High-frequency trading improves market quality, study finds

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While it's been the punching bag for nearly all of the ills on Wall Street, a new U.K. study has found that high-frequency trading (HFT) and algorithmic trading (AT) have several beneficial effects on market quality.

The report, entitled 'Foresight: The future of computer trading in financial markets' was commissioned by the U.K. Government Office for Science. The report claims that  computer-based trading (CBT) has many positive effects, a finding that could come as a surprise, says Jean-Pierre Zigrand, reader in finance at the London School of Economics and part of the group that oversaw the project.

Zigrand lauds CBT's "solid risk limits and beautifully risk-managed systems". However, while no direct evidence suggests that HFT has increased volatility, instabilities can nonetheless occur in specific circumstances. The study highlighted two possible causes of crashes and large swings in the market: the normalisation of deviance and self-reinforcing feedback loops.

"The normalisation of deviance is another feedback loop, but it's a very slow-moving feedback loop," says Zigrand. It is a social issue, where unexpected events come to be seen as normal until a disastrous failure occurs.

The report claims that the Flash Crash on May 6, 2010, where the Dow Jones Industrial Average plummeted 1,000 points before rebounding almost as rapidly, was quite possibly the result of the normalisation of deviance. Market participants were aware the high-speed changes in the prices of equities could lead to a high-speed crash, but warning signals were ignored.

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