"Marking the close": Acquiring a substantial position in a security prior to the close of trading, followed by offsetting the position at or immediately before the close in order to manipulate prices.20
High-frequency traders, who are reported to cancel at least 90 percent of their orders,21 should be particularly concerned. Evidence suggests that the recent dramatic rise in cancellation rates is due in significant part to high-frequency trading.22 Many contend that the high cancellation rates signal manipulative liquidity detection by which high-frequency traders attempt to discover the trading of large blocks of securities in order to trade with or ahead of those blocks, a front-running practice based on an information advantage "akin to having a microphone in the boardroom."23 High cancellations may also indicate attempts to artificially inflate prices by artificially creating an appearance of volume, allowing sellers to profit from falsely elevated demand.
In August 2010, FINRA fined high-frequency trading firm Trillium Brokerage Services $1 million and ordered disgorgement of almost $175,000 for employing layering and spoofing strategies, and related supervisory failures.24 In addition, 11 individual traders were fined and/or suspended.25 FINRA deemed the firm's practice of entering "non-bona fide market moving orders to generate selling or buying interest" that "created a false appearance or buy- or sell-side pressure" to be "an illicit high frequency trading strategy."26 In employing the strategy, the traders obtained advantageous prices that would have been otherwise unavailable on 46,000 occasions as "[o]ther market participants were unaware that they were acting on the layered, illegitimate orders."27
Dodd-Frank's explicit, blanket prohibition of spoofing and "bidding or offering with the intent to cancel the bid or offer before execution" makes high-frequency cancellations a likely subject for future CFTC enforcement action as well.28 The CFTC's interpretation seems to also prohibit layering29 and quote stuffing,30 and its position that the submission of even a single bid or offer with the intent to cancel constitutes a violation, signals a need for extremely diligent compliance programs.31
While marking the close is not exclusively the province of high-frequency traders, such traders are likely targets of future enforcement, given their unique ability to trade massive volumes of securities extremely rapidly. In April 2012, in its first major case against a high-frequency trading firm, the CFTC fined Optiver $13 million and ordered disgorgement of $1 million for marking the close.32 The complaint alleges that in March 2007, the firm and associated traders attempted to move energy futures prices on at least 19 instances by executing a large volume of trading in the final moments before the close.33 For the CFTC, the settlement was a milestone in its efforts to aggressively tackle high-frequency trading manipulations. For high-frequency traders, it serves as a warning of the heightened likelihood of enforcement action as the CFTC leverages its expanded authority.34
Defenses to Allegations of Manipulation
While the new technologies will lead to new claims by regulators and private plaintiffs, high-speed trading brings defense lawyers new tools as well.
Algorithms make pleading and proving scienter far more difficult, magnifying its importance in high-frequency trading cases. Scienter, a "mental state embracing intent to deceive, manipulate, or defraud," is required to demonstrate a cause of action for market manipulation under Rule 10b-5.35 An algorithm may not obviously be designed to execute a manipulative trading practice, and the layers of complexity and quasi-randomness that can be introduced when an algorithm reacts to market stimuli will make pleading and proving scienter in the high-frequency trading context far more difficult.
On any judicial test to assess scienter,36 a high-frequency trading firm might easily defend itself by saying that the result of its algorithm was a truly unanticipated consequence of the algorithm's response to market stimuliincluding other algorithms whose behavior could not possibly be predictedthus countering any intent to manipulate or to inject inaccurate information into the market.
It is also more difficult to demonstrate causation and actual manipulation in the high-frequency trading world. For every dishonest high-speed trader trying to manipulate a price, other algorithms can and frequently do react at the same eye-blink rate to nullify, or at least complicate, the effects of the first algorithm. These interactions can leave a fact-finder with thorny, multi-variable issues of causation and market effects that will challenge even experienced and technologically savvy regulators and plaintiffs with expert assistance to clearly plead and/or present to a fact-finder. Equally savvy defense lawyers will understand how algorithms interact in a way that undermines a finding of causation or actual manipulation.
Despite these defenses, however, a high-frequency trading firm suspected of manipulation may be subject to intense regulatory investigations and discovery obligations. The availability of a winning defense can minimize the pain at the end of the day, but often cannot fully eliminate the expense of getting to that end result.
The recent surge of interest in high-frequency trading, and the CFTC's expanded authority under Dodd-Frank, signal a substantial future increase in enforcement and litigation activity in this area. As regulators come to better understand high-frequency trading, they will be emboldened to bring actions for abusive practices. Firms employing sophisticated technologies should pay close attention to new regulatory and legislative developments, and avoid the pitfalls listed above during what is likely to be a period of intense scrutiny. As always, proper expertise and focus is necessary to streamline internal investigations and discovery, to present complex technical evidence to regulators, counterparties, and fact-finders, and to minimize the burdens of grappling with this complex and rapidly developing area.
Eliot Lauer is a partner, and Jason Gottlieb is counsel, at Curtis, Mallet-Prevost, Colt & Mosle. Alyssa Astiz is an associate at the firm.
1. Nathaniel Popper and Ben Protess, "To Regulate Rapid Traders, S.E.C. Turns to One of Them," The New York Times, Oct. 8, 2012, http://www.nytimes.com/2012/10/08/business/sec-regulators-turn-to-high-speed-trading-firm.html?pagewanted=all.
2. Nathaniel Popper, "Beyond Wall St., Curbs on High-Speed Trades Proceed," The New York Times, Sept. 26, 2012, http://www.nytimes.com/2012/09/27/business/beyond-wall-st-curbs-on-high-speed-trading-advance.html?pagewanted=1&_r=0.