High-frequency trading (HFT) could have positive effects on the functioning of financial markets, a U.K. government report found, contradicting an increasingly popular view that such trades have increased volatility and should be curbed or even banned.
The International Foresight Project was commissioned by the British government's Department for Business, Innovation, and Skills (BIS) to investigate the effects of HFT as calls for regulation grow louder.
Policy makers in the U.S. and Europe are considering controls on the trades, which involve placing orders for microseconds at a time to exploit tiny differences in share prices. But the project's findings seem to support arguments for the dynamism and liquidity offered by HFT, which represents about 30 percent of the U.K.'s equity trading and possibly over 60 percent in the U.S.
However, the report also sees risks associated with high-frequency trade.
"The key message is mixed," Sir John Beddington, chief scientific adviser to the British government, said in the report. "The project has found that some of the commonly held negative perceptions surrounding HFT are not supported by the available evidence and, indeed, that HFT may have modestly improved the functioning of markets in some respects."
He added: "However, it is believed that policy makers are justified in being concerned about the possible effects of HFT on instability in financial markets."
Over 150 academics from more than 20 countries have taken part in the investigation as the "relentless rise" of HFT and algorithmic trading highlights both its benefits of speed and cost-efficiency and pitfalls of high-profile technological glitches and alleged market abuse.
(Read More: The Risks Associated with HFT.)
Indeed, the project's report said that no direct evidence has been found for claims of market manipulation using HFT techniques, as reported by institutional investors such as pension funds and mutual funds in different countries. Though the evidence remains "tentative," however, and the effects could be substantial.
"Even if not backed by statistical evidence, these perceptions need to be taken seriously by policy makers. … High perceived levels of abuse may harm market liquidity and efficiency for all classes of traders," Sir Beddington said.
In September, curbs on trading shares in micro-seconds were announced when a European Union committee voted unanimously to update a law known as Mifid, which was instrumental in ending national stock exchange monopolies.
It means share orders will to be posted for at least half a second, longer than HFT firms currently stay in the market. After the move was announced, the HFT industry's trade body FIA EPTA told Reuters that the measures would erode the benefits of technological progress.
The markets have also responded to investor demands for better risk control mechanisms. NYSE Euronext announced the launch of two "low risk" indices in Paris and Amsterdam on Tuesday.
The report recommends more transparency and standardization in HFT trades. It suggests that globally coordinated instruments such as circuit breakers and a uniform tick size policy could regulate HFT, though it notes that these could be hard to implement and adds "two words of caution" to policy makers.
"It should also be recognized that … individual policy options interact with each other in important ways," the report said. "For example, the presence or absence of circuit breakers affects most other measures, as does minimum tick sizes. Decisions on individual policies should … take account of such important interactions."
Traders could become extinct in this new world of computer-generated trade, the report said, robot traders "could become more prevalent."
"In time, they could replace algorithms designed and refined by people, posing new challenges for understanding their effects on financial markets and for their regulation," according to the report.
Like rogue traders, robots could pose their own challenges, however.
"Understanding and managing these systems to prevent undesirable behavior in both humans and robots will be key to ensuring effective regulation," the report concludes.