Circuit breakers could mitigate risk in automated trading

Merchant banks that automate trading could use circuit-breaking technology to reduce problems caused by stock market volatility

The investment industry could use new circuit breaking technology to reduce the problems caused by market volatility, a working paper has revealed.

The paper, put together by academics as part of the Foresight project on The Future of Computer Trading in Financial Markets, recommends ways of reducing the risks associated with computerised trading.

Investment companies use algorithmic software to automate share trading while trading exchanges enable trades to be completed in microseconds. When problems occur they quickly escalate.

The report, Economic impact assessments on MiFID II policy measures related to computer trading in financial markets, looks at issues surrounding computer-based trading over the next ten years.

One of the suggestions is to use a new type of circuit breakers. These switches automatically shut down trading when problems occur. 

The report recommends circuit breakers triggered as problems approach, rather than after they emerge.

This could help avoid problems caused by market volatility accelerated by the use of computer-based automated trading. Trades can now be completed in microseconds so circuit breakers that react to events might not prevent damage.

“Algorithmic trading (AT) and high-frequency trading (HFT) have grown rapidly in use in recent years. As such, they have also fuelled increases in complexity as well as new system dynamics, making markets ever harder to understand and to regulate,” said the paper.

Hugh Cumberland, business development manager at IT service provider Colt – which provides connectivity to the trading sector – said attempts to control high-speed trading must balance the benefits and risks.

"A number of objective studies appear to show that HFT improves liquidity, reduces volatility and the cost of trading. Suggestions that HFT volumes should be reduced or activities be restricted would appear to be based on sentiment rather than hard fact.

"If there are demonstrable benefits to the market resulting from HFT, it would be a pity for these to be lost purely because of the negative light in which HFT has been cast - a case, surely, of throwing the baby out with the bath water."

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