The world's stock exchanges are trying to rein in some of the most controversial activities of high-speed trading firms, among their most valued clients, to help head off tough sanctions from regulators.
The London Stock Exchange Group
The trading firms use powerful computers to churn out thousands of proposed trades, or orders, in fractions of a second, a practice critics say has caused detrimental market crashes and can give rise to market abuse.
The traders seek out tiny price differences in the market, reaping a small margin on each trade, and need to trade in large volumes to make enough money. But these high volumes, which account for about half of all the trade on stock exchanges, can exaggerate market moves, critics say.
The speed traders hope to avoid draconian new rules in the works in Europe and America, which hit at the heart of their technology-driven business, and exchanges are working on voluntary measures to slow down trading.
The exchanges are looking to push self-regulation rather than have regulation imposed upon them, said Andrew Bowley, who heads the computerized trading unit at Japanese investment bank Nomura International <9716.T> in London.
High-frequency trading firms have grown rapidly in the United States and Europe in the past decade and are a vital source of income for exchange groups.
The firms - which include Getco and Citadel Securities in the United States, and Optiver and IMC Trading in Europe - can function as market makers, enabling their clients to trade in securities by guaranteeing buy or sell prices.
While market making is seen as a useful function, speed traders may also bet their own capital in markets, a more controversial practice known as proprietary trading.
The trade body representing them in Europe has just 21 members, including relative unknowns such as Chopper Trading, Mako Group and XR Trading, which between them share estimated revenues of a couple of billion euros.
But the industry hit the headlines in May 2010, when it was blamed for the flash crash in the United States, when the stock market plummeted over a 1,000 points, or nearly 10 percent, in a matter of minutes.
The fall was initially caused by one large erroneous trade from a funds firm, but the losses were rapidly magnified when computer-driven high-frequency traders followed the move down.
A number of academic initiatives are investigating what impact speed-trading firms can have on market gyrations, such as the government-led Foresight group in Britain.
But politicians in Europe have already set their sight on firms that seek to game the market by gleaning information from rivals, quickly dipping in and out of markets with large volume-orders to see how other traders react.
Arlene McCarthy, a British centre-left member of the European Parliament, wants exchanges to fine traders that put in more than 250 orders for each actual trade.
It is widely accepted in the market that not each order needs to lead to a trade, but the actual level of the order-to-trade ratio is hotly debated.
Markus Ferber, the German centre-right lawmaker steering the reforms through the European Parliament, said last month orders should be forced to stay in the market for at least 500 milliseconds, or half a second, before they can be cancelled.
The world's fastest exchanges can currently trade in less than 100 microseconds, or one ten thousandth of a second, so a resting time of 500 milliseconds would mean these trades are being slowed down by a factor of 5,000.
But the stock exchanges have now outlined their own measures, and have started fining high-frequency traders that exceed a set ratio of fake orders to real trades.
The LSE Group's Borsa Italiana has introduced a new charging model to punish firms that exceed an order to trade ratio of 100:1 and set a sliding scale of 0.01 to 0.025 euro fines per trade above the limit, depending on the severity of the breach.
Under the new rules, firms sending 101 orders before producing a real trade each day will be fined whereas those that have a ratio of 99:1 or less will avoid censure.
Investment banks, depending on their exposure to high-frequency traders, trade at about 4:1 and most hedge funds are also well below the stock exchange's threshold - though a handful may exceed it, traders said.
Not all traders agree, however, that the self-imposed rules by the exchanges will have real impact.
I'd question whether these are real penalties or whether it is more smoke and mirrors, said Joe Saluzzi, co-founder of U.S. broker Themis Trading, and an outspoken critic of the high-frequency trading industry.
SLOPPY, NOT ABUSIVE
Remco Lenterman, who heads the European Principal Traders Organization (EPTA) lobby group, said the stock exchanges had in the past had similar limitations in place because of a lack of computing power.
When computers became more powerful, high-frequency traders increased their volume, and there was less need for them to ensure that each algorithm generated a viable trading strategy, as long as it wasn't loss-making.
If you're offering unlimited capacity, participants will spend less attention to the orders they're sending in, Lenterman said in a telephone interview.
I like to call that sloppy algorithms. That is a better description, because it has nothing to do with market abuse ... We have to get away from the idea that it is market abuse.
Algorithms can be poorly programmed or become outdated over time, and unless they are turned off, they will continue firing orders without generating any real trades.
But plenty of high-frequency traders with genuine business models should not be affected by the measures.
(It) should prevent antisocial behavior in the market, but they are not so severe that they will affect genuine business, said Andrew Morgan, head of the Autobahn in-house equities trading platform at Deutsche Bank
(Additional reporting by Huw Jones; Editing by Will Waterman)