In Report, Speed Trades’ Problems and Pluses

The report released Monday night is the product of the most comprehensive effort to date to understand the computerized trading firms that have come to dominate the financial markets and generate anxiety among regulators and investors.

The committee that oversaw the study largely rejected some of the most troubling accusations that have been made about the firms that practice high speed trading, or H.F.T., including charges that they have caused greater volatility in markets and manipulated stock prices.

“Some of the concerns about the problems of H.F.T. are misconceived,” said John Beddington, the British government’s chief scientific adviser, and the head of the government body that ran the project, the Foresight Programme.

But the committee concluded that regulators had failed to gather enough data or build the expertise needed to allay a widespread assumption among professional investors that faster traders have an advantage and profit at the expense of ordinary investors.

The committee’s findings are likely to become a touchstone in global debates about how to deal with the fast rise of high-speed trading firms. While the companies have become entrenched in the American stock markets — now accounting for just over half of all trading — they are just beginning to rise to prominence in many foreign markets, including European stock exchanges.

Regulators and academics around the world have struggled to keep up with rapid development of the industry — a problem that the British Government Office for Science was hoping to alleviate with its inquiry. Over the last two years, the office has commissioned about 50 independent studies from more than 100 academics and industry experts from 20 different countries. The report out Monday is a synthesis of those findings.

The committee’s conclusions are consistent with a number of academic studies that have found that competition between H.F.T. firms has made it easier and cheaper for ordinary investors to buy or sell stock whenever they want.

They also confirm some of the problems with high-frequency trading that academics have pointed to in the past. For instance, the report said that high-speed traders can exacerbate big swings at moments of crisis, similar to the 2010 findings of Frank Zhang, a professor at the Yale School of Management. But the authors of the report that these are only isolated events.

Mr. Zhang said on Monday that the incidents of big price swings were a problem precisely because they were isolated, and as a result they were that much more unpredictable and unnerving for ordinary investors. The clearest example, he said, was the 2010 flash crash, when share prices dropped almost 10 percent in half an hour with little obvious reason.

“They miss the bigger picture,” Mr. Zhang said of the report’s authors.

David Lauer, a former employee at a few of these trading firms who has testified against the industry, said the British commission ignored or downplayed a number of studies that had pointed to the significant costs imposed on ordinary investors by recent developments.

Mr. Lauer pointed to a paper released in September by the Federal Reserve Bank of Chicago that said that many trading firms did not have stringent processes to test their trading programs or to stop runaway trading after it started. That finding was notable because the trading firm Knight Capital lost nearly $460 million in half an hour in August when one of its computer programs went awry.

But Mr. Lauer said his larger concern with the British report was that it did not acknowledge the degree to which the markets had become too complex to be understood even by the world’s most advanced scientists.

“If you can’t understand the market then you can’t understand how to fix it,” Mr. Lauer said.

Germany Is Expected to Act to Curb High-Speed Trades

Chancellor Angela Merkel’s government approved draft legislation on Wednesday that foresees imposing additional controls on such trading. The proposed measures include requiring that all high-frequency traders be licensed, requiring clear labeling of all financial products traded by powerful algorithms without human intervention and limiting the number of orders that may be placed without a corresponding trade. Traders who violate the limits, which would be set once the law took effect, would face a fine.

“Computer-generated algorithmic transaction involves a variety of new risks,” Germany’s finance ministry said in a statement. “Germany is reacting to these risks with legislation that will create more transparency, security and a better overview.”

The legislation, which is subject to approval by both houses of Parliament, was written with an eye toward similar legislation being discussed in Brussels that could eventually apply across the European Union, which has 27 member nations, the official said.

Steps to pass the broader legislation on high-frequency trading are expected to proceed Wednesday, when the influential Committee on Economic and Monetary Affairs of the European Parliament will vote on how to update the law that governs securities trading to take account of new technologies.

The Europeans are not alone in their concern about high-speed computerized trading, which has led to several notorious market disruptions in recent years.

The latest occurred in early August in the United States, when problems with newly installed software caused the Knight Capital Group, a New Jersey broker that specializes in computer-driven trading, to lose $440 million. The problem led Knight’s computers to rapidly buy and sell millions of shares in more than 100 stocks for about 45 minutes after the markets opened on a Wednesday. Those trades pushed the price of many stocks up, and Knight lost money when it had to sell the shares back into the market at a lower price the next day.

The Knight episode raised alarms on Wall Street and in Washington, but no new curbs have yet been proposed for high-frequency trading in the United States.

In Berlin, German officials have acknowledged that the technological advances of recent years have led to irrevocable changes in the nature of trading and that the fast pace must be accepted. By adopting tighter controls, they say they hope to protect the interests of all market participants.

The German draft legislation “is deliberately arranged so that the Finance Ministry has the capability of making things more precise through provisions, and the stock markets are required by the law to be aware when the next trick from high-frequency traders pops up,” said a German government official who spoke anonymously on Tuesday.

While high-frequency trading firms are unlikely to welcome tighter rules, Deutsche Börse, the main German stock exchange, based in Frankfurt, said it would welcome the greater supervisory powers that regulators would have under the proposed law.

“It is good for all parties acting on the German financial market that we now have legal certainty how to deal with high-frequency traders,” the exchange said last week.

The European legislation under discussion, if approved in committee, is expected to become the basis for talks between representatives from the European Parliament and individual governments. Upon completion of that process, the draft measure would need the approval of the full European Parliament and all 27 of the European Union’s members before becoming law.

The legislation would seek even tighter controls on fast trading than the German proposal. Among the most closely scrutinized aspects of the European measure are rules aimed at limiting the ability of algorithm-driven trading to exaggerate volatility in financial markets.

Markus Ferber, the lawmaker appointed by the European Parliament to report on the proposal, has recommended including rules to slow trading by a half-second, require all trading venues to institute ways to halt trading immediately and make it more expensive for traders to cancel large volumes of orders.

Those rules were needed to “curb mere volumes brought by high-frequency trading” and “to restore genuinely liquid, orderly and fair markets,” said Benoît Lallemand, a senior research analyst at Finance Watch in Brussels. “Only such markets can serve the real economy.”

Mr. Lallemand said he expected the committee to approve Mr. Ferber’s recommendations on Wednesday. “The focus then should be that governments come up with an equally ambitious proposal,” he said, though he said the legislation still could be watered down.

Melissa Eddy reported from Berlin and James Kanter from Brussels. Jack Ewing contributed reporting from Frankfurt and Nathaniel Popper from New York.

DealBook: Errant Trades at Knight Capital Reveal a Risk Few Expected

The trading firm Knight Capital recently rushed to develop a computer program so it could take advantage of a new Wall Street venue for trading stocks.

But the firm ran up against its deadline and failed to fully work out the kinks in its system, according to people briefed on the matter. In its debut Wednesday, the software went awry, swamping the stock market with errant trades and putting Knight’s future in jeopardy.

The fiasco, the third stock trading debacle in the last five months, revived calls for bolder changes to a computer-driven market that has been hobbled by its own complexity and speed. Among the proposals that gained momentum were stringent testing of computer trading programs and a transaction tax that could reduce trading.

In the industry, there was a widespread recognition that the markets had become more dangerous than even specialists realized.“What is starting to become clear is that the costs in terms of these random shocks to the system are occurring in ways that people never anticipated,” said Henry Hu, a former official at the Securities and Exchange Commission and a professor at the University of Texas in Austin.

Knight, founded in 1995, is a leading matchmaker for buyers and sellers of stocks, handling 11 percent of all trading in the first half of this year, according to the data firm Tabb Group. Knight lost three-quarters of its market value in the last two days, in addition to losing $440 million from the errant trades, and was scrambling to find financing or a new owner.

While the turbulence on Wednesday hit scores of individual stocks, the broader market took the spasm in stride, closing down less than 1 percent on Wednesday and Thursday. The S.E.C., which has opened an investigation into potential legal violations at Knight, said it was “considering what, if any, additional steps may be necessary.”

Some S.E.C. officials are pushing new measures that would force firms to fully test coding changes before their public debut, according to a government official who spoke on the condition of anonymity. While the idea has long been discussed at the agency, it gained traction after the Knight debacle.

The S.E.C. applied limited safeguards on trading after the “flash crash” of 2010 sent the broader market plummeting in a matter of minutes. But big investors like T. Rowe Price, members of Congress and former regulators said Thursday that the S.E.C. and the industry had been too complacent and needed to do more to understand and control the supercharged market.

“Things are happening far too regularly,” said Ed Ditmire, an analyst at Macquarie Securities who focuses on stock exchanges. “It’s not nearly as solid a market as it should be, so there’s plenty of room for improvement.”

Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, said that recent events “have scared the hell out of investors” and called for the agency to hold hearings.

“I believe this latest event was handled better than the flash crash, but the larger question is whether our markets are adequate to deal with the technology that is out there,” Mr. Levitt said. “I don’t think they are.”

Regulators have made changes to the markets over the last two decades that have taken it out of the hands of a few New York institutions and allowed dozens of high-frequency trading firms and new trading venues to dominate the stock market.

The high-speed firms like Knight, which connect directly to the servers of the exchanges and are capable of executing thousands of trades a second, are responsible for more than half of all activity in American markets. Companies that have benefited from the fragmentation and computerization of the markets have largely managed to fend off tighter controls by pointing to the steady decline in the cost of trading stocks.

Some large, institutional investors, like Vanguard, have said that the increased volume of trading has made it easier to get in and out of stocks, lowering the ultimate costs for individuals who invest in popular vehicles like mutual funds.

But even people who had previously defended the advances in trading technology said on Thursday that too many problems had been overlooked.

In Knight’s breakdown on Wednesday, as well as in the botched initial public offerings of Facebook in May and BATS Global Markets in March, the problems were caused by new computer programs that had not been adequately tested. Currently regulators have no protocol for signing off on new software programs like the one Knight rolled out.

“When they put these things out in the world they are really being tried for the first time in a real-life test,” said David Leinweber, the head of the Center for Innovative Financial Technology at the Lawrence Berkeley National Laboratory. “For other complex systems we do offline simulation testing.”

Mr. Leinweber has suggested to the S.E.C. that it do this work with the help of the supercomputing facilities at his center. The S.E.C. has recently moved in this direction by contracting with a high-speed trading firm that will provide it with more up-to-date market information.

Other changes to the markets would help slow trading during crises. Before computer trading became dominant, if a flood of unusual orders came in, they would usually be questioned by human order matchers, called specialists, working on the floor of the New York Stock Exchange.

To mimic that role, regulators are introducing a circuit breaker called the “limit up, limit down.” This forces a pause in trading of a stock if it starts occurring outside a normal price range. The mechanism will start in February.

“Quite literally, it could have stopped the flash crash,” said Gus Sauter, the chief investment officer at Vanguard.

The S.E.C. did introduce some circuit breakers after the flash crash but they stopped trading in only five of the stocks that were hit by Knight’s faulty program.

Some critics of the current market structure have said that much bolder reform is needed. One change that has been contemplated is a financial transaction tax, which would force firms to pay a small levy on each trade. At the right level, this could pare back high-frequency trading without undermining other types, supporters say.

“It would benefit investors because there would be less volatility in the market,” said Representative Peter DeFazio, a Democrat of Oregon. He introduced a bill containing a financial transaction tax last year.

Opponents of such a levy say that it could hurt the markets and even make it more expensive for companies to raise capital.

“I would be very concerned about unintended consequences,” said Mr. Sauter.

But Representative DeFazio, who favors a levy of three-hundredths of a percentage point on each trade, says he thinks the benefits of high-frequency trading are overstated. “Some people say it’s necessary for liquidity, but somehow we built the strongest industrial nation on earth without algorithmic trading,” he said.

Benjamin Protess and Jessica Silver-Greenberg contributed reporting.