Germany Restricts High-Frequency Trading, Chicago Fed Recommends Same

WSJ Article: Germany to Tap Brakes on High Frequency Trading
NYT Article: Germany Act to Increase Limits on High Speed Trades

Late last month, New York Times and WSJ reported on Germany's intention to restrict High Frequency Trading.  High Frequency Trading is the use of proprietary algorithms to trade securities rapidly and at high speed. The idea is to capture fractions of a penny per trade. 

Chicago Fed's Concern About HFT

Earlier this month, the Chicago Fed published an essay on the risks of HFT for financial markets. Every exchange it investigated has had problems attributable to errant algorithms and software malfunctions. The worst was the 2010 Flash Crash which caused a 700 point drop in the Dow within seconds. 

At fault is insufficient risk controls, a phenomenon due to the competitive time pressures involved. The Chicago Fed found that exchanges that impose pre-trade risk checks increase latency. Furthermore, investor confidence in the markets has also been adversely affected and the markets have seen a rise in volatility. 

In order to control risks associated with HFT, the Chicago Fed has recommended:

•               Limits on the number of orders that can be sent to an exchange within a specified period of time;

•               A “kill switch” that could stop trading at one or more levels;

•               Intraday position limits that set the maximum position a firm can take during one day; 

•               Profit-and-loss limits that restrict the dollar value that can be lost.

Chicago Fed Letter: How to Keep markets Safe in the Era of high-Speed Trading

Germany Acts to Restrict HFT

Draft legislation on the matter was approved by the German parliament. Proposed measures include requiring that all high-frequency traders be licensed, clear labeling of all financial products traded by HF algorithms without human intervention, and a limit to the number of orders that may be placed without a corresponding trade.

According to a press conference by the German Finance Ministry, as much as 40 percent of all trading sales can be attributed to HFT. Germany's goal in acting are essentially to limit the identified risks associated with HFT. If the bill becomes law, "excessive use" of trading systems would come with added fees. Traders also would have to maintain a balance between orders and executed transactions.

While France has already imposed a tax on high-frequency trades, legislation is also under consideration at the European Parliament and may become the basis for governmental legislation on HFT across the EU.

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Max Berre is an economist at the EDHEC-Risk Institute (Ecole Des Hautes Etudes Commerciales du Nord) who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands.