Bundesbank Says High-Frequency Trading Can Enhance Volatility

  • Findings support debate over tighter regulation, report shows
  • HFT makes up about 50% of trading in liquid U.S., E.U. markets

High-frequency trading has the potential to both increase market liquidity and remove it at times of higher volatility, a study by the Bundesbank has found.

The report, published Monday, studied granular data from Bund and DAX futures markets, the two most liquid German investment instruments in which HFT makes up a significant portion of trading activity.

Researchers found that while HFT usually improves market pricing, there is evidence that so-called market makers, who stand ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price, typically pull out during periods of high volatility. This reinforces volatility and could in extreme cases conceivably lead to flash events, the study suggests.

“In a calm market environment, HFT market participants contribute a significant amount of liquidity,” according to the Bundesbank study. “However, during highly volatile market phases, the research shows that HFT market makers in both Bund and DAX futures markets temporarily reduce liquidity. HFT actors are especially active in times of strong market fluctuations and can therefore contribute to trend-enhancing price developments.”

The results could give impulses to the ongoing regulatory debate over HFT, the study says.

“For one, the results demonstrate how important in implementation of incentive mechanisms is so that passive HFT market makers keep up liquidity provisions in periods of higher stress,” according to the study. “Future research from central banks, regulatory authorities and academic institutions could profit from easier access to similarly granular data.”

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