The Government Office for Science (GOS) said that although it had found "no direct evidence" to show that "computer-based high frequency trading has increased volatility in financial markets", it said that in "specific circumstances" it can do so.
"In particular, self-reinforcing feedback loops, as well as a variety of informational features inherent in computer-based markets, can amplify internal risks and lead to undesired interactions and outcomes," GOS said in a new report. (18-page / 535KB PDF) "This can happen even in the presence of well-intentioned management and control processes."
GOS said that because of the nature of computer-based trading (CBT), small changes can often have "very large effects". Among the other examples it gave of the "main mechanisms that may lead to instabilities" were circumstances in which some "agents in the market" have "more, or more accurate, knowledge than others". It said that that there is a risk that "extremely rapid crashes" on the market could become seen as "increasingly normal" and that there is a risk that a "disastrous failure" may occur as a result of this "social" cause.
"Legislators and regulators need to encourage good practice and behaviour in the finance and software engineering industries," GOS recommended. "This clearly involves the need to discourage behaviour in which increasingly risky situations are regarded as acceptable, particularly when failure does not appear as an immediate result."
GOS said that high frequency computer-based trading (HFT) and algorithmic trading (AT) will likely "become more deeply reliant" on new technologies that provide "capabilities that no human trader could ever offer". New technology has allowed for the "assimilating and integrating [of] vast quantities of data and [the] making [of] multiple accurate trading decisions on split-second time-scales," GOS said.
Other "ever more sophisticated techniques for analysing news are also being developed and modern automated trading systems can increasingly learn from monitoring sequences of events in the market," it added.
GOS said that the nature of HFT can lead to "periodic illiquidity", but that the use of "circuit breakers" across the different financial markets could help resolve the problem. In addition, GOS said that the industry could help to agree on the minimum numerical increment at which it is appropriate to denote changing asset values.
Financial systems are likely to become more complex as a result of advancements in technology and this could lead to problems that themselves cause trust in the systems to be damaged, GOS said.
Policy makers should therefore consider introducing a requirement that trading platforms use an "accurate, high resolution, synchronised timestamp" when publishing information, and that "standardisation of connectivity" to the platforms should also be considered, it said.
"A corrective step that could, and should, be taken is to simplify (electronic) financial systems by the application of greater standardisation, particularly in the form of accurate, high resolution, synchronised timestamps," GOS said. "CBT, operating on many trading platforms, has led to a vast expansion of data, which are often not standardised, nor easily accessible to third parties (for example, regulators and academics) for analysis and research. The relevant authorities should consider following the US example and establish a European Financial Data Centre to collect, standardise and analyse such data."
GOS said that there are currently difficulties in understanding CBT and its effects on the market. It said that "effective regulation must be founded on robust evidence and sound analysis" but warned that the current environment of speedy advances in technology and a lack of information about the technology in use may not be conducive to writing new laws.
"Rapid developments and applications of new technology, coupled with ever-increasing complexity of financial trading and markets make it difficult to fully understand the present effects of HFT and AT on financial markets and even more difficult to develop policies and regulatory interventions which will be robust to developments over the next decade," the GOS report said. "There is [also] a relative lack of evidence and analysis to inform the development of new regulations, not least because of the time lag between rapid technological developments and research into their effects, and the lack of available, comprehensive and consistent data."
GOS said that the ability to use "faster and more intelligent trading systems" will be derived by those that turn to cloud computing, whilst new "robot traders" may also eventually entirely "replace algorithms designed and refined by people" and pose "new challenges for understanding their effects on financial markets and for their regulation".