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Whatever the flash crash's ultimate impact, it has the potential to revamp the way tens of trillions of dollars circulate through the world's stock markets. It could also spell significant changes to the business models of banks, brokers, exchanges, funds, and the increasingly dominant proprietary trading firms that all interact daily.
The biggest battles in coming years will likely center on so-called high-frequency trading, or HFT, in which firms use computer codes called algorithms to submit rapid-fire bids and offers, making short-term markets and earning tiny profits on price imbalances.
Having effectively replaced the trading floor specialists of years past -- and often based in offices nowhere near Wall Street or the City of London -- these operations remained quite profitable through the volatile market drop two years ago this month. HFT is now involved in an estimated 60 percent of U.S. stock trading, and 40 percent of that in Europe.
The battle lines are now being drawn.
In a July draft report, British EU lawmaker Kay Swinburne called for a full examination of HFT's costs and benefits, as well as "stress tests" to determine how exchanges would handle a European version of the flash crash. Top European Commission member Michel Barnier went a step further on Tuesday, declaring that HFT needs new governing rules given the inherent risks it poses. [ID:nN12159642] [ID:nLDE66K0QZ]
"I think a number of us are coming to the view that this high-frequency trading has negative social value, and that it's not information discovery," Nobel Prize winning economist Joseph Stiglitz, a member of the joint CFTC-SEC advisory panel studying the flash crash's implications, said on Sept. 30.
"They're playing games. They're trying to extract information from informed traders, people who are doing the research," Stiglitz added at a reception hosted by Thomson Reuters in New York.
SEC Chairman Mary Schapiro has said HFT strategies need a closer examination, and the agency is considering saddling such traders with market-making obligations and privileges so that they provide liquidity when it is most needed. Such a move would put U.S. markets at sharp odds with Europe, which has done away with market makers.
All this tough talk has spooked high-frequency traders and the exchanges that rely on their liquidity and volumes. They note that HFT was not blamed outright in the SEC-CFTC flash crash report, and argue that its short-term strategies have made trading cheaper and easier for all investors.
Richard Balarkas, CEO of Instinet Europe, the Nomura Holdings Inc-owned (8604.T) agency brokerage and alternative venue operator, said winding back the clock is a mistake.
"I don't think investors on the whole want to go back to a market where they all pay a tax, usually in the form of a wider spread, to a firm making monopoly profits that will in any case wave a white flag as soon as a stock has a liquidity shock," he said in an interview.
"It's crystal clear why the flash crash happened: a lack of buyers, and unthinking selling. It was pure, simple supply and demand within a regulatory regime that the SEC had created."
The soul searching in the United States and Europe has spawned some anxiety elsewhere. Exchanges in Asia and Latin America invested heavily in recent years to install electronic matching engines and order routing systems to attract the very kind of trading now under the microscope.
Executives said that while there are lessons to be learned from the flash crash, there is a danger in overreacting.
"It's unfortunate for places like India, that the confidence among the global regulators was shaken in exchanges in the developed countries," James Shapiro, head of market development at Bombay Stock Exchange .BO, said on the sidelines of the Paris conference. "India is basically now where it needs more deregulation to some degree. This has introduced an element of caution."
Atsushi Saito, CEO of the Tokyo Stock Exchange .TOPX, which launched a $140-million super-fast "Arrowhead" stock trading system in January, told the conference: "We are carefully watching the report from the United States on this May 6 event... But we are very uncomfortable about the demonization of high-frequency trading."
When so-called MiFID II takes effect in 2012, it could set the tone for any possible cross-border marketplace in East Asia, where, as in Australia and Brazil, exchanges face the prospect of new competition and a race to ever-faster electronic trading in the near future.
It is here that the most severe aftershocks of the U.S. flash crash could hit, said Joseph Gawronski, president at New York-based institutional broker Rosenblatt Securities.
"Certainly the incumbents don't want to see fragmentation," he said. "But at the same time they do want to see high-frequency trading come to increase their velocity. And that's a very fine line." (Reporting by Jonathan Spicer; editing by Jim Impoco and Claudia Parsons)