Recent high-profile market disruptions caused by advanced trading technologies, including the so-called "flash crash" and Knight Capital's software-driven collapse, have magnified interest in high-frequency trading. Regulators and legislators are driving to expand surveillance and regulation of high-frequency trading practices. The SEC has solicited a high-frequency trading firm to design a computer program that will, for the first time, afford the regulators real-time monitoring capabilities.1 The U.S. Commodity Futures Trading Commission (CFTC) is expanding its regulatory oversight of high-frequency trading as directed in the landmark Dodd-Frank Wall Street Reform and Consumer Protection Act.
While the United States has not yet formulated a cohesive plan of action, countries around the globe are responding to similar concerns, advancing or enacting legislation to impose limits on high-frequency trading strategies.2
We believe there will be a substantial increase in U.S. enforcement activity aimed at curbing unfair practices in high-frequency trading. This article examines some high-frequency trading strategies likely to be targeted in the coming wave of enforcement and litigation actions, and outlines new defense tactics suited to high-frequency trading.
High-Frequency Trading Today
High-frequency trading (also called high-speed trading) employs computerized systems capable of rapid calculation and data transmission time to run algorithms that identify and execute trading opportunities in millisecondsand increasingly in microseconds. The principal objective "involves minimizing risk and posting small deal sizes that enable [high-frequency traders] to move in and out of trades extremely quickly, arbitraging between spreads available on different exchanges and platforms, and even between the speed of trading available on them."3 High-frequency traders often hold positions for very short periods, collecting fractions of a penny on each share of a large-quantity trade.
Proponents argue that the resulting liquidity affords other investors trading opportunities, and has led to historically low transaction costs and increased market efficiency. Critics contend that high-frequency trading has disadvantaged investors without access to cutting-edge technologies,4 contributed to market volatility, eroded investor confidence, and has led to a two-tiered marketplace: high-frequency traders, and "everyone else."
High-frequency trading has grown to a 2009 peak of 60-70 percent of equity trading volume.5 Despite a recent decline in this percentage, high-frequency trading now accounts for approximately half of all U.S. equity trading, and 60 percent of futures contracts trading on the Chicago Mercantile Exchange.6 In addition, high-frequency trading has been increasingly employed in other asset classes, including options, foreign exchange, and fixed income. Experts predict continued growth.7
Although already on the SEC's radar, Dodd-Frank explicitly requires the SEC to conduct inquiries into high-frequency trading.8 Dodd-Frank provides the CFTC with "new ammo in [its] enforcement arsenal" through broader anti-manipulation authority and new "disruptive practices" authority, likely to trigger enforcement activity in the futures and commodities markets for high-frequency traders, a species of traders CFTC Commissioner Bart Chilton has named "cheetahs."9 Looking to become more of "a player in the fraud game,"10 the CFTC has adopted rules providing enhanced enforcement authority akin to that of the SEC's powers under §10(b) of the Securities Exchange Act and corresponding Rule 10b-5.11
High-Frequency Trading Manipulations
Various high-frequency trading strategies, referred to as "market manipulation,"12 "nefarious, predatory behavior,"13 and "inherently wrong,"14 are likely targets of future securities litigation. While some strategies are simply high-speed variants of old market manipulations, the high-speed, algorithmic nature of the trading complicates the nature of the violation. Traditional practices targeted by regulators that have new, high-speed variants include:
"Layering": "[T]he placement of multiple, non-bona fide limit orders on one side of the market at various price levels at or away from the [National Best Bid or Offer (NBBO)] to create the appearance of a change in the levels of supply and demand, thereby artificially moving the price of the security."15 Upon execution at the artificial price, the non-bona fide orders are immediately cancelled.16
"Spoofing": "[P]lacing certain non-bona fide order(s), usually inside the [NBBO], with the intention of triggering another market participant(s) to join or improve the NBBO, followed by cancelling the non-bona fide order, and entering an order on the opposite side of the market."17
"Quote stuffing": Placing a large number of buy or sell orders that are then cancelled almost immediately, thereby generating order congestion that slows down traders with inferior technology and creating a false sense of actual supply and demand.18
"Pinging": Submitting and rapidly withdrawing an order to gauge market interest, thereby providing traders with response information that can enable them to force buyers into accepting a higher price simply by virtue of access to faster technology systems.19