseconds, so when multiple firms run similar strategies (and they certainly do), speed won’t be the deciding factor anymore. These regulations are effectively discouraging competition and will lead to a more level playing field among HFT firms and thus to a slow-down in the technological arms race.

It is up to the regulators and exchanges to decide whether the wider bid/ask and the forced reduction in competition justify the cost savings. Personally, I am all for free markets and wouldn’t regulate when it isn’t needed – but this proposal is as feasible as I’ve seen. It’s certainly a less ludicrous idea than introducing a financial transaction tax or a minimum holding period.


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