Algorithmic Trading and the Limits of Securities Regulation

Abstract

Since the infamous flash crash of 2010, instances of unexplained high volatility in financial markets, often driven by algorithmic and high-frequency trading, have received increased attention by policy makers and commentators. A number of regulatory initiatives in the EU and US deal specifically with the perceived risks that algorithmic and high-frequency trading pose to market quality. However, their efficacy is disputed, with some claiming that they are unlikely to prevent the future misuse of HFT practices, while others caution that the additional regulatory burden may have unintended and counterproductive consequences for market efficiency. This paper examines whether existing regulatory techniques, notably disclosure, internal testing and monitoring systems, and the regulation of structural features of the trade process, such as order execution times and circuit breakers, are adequate to address the risk of extreme market turbulence. It draws on market microstructure theory in arguing that regulation in the EU and the US takes in sufficient account of the mechanics of automated trading in modern financial markets.