HFT is changing the ecology of the forex market, says BIS committee

Bank for International Settlements report on high-frequency trading in the forex market is lukewarm about recent initiatives to monitor HFT, and recommends further analysis by regulators and participants

High-frequency trading (HFT) might contribute liquidity to the foreign exchange market, but it has affected the ecology of the sector "in ways that are not yet fully understood", according to findings published on September 27 by the markets committee of the Bank for International Settlements (BIS).

In a 31-page report, High-frequency trading in the foreign exchange market, the BIS committee analyses the activity of HFT participants in forex and highlights a number of issues that warrant further consideration, both from participants and regulators.

David Rutter, New York-based chief executive of Icap electronic broking, which operates the EBS spot-trading platform, welcomes the report as a timely examination of an increasingly important element of forex market structure.

"A consistent examination of underlying trends in the forex market, specific to HFT, is very important and we hope it will dispel some of the common myths. For example, it's simply not true that high-frequency traders only ever take liquidity from the market and they're never additive, or that in times of stress you can't find a high-frequency trader anywhere. Both are factually inaccurate," says Rutter.

But the BIS report questions whether HFT participants are genuinely able to provide liquidity on a sustained basis in different market conditions, and whether their activity affects that of traditional participants. "While HFT generates increased activity and narrower spreads in normal times, it might have reduced the resilience of the system as a whole in stressed times by reducing the activity of traditional participants (for example, major market-maker banks), which might have otherwise been an important stabilising presence in volatile environments," the report states.

In June, four forex prime brokers joined together with the major electronic communications networks, including EBS, to monitor high-frequency trading activity through Traiana's Harmony CreditLink platform. While the BIS acknowledges the potential merits of that initiative, it points to the commercial incentives prime brokers might be under to retain high-frequency traders as customers, and raises concerns about their pricing practices.

"It remains to be seen whether this and any other risk-mitigation initiatives would help address the concern that prime brokers seeking to generate more income from greater trading volume might be under-pricing the services they provide to clients, including HFT clients, relative to the risks they are incurring from that business," the BIS explains.

Although some of the report's findings might make uncomfortable reading for forex prime brokers and trading platforms, Icap's Rutter stresses it is important to dispel some of the myths that surround HFT and the links between high-frequency trading activity in equities and forex.

"One of the unfortunate things that has happened over the past few years is that HFT has been demonised because of experiences in the equity market such as the US flash crash. But equity markets and forex markets are very different – forex markets have concentrated liquidity, so it's far more difficult for high-frequency traders to move currencies," argues Rutter.

The BIS report presents a detailed analysis of the role HFT participants played in the currency moves on the day of the equity flash crash on May 6, 2010, and also the freak move in US dollar/yen on March 17, 2011, which saw the pair move from 79.50 to 76.50 in just 25 minutes. It concludes the latter move was due, in part, to a withdrawal of HFT participants.

"During this episode, both HFT players and traditional market-makers reportedly withdrew, to a large extent, from the market. But in the light of the specific time of day, the withdrawal could also be related to system pauses, rather than just the operation of the HFT firms' internal risk controls," the BIS says.

According to David Clark, chair of the Wholesale Markets Brokers' Association, the risk of a flash crash in forex markets, although not insignificant, is far less serious than in equity markets because liquidity is much deeper in forex and currency pairs are less homogenous than stocks.

"What is of greater concern is that the trade sizes in forex have become smaller and smaller because of HFT, and it is crucially important to maintain the liquidity in the market. The BIS recognises the importance of the multiple trading venues in the market, which is encouraging, because they are the platforms that ensure liquidity is maintained," he says.

The markets committee's conclusion is that the growth of HFT in foreign exchange will have significant implications for both the structure and functioning of the global forex market, and policy-makers need to keep abreast of developments. It recommends regulators maintain a dialogue with forex trading platforms, prime brokers and HFT participants to make sure the issues raised are properly monitored.

But Clark warns regulators should be careful about interfering too much and hurting liquidity as a result. "High-frequency traders certainly contribute liquidity and for that reason, it is critical regulators don't try to curb their participation – that could have unwelcome consequences for the integrity of the forex market as a whole. It must also be acknowledged that large blocks will continue to be traded outside of the algos used in HFT, and with larger spreads."

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