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Colin Howard December 15, 2011 University of Maine School of Law
Technological developments have far outpaced far outpaced regulatory oversight, and traders who buy and sell stocks in milliseconds capitalizing everywhere on very small price differentials in a highly fragmented marketplace now predominate over value investors. Senator Kaufman
Introduction: Advancements in computer and communication technology have
had a massive impact on financial markets.
Developments in the
speed and efficiency of trade have created new opportunities for short-term gain, which new strategies attempt to take advantage of. Competition for these opportunities has resulted in their Trade must now
existing for shorter and shorter periods of time.
be measured in units smaller than a millisecond, average daily volume is increasing exponentially, and regulators are scrambling to keep up. One of the most significant developments is high-frequency trading ( HFT ). The speed and volume that HFT is characterized The
by has made its influence on the markets pervasive.
stability of the financial markets requires increased regulation of HFT. This paper will explore the current regulations HFT is subject to, and their limited effectiveness. This paper will
then describe how the newly enacted Dodd-Frank Wall Street Reform and Consumer Protection Act may influence regulation, and suggest how some of its provisions might be most effectively implemented
in this area.
Finally, this paper will describe some newly
enacted, proposed, and possible HFT regulations. II. a. Modern Markets: Electronic Markets Recent advances in computer technology and electronic communication have dramatically affected the financial markets
in the United States.1
The various and important changes are But the speed,
largely beyond the scope of this paper.2
processing power, and efficiency of computers, as well as several regulations,3 have pushed markets towards an environment where much of trade is electronic: trades may be initiated by computers, executed by computers, and in some cases, controlled exclusively by computers.4 The speed, capacity, and sophistication
of trade has
In 1987, the New York Stock Exchange
( NYSE ) had the capacity to handle about 95 trades per second.
Concept Release on Equity Market Structure, 75 Fed. Reg. 3554, 3594 (Jan. 21, 2010) (Changes have been driven by continual evolution of technologies for generating, routing, and executing [trade] orders. ) [hereinafter Concept Release on Equity Market Structure]. 2 For a detailed discussion of how computers and electronic communication have affected the markets, see generally, Jerry W. Markham, Daniel J. Harty, For Whom the Bell Tolls: The Demise of Exchange Trading Floors and the Growth of ECNs, 33 J. Corp. L. 865 (2008). 3 See Emily Lambert, Flash Crash: The Regulators Did It, Forbes.com (Sep. 29, 2010) ; Tom Lauricella, et al., Investors, Regulators Laid Path to Flash Crash, The Wall Street Journal (Sep. 29, 2010) (describing the various SEC regulations that have pushed markets into electronic markets including requiring stocks be priced in pennies instead of 1/8 fractions). See also, Concept Release on Equity Market Structure at 3594 n.1-2 (listing regulations that have helped push markets towards an electronic environment) citing Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496 (June 29, 2005) ( Regulation NMS Release ); Securities Exchange Act Release No. 37619A (September 12, 1996) ( Order Handling Rules Release ). 4 See Markham, supra note 2, at 866-67. 5 Concept Release on Equity Market Structure at 3594.
By 2007, that number had increased to 38,000 per second.6 is more efficient as well, reducing transaction costs.7
speed plus efficiency seems to equal a massive increase in trading volume: consolidated average volume in the U.S. increased from 2.1 billion shares in January 2005, to 5.9 billion shares (an increase of 181%) in September 2009. Trades in NYSE stocks
increased from 2.9 million trades in January 2005 to 22.1 million trades (an increase of 662%) in September 2009.8 Finally, and
important for this paper s discussion, developments in computer technology have enabled automation of trade. These new developments have created new opportunities for gain in the markets. Due to increases in speed and efficiency, Firms have devised new trading
tiny gains may now be profitable.
strategies and revised old ones to take advantage of these new opportunities. Several of these strategies may be described as
HFT strategies, which are based on speed, processing power, and volume. Developments in electronic trade and the strategies devised to meet opportunities they have spurred a micro-arms race, as
firms clamor for advantages over other firms.9
6 Markham, supra note 2, at 882 (citing Aaron Lucchetti, After Crash, NYSE Got the Message(s), Wall St. J., Oct. 16, 2007, at C1). 7 Manoj Narang, Submission to SEC s Request for Comment (January 21, 2010) on Behalf of Tradeworx, Inc. 9 (April 21, 2010) [hereinafter Letter from Monoj Narang]. (explaining that [a]s trading costs diminish, smaller and smaller opportunities become profitable to trade, leading to higher volumes. ) 8 Large Trader Reporting System, 74 Fed. Reg. 21456 at 2 (proposed April 14, 2010) (to be codified at 17 C.F.R. pt. 240 & 249). 9 Letter from Sen. Ted Kaufman to Mary Shapiro, Chairman, Securities and Exchange Commission [hereinafter Letter from Sen. Kaufman] (Aug. 5, 2010) available at http://sec.gov/comments/s7-27-09/s72709-96.pdf. ( [W]hile speed and efficiency can produce certain benefits, they have also created a micro-
as computers become faster, the opportunities that these firms are competing for exist for shorter and shorter periods of time.10 Now the opportunities last for such a short amount of
time that no one without the proper equipment can hope to participate: the opportunities are cost-prohibitive to the average trader.11 The proper equipment is computer automation: only
computers can process information, make decisions, and execute trades quickly enough to capture these opportunities. automation of trade activity is called ( AT ), or program trading.
Because HFT is a subset of AT, a
discussion of AT is helpful. b. Algorithmic Trading AT, or program trading, is trading based upon the use of
computer software that automates trading decisions and places
arms race that is being waged in our public marketplace by high frequency traders and others. ) 10 See High-Frequency Traders: Spread Betting, The Economist (Aug. 14, 2010) (Explaining that as a result of electronic, and in particular automated trading, bid-ask spreads have narrowed and arbitrage opportunities exist for ever-briefer periods. ) 11 See Dark Pools, Flash Orders, High-Frequency Trading, and Others Market Structure Issues: Hearing Before the Subcomm. on the Securities, Insurance, and Investment of the Comm. on Banking, Housing, and Urban Affairs, 111th Cong. 8 (2009) [hereinafter Hearings] (prepared statement of Daniel Mathisson, Managing Director, Credit Suisse) (Explaining that opponents of HFT argue that these traders have an informational advantage, since most people don t have the technology to read and respond to market data in a split-second time frame. ) 12 Terrence Hendershott, Charles M. Jones, & Albert J. Menkveld, Does Algorithmic Trading Improve Liquidity? 1, Journal of Finance, Forthcoming (August 30, 2010).
The use of programs and algorithms to automate trading First, because computers can process
has several advantages.
information much more quickly than a human, computer programs can analyze a vast quantity of market data in a short amount of time. Second, computers can make decisions informed by this analysis much more quickly than a human can. Third, the combined speed
and processing power of computers enables them to execute trades at speeds much faster than humans are capable of. These advantages have translated into several uses of AT. First, AT can be used to break up large orders into small parts in hopes of minimizing market impact.14 Second, AT can utilize a
computer s processing power to analyze massive amounts of information in order to identify statistical correlations between two different stocks.15 Third, AT can use a computer s speed to
take advantage of certain opportunities in the market unavailable to slower traders, like humans. discussion of HFT. c. High Frequency Trading HFT is a subset of algorithmic and program trading: it is based on sophisticated computer algorithms and software.16 the HFT subset is carved out of AT by its two defining characteristics: speed and high-volume. But This final use brings us to our
Id. See also, Tara Bhupathi, Technology's Latest Frequency Trading: The Strategies, Tools, Risks and Tech 377, 383-83 (2010). 14 Hendershott, supra note 12, at 1. 15 Letter from Manoj Narang at 9. 16 See Hearings (statement of Frank Hatheway, Senior Economist, NASDAQ OMX) ( High-frequency trading and automation. )
Market Manipulator? High Responses, 11 N.C. J. L. &
Vice President and Chief algorithmic trading is
For a number of reasons, there is confusion over what exactly the term high-frequency trading means. First, HFTs
keep their trade strategies secret.17
Second, there currently is
no adequate system in place to monitor HFT activity.18 In a recent Concept Release on Equity Market Structure intended to solicit comment on, inter alia, HFT, the Securities and Exchange Commission ( SEC ) said that [t]he term [HFT] is
relatively new and is not yet clearly defined. that this confusion is problematic.
They worry that regulators
may enact rules that, while only intended or required for a small portion of HFT practices, may sweep too broadly.20 The confusion
over what constitutes HFT is a result of the variety of strategies that HFTs practice. the SEC described HFT as For example, James Brigagliano of
generally involv[ing] a trading
strategy where there are a large number of orders and also a large number of cancellations often in subseconds and moving into and out of positions many times in a single day.
definition may conflate a particular HFT strategy (i.e.
See Michael J. McGowan, The Rise of Computerized High Frequency Trading: Use and Controversy 2010 Duke L. & Tech. Rev. 6, P 44. 18 See below for the SEC s proposed monitoring system. See also, Hearings 19 Concept Release on Equity Market Structure at 3606. (statement of James Brigagliano, Coacting Director, Div. of Trading and Markets, SEC) ( [T]he terms lack a clear definition. ) 20 See Hearings (statement of Frank Hatheway, Senior Vice President and Chief Economist, NASDAQ OMX). ( We also believe that dark pools and flash orders are wrongly confused with high-frequency trading and algorithmic trading. ) See also, Concept Release on Equity Market Structure at 3606 ( The lack of a clear definition of HFT . . . complicates the Commission s broader review of market structure issues. ) 21 Hearings (statement of James Brigagliano, Coacting Director, Div. of Trading and Markets, SEC).
directional )22 with HFT in general.
But despite the confusion, Those
there are definite commonalities connecting all HFT. characteristics will be discussed here.
The various strategies
that differentiate the types of HFT will be discussed below. For the purposes of this paper, HFT is defined as a computerized trading strategy that utilizes high speed and high volume to take advantage of opportunities in the market that are short-lived and of low-value.23 While the particular HFT strategies vary, each is characterized by speed, volume, and powerful computers. commentator described it, As one
Regardless of the strategy these high
frequency traders utilize, they all attempt to do the same thing: Make vast profits by being smarter and faster than everyone else.
HFT traders ( HFTs ) rely on
See below. 23 See Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities, Insurance, and Investment) (Explaining that basically, HFT is the buying and selling of stock at extremely fast speeds with the help of powerful computers. ); Concept Release on Equity Market Structure at 3606 (Explaining that the term HFT typically is used to refer to professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis. ); Staffs of the Commodity Futures Trading Comm n and Securities and Exchange Comm n, Rep. to the Joint Advisory Comm. on Emerging Regulatory Issues, Preliminary Findings Regarding the Market Events of May 6, 2010 Appendix A. 11 (May 18, 2010) [hereinafter Preliminary Flash Crash Report] (Explaining that in general, HFT strategies typically employ the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders. ); Staffs of the Commodity Futures Trading Comm n and Securities and Exchange Comm n, Rep. to the Joint Advisory Comm. on Emerging Regulatory Issues, Findings Regarding the Market Events of May 6, 2010 pg. 45 (Sep. 30, 2010) [hereinafter Final Flash Crash Report] ( HFT s are proprietary trading firms that use high speed systems to monitor market data and submit large numbers of orders to the markets. HFT s utilize quantitative and algorithmic methodologies to maximize the speed of their market access and trading strategies. ) 24 McGowan, supra note 17, at ¶3.
speed and sophisticated computer programs for generating, routing, and executing orders. For HFT, speed
matters both in the absolute sense of
achieving very small latencies and in the relative sense of being faster than competitors, even if only by a microsecond.
must have fast connections to markets in order to receive data and to send their orders and cancellations as quickly as possible.27 on expensive Colocation While beyond the scope of this paper, most HFTs rely colocation for connection speed advantages.
refers to the practice of setting up . . . trading
computers in the same physical building as the exchange s computers, to get a time advantage over . . . competitors. is estimated that colocation afford[s] traders a 100-200
millisecond advantage over other investors.
tiny advantage illustrates the time frame that HFTs operate in. Volume is important to HFTs because each individual opportunity is of low reward.
Manoj Narang, the founder, CEO
Concept Release on Equity Market Structure at 3606. 26 Id. at 3610 ( Many proprietary firm strategies are highly dependent upon speed - speed of market data delivery from trading center servers to servers of the proprietary firm; speed of decision processing of trading engines of the proprietary firm; speed of access to trading center servers . . . ; and speed of order execution and response by trading centers. ) 27 Id. 28 See Hearings (prepared statement of Daniel Mathisson, Managing Director, Credit Suisse) (Also arguing that colocation is merely the 21st century version of traders trying to get office space close to the exchange. ); Concept Release on Equity Market Structure at 3610 ( Colocation is one means to save microseconds of latency. ) 29 Letter from Sen. Ted Kaufman at 4. 30 See Letter from Manoj Narang at 9; Timothy Lavin, Monsters in the Market, The Atlantic (August 2010) ( [HFT] . . . is a very low-margin, low-risk strategy.) But see, Concept Release on Equity Market Structure, 75 Fed. Reg. 3554, 3607 (proposed Jan. 21, 2010) (to be codified at 17 C.F.R. pt. 242)
and chief investment strategist of Tradeworx, a company involved in HFT,31 claims that each individual share involved in a HFT strategy typically earns only a hundredth-of-a-cent per trade.32 How prevalent is HFT?First, note that, according to one estimate, HFTs represent approximately 2% of the 20,000 or so
trading firms operating in the U.S. markets.
is impressive compared with the every-day trade volume that is attributed to HFT. While [e]stimates of HFT volume in the
equity markets vary widely . . . , they often are 50 percent of total volume or higher.
Estimates in the higher range The various estimates
attribute 75% of trade volume to HFTs.35
of HFTs prevalence in the market are due to confusion over HFT s definition.36 But by any measure, HFT is a dominant component
(Noting that some have raised concerns that some HFT strategies may not necessarily involve a large number of trades. ) develop[s] advanced technology solutions . . . based on 31 Tradeworx mathematical algorithms . . . used . . . for high performance trading - by Tradeworx for its own account, by its hedge fund, and by third parties who purchase Tradeworx s technology. Letter from Manoj Narang at 1. 32 Timothy Lavin, Monsters in the Market, The Atlantic (August 2010). 33 Rob Iati, The Real Story of Software Trading Espionage, Advanced Trading.com, July 10, 2009. 34 Preliminary Flash Crash Report at Appendix A. 11 (citing Jonathan Spicer and Herbert Lash, Who s Afraid of High-Frequency Trading?, Reuters.com, December 2, 2009 ( High-frequency trading now accounts for 60 percent of total U.S. equity volume, and is spreading overseas and into other markets. )); Scott Patterson and Geoffrey Rogow, What s Behind High-Frequency Trading, Wall Street Journal, August 1, 2009 ( High frequency trading now accounts for more than half of all stock-trading volume in the U.S. ). 35 See Hearings (prepared statement of Christopher Nagy, Managing Director of Order Routing Strategy, TD Ameritrade) (75%); Hearings (prepared statement of Larry Leibowitz, Group Executive Vice President, NYSE Euronext) (two-thirds). 36 See Concept Release on Equity Market Structure at 3607 ( The lack of clarity may, for example, contribute to the widely varying estimates of HFT volume in today s equity markets. ); Hearings (statement of Daniel Mathisson, Managin Director, Credit Suisse) ( [T]here is no clear definition of the term [HFT], making it very difficult to analyze its effects or estimate what
of the current market structure and is likely to affect nearly all aspects of its performance. that
Indeed, the SEC has noted
[t]he use of certain [HFT] strategies by some proprietary
firms has, in some trading centers, largely replaced the role of specialists and market makers.38 market maker, III. a. HFT s role in this regard, as
is discussed below.
High Frequency Trading Strategies: Statistical Arbitrage Statistical arbitrage strategies depend on relationships and
correlations between two different securities.39
for gain are found by identifying these relationships, discern[ing] historical patterns and correlations, and In other
acquiring certain positions informed by the analysis.40 words, statistical arbitrage is
based on mispricing in the
markets or a temporary deviation from historical trends . . . .
This strategy has been termed the
the HFT strategies,42 but speed and volume are still important.
percent of the market it is, resulting in what appear to be wide overestimates of what percent of the market [HFT] makes up. ) 37 Preliminary Flash Crash Report at Appendix A. 11. 38 See Concept Release on Equity Market Structure at 3607. 39 See Letter from Manoj Narang at 9. 40 Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) (Explaining that depending on the statistical analysis, firms will buy and short the affected securities to help push them back to their traditional correlations, collecting the spread along the way. ) 41 Mobis Philipose and Ravi Ananthanarayanan, Flash Orders Not Synonymous with High-Frequency Trading, LiveMint.com (September 18, 2009). See also, Concept Release on Equity Market Structure at 3608 ( An arbitrage strategy seeks to capture pricing inefficiencies between related products or markets. ) For a plain-language explanation of statistical arbitrage, see also, Jon Stokes, The Matrix, But with Money: The World of High-Speed Trading, Arstechnica.com (2009) ( Stat arbs make their money by vacuuming up mountains of historical data and looking for correlations between various datapoints and asset prices. The stat arb's trading platform, which is basically a large computer system
Statistical arbitrage strategies are assisted by computers in three ways. First, computers are required to analyze market Second, because these Third,
data and identify correlations.
opportunities last for a very short amount of time.
because the gain associated with any single trade in statistical arbitrage tend to be very low, the reduced trading cost that is associated with computer trading and automation is required for profitability.43 b. Passive Market Making Another common HFT strategy, which is particularly associated with high volume and called passive market making.
high cancellation rates,
Market making is the practice,
traditionally employed by era,
screaming floor traders of a bygone to a market.47
of, in essence,
Market makers are intermediaries in the markets: they fill buy and sell orders placed by investors.48 Because of the important
manned by programmers and financial engineers, uses those correlations to build predictive models that take in a stream of information inputs like news reports and stock prices . . . , and output a rapid-fire stream of "buy" and "sell" orders for different assets. ) 42 Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) . 43 See Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) ( The profits on any one trade tend to be small but, with enough speed and volume, they can create enormous profits. ) 44 Concept Release on Equity Market Structure at 3607 (stating that cancellation rates may reach 90%). But see, Letter 45 See Concept Release on Equity Market Structure at 3607-08. from Manoj Narang at 9 ( It is increasingly difficult to differentiate marketmaking from statistical arbitrage. Statistical arbitrage techniques are often used by market-makers . . . . ) 46 Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) . 47 Concept Release on Equity Market Structure at 3607. 48 See, e.g., Perrie M. Weiner et al., Catch Me if You Can: Speed Traders Under Scrutiny, 1843 PLI/Corp 341, 343 (July 20, 2010) ( When a mutual fund
role they play in the market, market makers are traditionally subject to affirmative and negative obligations.49 These
obligations, and the fact that HFTs embodying the roles of market maker are not subject to them, will be discussed below. Passive orders.
market making is characterized by placing
A resting order is a type of limit order,51 meaning
that it may only be executed if its specified price is met by another party,52 that is placed in positions to take advantage of an anticipated price move.
HFTs using a market making strategy make profits in two ways.54 stock. First, by collecting the A HFT will bid-ask spread on a given
[earn] the spread by buying at the bid and
selling at the offer . . . .
Basically: buy low, sell high.56
wants to buy 10,000 shares of Tesla, Inc, odds are a high-frequency trader will be ready to provide the shares. ) 49 See Concept Release on Equity Market Structure at 3607. 50 See id. [a]n order [that specifies] a minimum sale price or 51 A limit order is maximum purchase price, as contrasted with a market order, which implies that the order should be filled as soon as possible at the market price. CFTC Glossary, CFTC.gov. resting order as a limit order to 52 See CFTC Glossary, CFTC.gov (defining buy at a price below or to sell at a price above the prevailing market that is being held by a floor broker. ) 53 Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic Market 14 (November 9, 2010). 54 Concept Release on Equity Market Structure at 3607 ( [T]he primary sources of profits [in market making strategies] are from earning the spread by buying at the bid and selling at the offer and capturing any liquidity rebates offered by trading centers to liquidity-supplying orders. ) But see, Letter 55 See Concept Release on Equity Market Structure at 3607. from Manoj Narang at 8 ( For stocks that are extremely liquid, some marketmakers may be willing to buy and sell at the same price . . . . Such marketmakers are said to be operating rebate-capture strategies because their only compensation is the rebate offered by exchanges for posting orders. ) (emphasis in original).
Second, by collecting the tiny (usually 1/4 or 1/3 of a cent per trade),57 rebate that many markets pay firms for providing liquidity.58 Why do markets offer rebates? Most liquid stocks
trade at 1 cent bid-ask spreads[.] is not a large enough
[B]ut in most cases, 1 cent As a
to cover the risk of trades.
result, exchanges offer [these rebates as] further inducement for traders to post orders . . . . detractors. interest.
This practice is not without
Payment for order flow is an inherent conflict of Because it encourages broker dealers to send retail
order flow to the highest bidder and not to the trading center that is necessarily best of the buyer or seller, payment for retail order flow is a highly dubious practice. c. Directional Strategies Some HFTs use directional strategies.61 Directional
strategies, at least in the long-term investor context, are
See McGowan supra note 17, at ¶ 23 ( To make money off of the spread, market makers will buy and sell securities on both sides of the trade by placing a limit order to sell (or offer) above the current market price or a buy limit order (or bid) below the current price in order to benefit from the bid-ask spread. ) 57 Id. at ¶ 26 (citing Mark Hutchinson, High Frequency Trading: Wall Street's New Rent-Seeking Trick, Money Morning, Aug. 14, 2009). 58 Letter from Sen. Ted Kaufman at 5 (Explaining that, in essence, market making generate[s] profits by capturing spreads and earning liquidity rebates under the current maker-taker pricing models used by many market centers to attract order flow. ) 59 Letter from Manoj Narang at 8 ( Most liquid stocks trade at 1-cent bid-ask spreads, but in most cases, 1 cent is not a large enough spread to defray the cost of adverse selection . . . . As a result, exchanges offer further inducement for traders to post orders in the form of rebates. For stocks that are extremely liquid, some market-makers may be willing to buy and sell at the same price . . . . Such market-makers are said to be operating rebatecapture strategies because their only compensation is the rebate offered by exchanges for posting orders. ) 60 Hearings (statement of Sen. Kaufman). 61 See Concept Release on Equity Market Structure at 3608.
They are based on obtaining positions in anticipation of speculat[ion] on the direction of the
price movements, or underlying market. as
Some HFT directional strategies are just
straight-forward as concluding that a stock price temporarily fundamental value and establishing a
has moved away from its
position in anticipation that the price will return to such value.
However, two subsets of HFT directional strategies,
recently noted by the SEC in its Concept Release on Equity Market Structure, are more complicated and novel, and raise particular concerns about the stability and fairness of the markets. i. Order Anticipation
When large institutional traders buy or sell a large number of a particular share, the price is affected.64 Order
anticipation strategies attempt to predict these price movements, and trade in front of them; either selling (or shorting) before the price drops, or buying before it rises.65 To minimize the
effect that large trades can have on price, and to avoid other traders taking advantage of that movement, institutional traders often break large trades into small pieces.66 play in two different ways. different strategies to HFT comes into
First, HFTs are thought to employ large trades disguised as a
CFTC.gov, CFTC Glossary, Directional Trading available at http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/glossary_d .html. 63 Concept Release on Equity Market Structure at 3608. 64 Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic Market 3, 17-18 (November 9, 2010). 65 See Concept Release on Equity Market Structure at 3608. 66 High-Frequency Trading: Rise of the Machines, The Economist (Aug. 1, 2009).
series of small ones.67
HFTs may use
recognition software to ascertain from publicly available information the existence of a large buyer . . . . HFTs may use their speed to investors.69 This term, trade in front of
trade in front of,
does not While the practice
necessarily connote illegal trade behavior. of front running
is certainly illegal, using sophisticated In
methods of analysis and high speed is not necessarily so.70 this context, trade in front of means using high speed to
capture bid-ask spreads. ii. Momentum Ignition momentum ignition,
Another form of directional strategy is and is most likely illegal.71
This strategy seems primarily to
be targeted against other algorithmic traders in the market.72 According to this strategy, the HFT may send out a large number of orders and cancellations in rapid succession in an attempt to
See id. 68 Concept Release on Equity Market Structure at 3609. 69 Id. 70 See Concept Release on Equity Market Structure at 3609 (Explaining that their discussion of order anticipation strategies excludes those that would be illegal: The type of order anticipation strategy referred to in this release involves any means to ascertain the existence of a large buyer (seller) that does not involve violation of a duty, misappropriation of information, or other misconduct. ) See also, Letter from Manoj Narang at 15 ( Should the anticipation of the behavior of other market participants by HFTs be prohibited? No! . . . We submit that any trading signal is perfectly fair so long as publicly available data is being used in its construction. If somebody is able to build a better signal using the same data, should that be discouraged? No matter what restrictions regulators impose, some players will always be superior in terms of their ability to analyze data. ) 71 See Concept Release on Equity Market Structure at 3609. 72 Id.
the other algorithms to buy or sell more aggressively.73
By establishing a position early, the proprietary firm will attempt to profit by subsequently liquidating the position if successful in igniting a price movement.
The speed at which sharp price
HFTs operate allows them first ignite these movements and second to
then profit from the resulting short-
The high volume use of orders and cancellations may be used to manipulate the market in another way, in a practice called quote stuffing, where high volumes of quotes are purposely
sent to exchanges in order to create data delays that would afford the firm sending these quotes a trading advantage.
Both momentum ignition and quote stuffing are most likely illegal because intentional manipulation of the market is against the law.77 But both practices may be difficult to control.78
However, some firms have been fined for using HFT to manipulate the market.79
Id. 74 Id. 75 Hearings (statement of James Brigagliano, Coacting Director, Div. of Trading and Markets, Securities and Exchange Comm.). 76 Final Flash Crash Report at pg. 79. 77 See 15 U.S.C. S 78i. 78 See Concept Release on Equity Market Structure at 3609 ( [W]hile spreading false rumors to cause price moves is illegal, such rumors can be hard to find (if not spread in writing), and it can be difficult to ascertain the identity of those who spread rumors to cause price moves. ) 79 In September 2010, the Financial Industry Regulatory Authority ( FINRA ) fined Trillium Brokerage Services $2.3 million for using an illicit high frequency trading strategy. Press Release, Financial Industry Regulatory Authority, FINRA Sanctions Trillium Brokerage Services, LLC, Director of Trading, Chief Compliance Officer, and Nine Traders $2.26 Million for Illicit Equities Trading Strategy, (Sept. 13, 2010) available at http://www.finra.org/Newsroom/NewsReleases/2010/P121951. Trillium, through
Position Identification An additional strategy that some opponents of HFT have
identified is characterized by the sophisticated use of orders to identify and take advantage of another trader s position.80 According to this strategy, an HFT firm will send out many immediate-or-cancel sell orders, that if not accepted This practice could potentially
immediately, are cancelled.81
allow an HFT firm to foil a trader s attempt at keeping secret how much it is willing to pay for a certain stock.82 believe that HFTs are able to Some
game the system using repeated and
lightning-fast orders to quickly identify other traders positions and take advantage of that information, potentially
nine proprietary traders, entered numerous layered, non-bona fide market moving orders to generate selling or buying interest in specific stocks. By entering the non-bona fide orders, often in substantial size relative to a stock's overall legitimate pending order volume, Trillium traders created a false appearance of buy- or sell-side pressure. This trading strategy induced other market participants to enter orders to execute against limit orders previously entered by the Trillium traders. Once their orders were filled, the Trillium traders would then immediately cancel orders that had only been designed to create the false appearance of market activity. As a result of this improper high frequency trading strategy, Trillium's traders obtained advantageous prices that otherwise would not have been available to them on 46,000 occasions. Press Release, Financial Industry Regulatory Authority, FINRA Sanctions Trillium Brokerage Services, LLC, Director of Trading, Chief Compliance Officer, and Nine Traders $2.26 Million for Illicit Equities Trading Strategy, (Sept. 13, 2010) available at http://www.finra.org/Newsroom/NewsReleases/2010/P121951. 80 For two somewhat sensational discussions on the potentially nefarious uses of probing quotes, see generally, Alexis Madrigal, Explaining Bizarre Robot Stock Trader Behavior, The Atlantic (August 6, 2010) available at http://www.theatlantic.com/technology/archive/2010/08/explaining-bizarrerobot-stock-trader-behavior/61028/; Ellen Brown, Computerized Front-Running: Another Goldman-Dominated Fraud (April 21, 2010) available at http://www.webofdebt.com/articles/computerized_front_running.php. 81 Concept Release on Equity Market Structure at 3607 n.69. 82 To avoid signaling their intentions to the market, institutional investors trade large orders . . . within specified price ranges. High-Frequency Trading: Rise of the Machines, The Economist (Aug. 1, 2009).
disadvantaging retail investors.
HFTs attempt to uncover how
much an investor is willing to pay (or sell for) by sending out a stream of probing quotes that are swiftly cancelled until they elicit a response. The traders then buy or short the targeted
stock ahead of the investor, offering it to them a fraction of a second later for a tiny profit. IV. Regulation: a. Need for Regulation This section will discuss regulation of HFT. First, it will Second,
discuss several reasons why HFT needs to be regulated.
it will discuss the regulations that HFT is subject to now. Third, it will discuss why those current regulations are ineffective. Fourth, it will explore new legislation, and
suggest how it might be implemented to most effectively regulate HFT. Finally, it will examine proposed and potential regulation. HFT must be regulated because it influence over trading.
HFT is a dominant component
of the current market structure, [it] is likely to affect nearly all aspects of its performance.
An aspect of trading that, by
all estimates, comprises at least 50% of daily trading volume has a tremendous capacity to affect the stability and integrity of the equity markets.
Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities, Insurance, and Investment). 84 High-Frequency Trading: Rise of the Machines, The Economist (Aug. 1, 2009). 85 Mary L. Schapiro, Chairman, Securities and Exchange Comm n, Remarks Before the Security Traders Ass n (Sept. 22, 2010). 86 Preliminary Flash Crash Report at Appendix A. 11. 87 Mary L. Schapiro, Chairman, Securities and Exchange Comm n, Remarks Before the Security Traders Ass n (Sept. 22, 2010).
HFT s largest potential for impact on systemic stability is its association with liquidity. Proponents of HFT claim that it Indeed, some go so far as
provides the markets with liquidity.88 to say that
HFTs are the liquidity backbone of the market.
But according to critics, this is the precisely the concern, and the very reason why HFTs must be regulated closely. As major suppliers of liquidity to the market, many HFTs act as de facto market makers. Traditional market makers are
important for maintaining market stability, and are thus subject to affirmative90 and negative obligations.91The most important obligations imposed upon registered market makers require them to continue providing liquidity, whether markets are up or down, and to assist in the maintenance, insofar as reasonably practicable,
of fair and orderly markets. HFTs
Unlike market makers, however,
are subject to very little in the way of obligations either
to protect that stability by promoting reasonable price
For a study on whether HFT provides liquidity to markets, see Terrence Hendershott, Charles M. Jones, & Albert J. Menkveld, Does Algorithmic Trading Improve Liquidity? available at http://faculty.haas.berkeley.edu/hender/Algo.pdf But see, Hearings (statement of Sen. 89 Letter from Manoj Narang at 7. Kaufman). (arguing that liquidity is not the only consideration in matters of market stability and fairness; [l]iquidity as an end seems to have trumped the need for transparency and fairness. We risk creating a two-tiered market that is opaque, highly fragmented, and unfair to long-term investors. ) 90 Affirmative [market maker] obligations might include a requirement to consistently display high quality, two-sided quotations that help dampen price moves . . . . Concept Release on Equity Market Structure at 3607 n.70. reaching across the 91 [N]egative obligations might include a restriction on market to execute against displayed quotations and thereby cause price moves. Concept Release on Equity Market Structure at 3607 n.70. But see, id., (explaining 92 Preliminary Flash Crash Report at Appendix A. 9. that market makers may use stub quotes, an offer to buy or sell a stock at, for example, a penny, during times of volatility when they do not wish to trade.)
continuity in tough times, or to refrain from exacerbating price volatility.
This lack of obligation is especially worrisome
given that many HFT strategies profit during times of volatility.94 Concerns about systemic stability thus center around the liquidity that HFTs supply. For example, one HFT proponent,
Manoj Narang, in a misguided attempt at assuaging fears that HFT algorithms could trigger a hot potato effect,95 explained that it would
if an HFT algorithm detected an simpl[y] turn off
its strategy . . . .
Indeed, Narang, who
runs an HFT operation through his Tradeworx Inc. firm, did shut down his HFT algorithm on May 6, 2010, during the height of the Flash Crash.
This is precisely the fear: if HFTs provide 50%
of liquidity in the markets every day, they also stand in a
Mary L. Schapiro, Chairman, Securities and Exchange Comm n, Remarks Before the Security Traders Ass n (Sept. 22, 2010). See also, Hearings (prepared statement of Peter Driscoll, Chairman, Security Traders Association) ( Market makers . . . have traditionally had significant obligations to the markets and generally position risk for longer than milliseconds. ) 94 Letter from Manoj Narang at 4 ( HFTs benefit from volatility . . . . ) (emphasis in original). 95 See Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic Market 3, 17-18 (November 9, 2010) (explaining the hot potato effect, where HFTs rapidly buy and sell contracts from one another many times, driving prices down. Also explaining how the hot potato effect played into the May 6, 2010 Flash Crash. ) 96 Letter from Manoj Narang at 10. Black Swan 97 See Scott Patterson & Tom Lauricella, Did a Big Bet Trigger Stock Swoon? The Wall Street Journal (May 10, 2010) available at http://online.wsj.com/article/SB10001424052748704879704575236771699461084.html . The prevalence of algorithmic trading in the markets amplifies the problems that could be caused by a faulty program. Indeed, it is believed that the May 6, 2010 Flash Crash was initiated by a faulty sell order from an algorithmic trader. See Final Flash Crash Report at pg. 2 (explaining that the sell algorithm was programmed to target an execution rate of 9% of the trading volume calculated over the previous minute, but without regard to price. )
position to remove (or more accurately, cease to provide) 50% of liquidity whenever they choose. Critics [thus] accuse high frequency traders of being fairweather market makers who, unlike the former . . . [market makers] they ve largely replaced, don t have a legal obligation to trade during periods of stress. the May 6, 2010 Flash Crash, underneath the market:
Indeed, at the height of
offers to buy stocks vanished from
on the morning of May 6, there were
hundreds of offers above $51 to buy shares of a certain stock that, hours later, during the height of the Flash Crash, showed just four bids above $14.99 The Flash Crash Report100 found that
six of the twelve HFTs it interviewed scaled back their trading on May 6th, and that two of the larger ones withdrew completely.101 A second source of instability is the volatility that some fear HFT may induce. may be more easily Automated traders pursuing short-term gain spooked into aggressive trade by sudden And the speed at
price changes than humans or long-term traders. which they might react could be problematic.
Michael Peltz, Inside the Machine: A Journey into the World of HighFrequency Trading, InstitutionalInvestor.com (Jun. 10, 2010). Black Swan Stock 99 Scott Patterson & Tom Lauricella, Did a Big Bet Trigger Swoon? The Wall Street Journal (May 10, 2010). The certain stock was the iShares Russell 1000 Growth Index exchange-traded fund. Id. 100 Final Flash Crash Report at pg. 45. See also, America s Stockmarket Plunge: A Few Minutes of Mayhem, The 101 Id. Economist (May 15, 2010) ( Another factor [in the May 6th Flash Crash] was the sudden retreat by the high frequency firms whose algorithmic trading has come to dominate equity markets. In normal times they play a crucial role in providing liquidity. But unlike market makers, they are not obliged to do so during bouts of turbulence. Regulators think that some high-frequency traders switched off their programs when prices began to spiral, fearful that their trades would be cancelled because of the severity of the declines. )
worries that the
of multiple HFTs on a single,
short-lived opportunity sudden price swings. potato
may leave the marketplace vulnerable to Such convergence could ignite a hot
effect (alluded to above), where HFT algorithms rapidly magnif[ying] changes.
trade between each other,103
Critics of HFT also argue that some HFT strategies make profits at the expense of long-term investors,105 who the markets and regulators are meant to primarily serve.106 They point to
the HFT practice of identifying large investors and their positions as particularly unfair. A New York Times article
argued that the profits HFTs make through use of their speed and processing power are translated into additional costs for the long term investor. The article provided an example where [t]he
result [of HFT activity] is that the slower-moving investors paid . . . $7,800 more than if they had been able to move as quickly as the high-frequency traders. b. Current Regulation
Letter from Sen. Ted Kaufman at 1. Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency 103 Trading on an Electronic Market 3, 17-18 (November 9, 2010). 104 High-Frequency Trading: Rise of the Machines, The Economist (Aug. 1, 2009). 105 See Jason Zweig, The Market War Between Traders and Investors Heats Up, The Wall Street Journal (September 25, 2010) . See also, Elimination of Flash 106 See Letter from Sen. Ted Kaufman at 1. Order Exception From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01, 48636 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242) ( If . . . the interests of long-term investors and professional short-term traders conflict, the Commission previously has emphasized that its clear responsibility is to uphold the interests of long-term investors. ) citing Securities Exchange Act Release No. 51808 (June 9, 2005) 70 FR 37496, 37500 (June 29, 2005). 107 See Charles Duhigg, Stock Traders Find Speed Pays, in Milliseconds, The New York Times (July 23, 2009).
HFT is currently regulated in some ways.
First, some firms
operating a HFT strategy are registered as broker-dealers,108 and are subject to certain obligations as such.109 Second, all
traders must comply with various laws and regulations that control fraud, market manipulation, insider trading, and frontrunning.110 In addition, every exchange is required to enact
rules to prevent fraudulent and manipulative practices and protect investors and the public interest.111 c. Ineffectiveness of Current Regulation However, the effectiveness of the laws and regulations that HFTs are subject to is lessened by the current inability of regulatory bodies to adequately monitor HFT activity.112 It is
difficult to monitor HFT activity because of the fragmentation of trade across various markets, fragmentation of regulatory authority, and the massive volume of data that such monitoring would entail.113 Also, the current monitoring system does not
even have the capability of discerning which trades originate from algorithmic programs. The inability to adequately monitor
HFT activity is illustrated by the confusion over just what HFT
108 Broker-dealer is defined in §§ 3(a)(4)(A) and 3(a)(5)(A) of the Securities Exchange Act of 1934. 109 See Concept Release on Equity Market Structure at 3606; Financial Industry Regulator Authority, Comment Letter to Elizabeth M. Murphy, Secretary, Securities and Exchange Comm n. at 4 (April 23, 2010). See also, Louis Loss, Fundamentals of Securities Regulation, 676 (1983, Supp. 2010) (describing the capital requirements of registered broker-dealers). 110 See, e.g., 15 U.S.C. § 78i (banning manipulation of security prices); 15 U.S.C.A. § 78t-1 (banning insider trading). 111 See Financial Industry Regulator Authority, Comment Letter to Elizabeth M. Murphy, Secretary, Securities and Exchange Comm n. (April 23, 2010) (citing Securities and Exchange Act §§ 6(b)(5), 15A(b)(6)). 112 See id. 113 See id.
While speculation abounds, there is frustratingly
little reliable information about HFT strategies. d. The Dodd-Frank Wall Street Reform and Consumer Protection Act In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act ( DFA ) was passed.114 In it are several
provisions that might bear upon the regulation of HFT activities. i. SEC the effect
The DFA instructs the SEC to conduct a study of
of high-frequency trading and other technological advances on the market and what the SEC requires to monitor the effect of such trading and advances on the market. present its findings along with
The SEC is then to
recommendations for legislative,
regulatory, or administrative action.
In accordance with
these instructions, the SEC has released a Concept Release on Equity Market Structure, cited frequently in this paper, which seeks to solicit comments from the industry on how HFT and other technological advancements are affecting the markets.117 The DFA also increases the SEC s ability to monitor hedge funds.118 Because hedge funds are typical users of HFT
strategies,119 this new development could be significant in HFT regulation. Now the SEC may require hedge funds to maintain and as necessary and appropriate in the public
114 Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. (2010) ( DFA ). 115 DFA § 967(a)(2)(D). 116 DFA § 967(b)(2). 117 See generally, Concept Release on Equity Market Structure, 75 Fed. Reg. 3554 (Jan. 21, 2010). private investors ); 118 See DFA §§ 403 (removing registration exemption for 404 (increasing reporting requirements). 119 See Concept Release on Equity Market Structure at 3606.
interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council (described below).120 The information required may
include the amount and types of assets held, trading and investment positions, trading practices, and any other information that the SEC determines is necessary.121 The
availability of this information will be potentially helpful to regulators, because it is generally kept secret. Not only would
the information help keep such firms accountable for their practices, it would help shed light on how HFT practices might affect the markets. However, a provision in the DFA exempting
hedge funds managing less $150 million in assets will lessen the helpfulness of these reporting requirements.122 The SEC should first use both of these powers to gain a more thorough understanding of HFT. ii. HFT are currently kept
Financial Stability Oversight Council
The DFA established a new Financial Stability Oversight Council ( FSOC ),123 whose purpose it is to . . financial stability, [financial] stability. information,
identify risks to .
respond to emerging threats to collect
The FSOC s duties are to
monitor the financial services marketplace,
DFA § 404(b)(1)(A). But see DFA § 404(b)(10)(B) (reserving from public 121 DFA § 404(b)(3). disclosure all proprietary information such as trading data, computer or software containing intellectual property, etc.). any investment adviser 122 See DFA § 408 (exempting for reporting requirements of private funds, if each of such investment adviser acts solely as an adviser to private funds and has assets under management . . . of less than $150,000,000. ) 123 DFA § 111. 124 DFA § 112(a)(1).
identify gaps in regulation,
require supervision . . . for stability risks, and
nonbank financial companies that may pose to
make recommendations to primary financial regulatory agencies
to apply new or heightened standards and safeguards for financial activities markets.125 Much of the FSOC s power comes from its ability to recommend nonbank financial companies that pose a systemic risk126 for regulation under the Board of Governors of the Federal Reserve ( Board of Governors ).127 Some nonbank financial firms that are that could pose a risk to financial stability in the
thought to employ HFT strategies, such as large companies that trade in a proprietary fashion (e.g., Goldman Sachs), will probably qualify for this FSOC recommendation because of their massive size and interconnectedness.128 However, exactly who
will be subject to this new scrutiny remains to be seen, as the DFA does not, perhaps intentionally, provide many benchmark criteria.129 The criteria that the FSOC bases its determinations upon will have a large impact on which HFT companies fall subject to its regulation. Criteria that are based solely upon size of Instead, the FSOC
capital will not capture enough HFT firms. should use trade volume as criteria.
125Id. 126 Defined in DFA § 102(a)(4); qualifications listed in DFA § 113(a)(2) ( any other risk-related factor ). 127 DFA § 112(a)(2)(H). 128 See DFA § 112(a)(2)(H). But see, DFA § 165(a) (intimating a benchmark of $50 129 See DFA § 113(a)(2). billion).
For example, Tradeworx, who has been mentioned previously in this paper, trades with only $6 million capital.130 Through that
lens, and compared to firms the size of Goldman Sachs, Tradeworx would not seem to qualify as a systemic risk. However, Tradeworx
has reported that it makes more than 200,000 trades everyday with over 40 million shares:131 its impact on systemic stability comes not from the size of its capital, but how it uses it. Tradeworx,
like many HFT firms, uses its capital many times over the course of a day by rapidly acquiring and liquidating different positions. Therefore, concentrating on size of capital alone The FSOC should devise
would miss the risk that HFTs create.
criteria to capture relatively small but nonetheless systemically significant HFT firms like Tradeworx by concentrating on the amount of liquidity they supply and have the ability to withhold.132 The firms that the FSOC recommends for regulation under the Board of Governors may be subject133 to prudential standards, enhanced supervision and
such as risk-based capital requirements,
leverage limits, enhanced public disclosures, and overall risk management requirements.134 These standards seem based at
addressing the risk of an interconnected company s failure; it is unclear whether these enhanced standards can adequately address
Michael Peltz, Man vs. Machine: Inside the World of High-Frequency Trading, CNBC.com (Sept. 13, 2010) available at http://classic.cnbc.com/id/39099331/. 131 Jason Zweig, The Market War Between Traders and Investors Heats up, The Wall Street Journal (Sept. 25, 2010). any other risk-related 132 See DFA § 113(a)(2) (listing, as a consideration, factor ). 133 See DFA § 112(a)(2)(I). 134 DFA § 115(b)(1).
the stability risks that HFTs represent,135 which are based not on failure but on the volatility HFT practices may create. If
they cannot, then the FSOC s greatest impact on HFT will most likely emanate from its duty to monitor the markets for stability risks136 and make recommendations to primary regulators (like the SEC, who could perhaps impose trading obligations) based on its findings.137 iii. Commodity Futures Trading Commission
Although HFT activity has been discussed solely in terms of the equity markets so far, the DFA prohibits some commodity market activity that could affect some of the HFT strategies described above. practices In Section 747, the DFA prohibits disruptive
in the commodities markets.138
In pertinent part, the commonly known to
DFA defines disruptive practices as what is the trade as, spoofing
(bidding or offering with the intent to
cancel the bid or offer before execution).
Futures Trading Commission ( CFTC ) is currently in the process of considering whether it needs to promulgate additional regulations to enforce these new anti-disruption laws.140 e. Proposed and Newly Enacted Regulations i. Prohibition of Naked Access
See DFA § 115(b)(1) (listing the various regulations that may be imposed). 136 DFA § 112(a)(2)(C). 137 DFA § 112(a)(2)(K). 138 See DFA § 747, amending § 4c(a) of the Commodity Exchange Act (7 U.S.C. § 4c(a) as amended). 139 DFA § 747, amending § 4c(a)(5)(C) of the Commodity Exchange Act (7 U.S.C. § 4c(a)(5)(C) as amended). 140 See Antidisruptive Practices Authority Contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act, 75 Fed. Reg. 67301 (November 2, 2010).
The SEC has formally enacted one regulation that will impact HFT. While beyond the scope of this paper, the SEC has recently naked access.
(November 3, 2010) banned
that naked access, where broker-dealers allow HFTs to have direct access to the markets by bypassing certain risk-management systems, allowed HFT firms to act as unregistered and unregulated broker-dealers.142 ii. Increased and Enhanced Market/Trader Monitoring
The SEC has proposed two rules that would enhance its ability to monitor HFT activity. implementing a First, the SEC has proposed
Large Trader Reporting System
which is Most HFTs would
essentially designed to monitor HFT activity.144 meet the definition of large trader,
which is any person whose
transactions equal or exceed (1) two million shares or $20 million during any calendar day or (2) 20 million shares or $200 million during any calendar month.145 After identifying
themselves, large traders would be assigned a unique identification number that would enable the SEC and other
Risk Management Controls for Brokers or Dealers with Market Access, 17 C.F.R. S 240 (2010). 142 See Hearings (statement of William O Brien, CEO, Direct Edge). 143 Large Trader Reporting System, 74 Fed. Reg. 21456 (proposed April 14, 2010). 144 See id. ( The proposal is intended to assist the Commission in identifying and obtaining certain baseline trading information about traders that conduct a substantial amount of trading activity, as measured by volume or market value, in the U.S. securities markets. In essence, a large trader would be defined as a person whose transactions in NMS securities equal or exceed (i) two million shares or $20 million during any calendar day, or (ii) 20 million shares or $200 million during any calendar month. ) 145 Large Trader Reporting System, 74 Fed. Reg. 21456 (proposed April 14, 2010).
regulators to track their activity across different markets.146 The system would help the [SEC] reconstruct market activity,
analyze trading data and investigate potentially manipulative, abusive or otherwise illegal activity.
Second, the SEC has proposed a Consolidated Audit Trail ( CAT ), which would replace existing audit trails [that] are
limited in their scope and effectiveness in varying ways.
This proposed rule would require all securities exchanges to jointly in developing a consolidated order tracking system.
The CAT is aimed at satisfying
a heightened need for regulators
to have efficient access to a more robust and effective crossmarket order and execution tracking system. self-regulating markets151 in their
It will aid the
efforts to detect and deter
fraudulent and manipulative acts and practices in the marketplace, and generally to regulate their markets. will benefit the SEC s
market analysis efforts, such as
investigating and preparing market reconstructions and understanding causes of unusual market activity. Further, timely pursuit of potential violations can be important in seeking to
Id. 147 Liz Moyer, Ankle Bracelets for High-Frequency Traders, Forbes.com, (April 14, 2010). 148 Consolidated Audit Trail, 75 Fed. Red. 32556 at 1 (proposed May 26, 2010) (to be codified at 17 C.F.R. pt. 242). 149Id. 150 Id. 151 For a discussion on the self-regulation of the markets, see LOUIS LOSS, FUNDAMENTALS OF SECURITIES REGULATION, 689-702 (1983 & Supp. 2010). 152 Consolidated Audit Trail, 75 Fed. Reg. 32556 at 1 (proposed May 26, 2010).
freeze and recover any profits received from illegal activity. iii.
Elimination of Flash Order Exception
While beyond the scope of this paper, the SEC has also proposed banning flash orders.
An SEC market rule requires
markets to post their best bids and offers to all public markets.155But an exception156 that was [originally] intended to
facilitate manual trading in the crowd on exchange floors by excluding quotations that then were considered impractical to ephemeral and
post publicly,157effectively enables
who are not publicly displaying quotes to see orders before other investors . . . .
Critics fear that flash orders enable
Id. Flash orders begin as marketable buy or sell orders that are placed on an exchange. If the order is not immediately filled in its entirety on that exchange it may be flashed to market participants who are not currently displaying quotes in that exchange for a very brief period of time. During that brief period of time receivers of the flash order may respond and execute against it if they please. Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). 155 Rule 602 [of Regulation NMS] generally requires exchanges to make their best bids and offers in U.S.-listed securities available in the consolidated quotation data that is widely disseminated to the public. Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). excludes bids and offers 156 An exception ((a)(1)(i)(A)) to Rule 602, however, communicated on an exchange that either are executed immediately after communication or cancelled or withdrawn if not executed immediately after communication. Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). 157 Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). 158 Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities, Insurance, and Investment).
front-running by HFTs.159
The proposed rule would eliminate the
exception, effectively banning flash orders.160 iv. Liquidity Obligations
While the SEC has made no formal proposals, Mary Schapiro, Chairman of the SEC, has said that the SEC is interested in imposing obligations on HFTs that act in a market maker role.161 As noted above, even though many HFTs act as market makers, they are, unlike traditional market makers,
subject to very little in
[T]he flashing of orders to many market participants creates a risk that recipients of the information could act in ways that disadvantage the flashed order. With today s sophisticated order handling and execution systems, those market participants with the fastest systems are able to react to information in a shorter time frame than the length of the flash order exposures. As a result, such a participant would be capable of receiving a flashed order and reacting to it before the flashed order, if it did not receive a fill in the flash process, could be executed elsewhere. For example, a recipient of a flash order that was quoting on another exchange would be capable of adjusting its quotes to avoid being hit by the flash order if it subsequently were routed to that exchange. Alternatively, a recipient would be capable of rapidly transmitting orders that would take out trading interest at other exchanges before an unfilled flash order could be routed to those exchanges. In both cases, a flashed order that did not receive an execution in the flash process would also be less likely to receive a quality execution elsewhere. Elimination of Flash Order Exception From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). However, whether an order will be flashed is a voluntary decision on the part of the order-maker. Those who choose to flash their orders are probably sophisticated enough to consider the extent to which doing so would enable others to act against their interests. Elimination of Flash Order Exception From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). Although flashes show the intentions of investors, it s doubtful most flashed orders are big enough to move markets, disqualifying them from traditional front-running. Jonathan Spicer, Analysis: Have Flashes Spawned Front-Running?, Reuters News (Aug. 7, 2009). Most mutual funds do not allow their orders to be flashed, primarily because the process of displaying the orders to a select group of market participants could result in information leakage. Hearings (prepared statement of the Investment Company Institute). 160 Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). 161 Mary L. Schapiro, Chairman, Securities and Exchange Comm n, Remarks Before the Security Traders Ass n (Sept. 22, 2010).
the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility. consider carefully, according to Schapiro,
whether [HFT] firms
should be subject to an appropriate regulatory structure governing key aspects of their market behavior, including both their quoting and trading strategies.
Such obligations could
potentially require HFTs to continue trading in volatile periods, as market makers must. V. Conclusion: Due partly to the current inability of regulators to monitor it effectively, there is an inadequate understanding of HFT. it is clear that HFT is not regulated in proportion to its prevalence in the financial markets or the attendant stability risks it represents.The newly enacted Dodd/Frank bill will help impose more effective regulation on HFT. Its focus on financial But
stability will most likely result in imposition of trading obligations on HFT, and may prevent the most manipulative HFT practices. But most importantly, more robust and comprehensive
monitoring of HFT practices in needed; effective regulation of HFT requires that it be informed by HFT practices and how they might influence fairness and stability in the markets.
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