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Wednesday, January 26, 2011

US and UK to Lose Ground as Algorithms and HFT Emigrate

Posted by John Bates

High frequency and algorithmic trading will blossom in emerging markets such as Brazil and India, possibly signalling the end of US and UK dominance in financial markets.

Even as regulators in the US and Europe debate over how to regulate algorithmic and high frequency trading (HFT), firms in emerging markets such as Brazil and India are embracing the trading practices. US and UK proprietary trading firms and hedge funds are opening offices in emerging markets centers, partly to take advantage of these budding opportunities. But there is more than greener pastures calling them; stricter regulations in the US and UK may force large banks and hedge funds to trade in - or move to - more lightly regulated regimes. This mass regulatory arbitrage emigration could signal the end of US and UK dominance in financial markets.

Brazil is attracting HFT like bees to honey. The world’s tenth largest economy, Brazil's exchange, BM&FBovespa, trades everything from cash stocks to commodity futures. The exchange has recently undertaken steps to further automate trading in an effort to capitalise on investor interest and gain more business from outside the country. Almost 90% of trading is now done electronically and about 10% on the floor. Demand for connectivity and trading access to the Brazilian market is increasing; exchanges are helping to upgrade Brazilian exchange platforms and bridge the gap between Brazilian markets and non-Brazilian traders (and vice versa). Technology vendors are building ticker plants for real-time, low latency market data as well as adding connectivity and algorithmic trading capabilities. And brokers are clamouring to join up with, or buy, Brazilian brokerage firms to help smooth the path for non-Brazilian customers - which by law must have local representation.

Algorithmic trading in India is also taking off. Spending on software for algorithmic trading is going to be easily worth $100 million in two years. The market share of algo trade will rise from 15 per cent at present to 50 per cent in the next three years. The number of trades on the NSE (National Stock Exchange) are 10 times that of the London Stock Exchange. Both NSE and BSE (Bombay Stock Exchange) are offering co-location facility; smart order routing and mobile trading has now been allowed, too. Also, commodity exchanges are catching up on algo trading. It is being put to use in foreign exchange derivatives too. That’s an enormous reason to do algorithmic trading. Smart order routing will force inefficiency out of the market, reduce price discrepancies between the two main equity exchanges and increase competition. (NSE’s process of validating every algo was putting a significant brake on its growth. The process is unsustainable and will be short-lived.)

Turkey’s main bourse, the Istanbul Stock Exchange, was the latest to open up to HFT and algo trading, according to the FT. Mexico is opening up, as are Asia Pacific markets in Japan, Australia, Singapore and Hong Kong. Bulge bracket banks, large hedge funds, and buy-side firms are all gearing up for the next onslaught of HFT in these areas, which may take business away from the more regulated markets.

Few of these markets are as heavily regulated as the US and Europe for this kind of trading. But regulated or not, any market that embraces HFT and algos has an obligation to make sure that they will not cause new issues such as flash crashes. Mandatory pre-trade risk and market surveillance should be there within the regulators and the exchanges. Regulators have had a rear-view mirror approach when it comes to understanding market software. They do not have the capability to know what is happening on a real time basis. The technology that SEC, the US stock market regulator, was using was two decades old. Regulators have to catch up here. All parties in the trading cycle should take more responsibility to ensure appropriate risk control and surveillance. Then perhaps algo trading can be fluid, with risk managed across borders. And the dominant players will go with the flow, retaining their HFT crowns.



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