A preliminary research report by three professors at the Toulouse School of Economics[1] has raised concerns over the impact impending regulations could have on market liquidity. The researchers used data from Euronext to investigate the behaviour of liquidity suppliers during the Greek crisis of 2010. Their initial findings demonstrate that all firms using high frequency trading technology continued to provide liquidity in the markets during the 2010 crash, even when slower liquidity providers had ceased. The researchers also found that principal traders were better able to carry inventory risk (risk from holding assets) than other traders because they commit their own capital and have more skin in the game. This is a clear indication of the value of principal trading firms and high frequency trading technology to maintaining liquidity and stability in our modern market structure.
The danger now, as the researchers identified, lies in unintended negative consequences of current regulatory reforms. In particular, they zero in on proposals under MIFID II whereby trading venues will be required to cap the ratio of the number of messages to the number of trades by participants (order-to-trade ratios). Their findings suggest this could be harmful for market liquidity, especially at times of market stress, when the need to modify and cancel orders is particularly acute.
As things currently stand, another (unintended) consequence of MiFID II coming into effect is that principal trading firms may also be subjected to the same capital requirements under the Capital Requirements Regulation (CRR) as banks. The authors of the Toulouse School of Economics study agree that banking regulations such as this can damage market liquidity by making it more difficult and costly to engage in proprietary trading. The post-crisis banking regulations have already caused banks to scale back their own market making activity, which has arguably reduced market liquidity, making the need for principal trading firms to supply liquidity ever-greater.
As we’ve mentioned many times before, market making is the core business model of principal trading firms, supported by HFT technology. However, both MiFID II & CRR currently pose threats to principal trading firms’ ability to provide liquidity.
Ensuring liquidity supply for the future is a concern that unites market participants. It has been a constant theme of 2015 media coverage around the markets on both sides of the Atlantic. The US government recently released its own report into the US Treasury Market event of October 2014 recognising the huge importance of principal traders to liquidity during the event. As the evidence mounts that principal traders are needed to secure the health of our markets, the time is ripe to ensure that incoming regulations won’t inadvertently prevent them from continuing to provide liquidity.
[1]Authors: Bruno Biais, Fany Declerck, Sophie Moinas
