Regulators must track FX high-frequency trade – BIS

• BIS report says HFT has significant impact on fx market
• Policymakers need to keep abreast to identify issues
• HFT could soon spread to emerging market currencies

LONDON (Reuters): Policymakers must deepen contacts with foreign exchange dealers, prime brokers and electronic trading platforms in the $ 4 trillion-a-day forex market to monitor the expanding activities of high-frequency trading, a report published on Tuesday said.

The report released by the Bank for International Settlements and authored by a group headed by Guy Debelle, assistant governor of the Reserve Bank of Australia, said high frequency trade (HFT) could in some circumstances accentuate shocks that originated elsewhere.

However, it said a “flash crash” in May last year suggested systemic risks are more likely to be triggered by an algorithmic trade gone wrong, rather than pure HFT which it said now accounted for about a quarter of spot forex trade.

HFT, which tends to involve small-size trades, short horizons and diverse strategies, is picking up in the forex market but its share was still below that in equities.

HFT involves the use of sophisticated, technological and quantitative tools like algorithms to generate near-term trading signals with very short risk-holding periods. Their growth in forex has been facilitated by rapid advances in information technology and wider use of electronic trading.

“Policymakers should continue to keep abreast of this development by maintaining contact and dialogue with the evolving set of relevant market participants,” the report said.

Supervising such trades is of particular interest to politicians and policymakers worldwide after the “flash crash” of May 6, 2010 when U.S. stock markets saw wild swings and triggered volatility across asset classes including forex.

“HFT may under some circumstances accelerate and propagate shocks initiated elsewhere,” the BIS report said.

“There are key differences in market structure that may make a flash crash-type event less likely in FX than in equities.

But certain longer-term trends such as the adoption of similar technologies have seen FX and equity trading converging.”

Regulators worldwide are ramping up efforts to supervise HFTs. The European Union is beefing up its eight-year old market abuse rules to catch up with high-frequency trading in the commodities market and plug supervisory gaps.

In the U.S., a Wall Street regulator has asked firms to turn over their algorithms as part of its probe into suspicious market activity.

The BIS report said HFT strategies in the forex and stock market were considerably different. For example, HFT in stocks can benefit from a strategy where local exchanges offer rebates to attract flows and boost volumes. No such market-making strategy is yet available in the FX market.

Having shot into the limelight in stock markets, HFT in forex has increased since it first appeared in early 2000.

The BIS report estimates their share at 25 per cent of the global spot market turnover. In comparision, some estimates put HFT’s share at 56 per cent of the U.S. equity market and 38 per cent in European markets.

So far, HFT is concentrated in the major currency pairs such as euro/dollar , dollar/yen , sterling/dollar and euro/Swiss franc , but it has the potential to spread to emerging market currencies, the BIS report said.The report said HFT has also helped to distribute liquidity across the forex market, improve efficiency and narrow spreads between bids and offers in major currency pairs.

It said recent experience showed HFT participants are not necessarily the first to flee during times of financial stress compared with other traditional players. In fact, they are quick to re-enter the market as stability returned.

HFT firms, which are mostly specialised and independently run, conduct their activities on inter-dealer electronic broking platforms -- EBS and Reuters -- and multi-bank electronic communication networks like Currenex, Hotspot FX and FXall.

They are also active on the Chicago Mercantile Exchange (CME) for trading involving FX futures and tend to trade on their own account. A few banks conduct some HFT in proprietary trading, but they are not major players.

The BIS report also debunked a notion put forward by politicians that high-frequency trades employed predatory or unfair practices, adding they are subject to three levels of regulation.

“In addition to HFT firms’ own risk controls, there is also monitoring by prime brokers. Furthermore, trading platforms also have rules to help foster an orderly and fair trading environment, but the nature and severity of such rules vary across platforms.”

The BIS report said the differing treatment of electronic trading platforms due to the various regulatory changes would have a longer term bearing on HFT.

So far, spot transactions, which constitute the bulk of HFT, are exempt from regulations of the Frank-Dodd Act in the United States.

But that could change as participants seek to migrate their transactions, including spot trades, to venues that seek to offer all FX derivatives trading for ease of execution, as well as to minimise margin, capital and collateral costs for non-spot FX transactions. “The impact on HFT participants depends on whether there will be more formal regulation of the venues that they currently favour and whether these participants will face some kind of registration requirement,” the report said.