WASHINGTON (Reuters) - High-frequency computerized trading could potentially destabilize the broader marketplace and should be more closely monitored by U.S. regulators, according to a U.S. Treasury research report released on Tuesday.
"High-frequency trading systems may obscure price discovery, exaggerate illiquidity, increase volatility and contribute to extreme price changes," said the annual report from the Treasury's Office of Financial Research (OFR), a new office created by the 2010 Dodd-Frank Wall Street reform law.
"High-frequency trading poses several potential financial stability risks, suggesting that closer monitoring may be warranted."
Tuesday's findings by the OFR could fuel the long-running debate about whether high-frequency trading helps or harms market liquidity, and whether it should be reined in.
Its conclusions are particularly important because the Treasury office is tasked with providing economic research that informs the policy decisions of a U.S. council of regulators who are charged with policing financial markets for systemic risks.
That council, known as the Financial Stability Oversight Council, has the power to classify large non-bank financial firms as "systemic" - a tag that carries high capital costs and strict oversight by the Federal Reserve.
Investor confidence in the U.S. equity markets has taken a hit in recent years, following a series of high-profile technology glitches.
Those incidents include the May 6, 2010, "flash crash," Nasdaq OMX's botched rollout of Facebook's initial public offering in 2012, a software error and $440 million trading loss at Knight Capital that same year, a flood of erroneous options trades earlier this year by Goldman Sachs, and a three-hour trading outage due to a processor outage at Nasdaq, also earlier this year.
While many of these incidents were not blamed on high-speed trading, they have led regulators to take a closer look at whether market structure reforms are needed.
The report cites these events, as well as natural disasters such as 2012's Hurricane Sandy and also cyber attacks, as examples of operational risks to the markets.
Research on high-frequency trading has been mixed, with some reports showing it improves market liquidity and others suggesting it may disadvantage some investors.
The U.S. Securities and Exchange Commission, which oversees equity markets, recently launched a new website full of data to help inform whether policymaking is needed to target high-speed trading.
The Commodity Futures Trading Commission is also studying whether to impose new rules for high-speed trading in futures contracts, such as the e-mini S&P 500, which are traded on the Chicago Mercantile Exchange.
Although the council has in prior years cited high-speed trading as an area of possible market risk, it has not made policy recommendations regarding the activity, instead leaving it to the SEC and CFTC.
The Treasury also said in its report on Tuesday that it is developing tools to monitor potential threats to financial stability more generally.
The report details the creation of a prototype, known as a "financial stability monitor," that it plans to use to track possible threats.
In addition to citing high-speed trading as a possible broad market risk, the report highlighted other areas including runs and fire sales in repurchase (repo) markets, excessive credit risk-taking and weak underwriting standards and exposures to duration risks in the event of a sudden spike in interest rates, among other things.
Reporting by Sarah N. Lynch; Editing by Karey Van Hall and Kenneth Barry