A Special Counsel with the Division of Swap Dealer and Intermediary Oversight at the U.S. Commodity Futures Trading Commission (CFTC) has published an article in the Connecticut Law Review questioning the legality of “pinging” and “front running” in the futures market by high-frequency trading (HFT) firms. The author expressly notes that it is his personal opinion and that he is not writing in his official capacity at the CFTC. However, the commentary does appear to be part of a larger trend to reign in the industry as several investigations by the SEC have settled and New York State is proceeding with a lawsuit against Barclays.
The HFT practices at issue involves the use of small orders that are cancelled quickly, akin to the high-speed pinging of sonar. A few are filled, most are cancelled instantly, and they allow the HFT firm to detect whether there is an institutional investor seeking to fulfill a large order in a futures contract. Once it is aware of the large order to buy or sell, the HFT will trade ahead for its own profit and earn far more than it lost due to the initial “ping” orders.
The paper begins by examining the practices in the context of insider trading. The HFT firm is able to detect the large order faster than than the order is displayed to the public. It is thus trading on nonpublic information in a fashion. However, the Act doesn’t contain a prohibition on insider trading.
The paper then compares the practice to deceptive or manipulative trading practices such as banging the close, spoofing, and wash trading. It examines whether it would violate four provisions of the Commodity Exchange Act and a regulation promulgated by the CFTC under its authority to enforce the Act. The CEA provisions at issue are: § 4c(a)(2(B) on causing the reporting of non-bona fide prices; § 4c(a)5(C) prohibiting spoofing; § 9(a)(2) on delivering false or misleading market information; and § 6(c)(1) prohibiting market manipulation. The CFTC regulation at issue is Rule 180.1.
It is an interesting read for anyone interested in a potential whistleblower case related to high frequency trading: http://connecticutlawreview.org/files/2015/01/7-Scopino.pdf
The legality of HFT has been a hot topic on Wall Street over the past year. In March, author Michael Lewis published Flash Boys, a book about high frequency trading firms that received widespread publicity for its claim that the markets are rigged. SEC Chairman Mary Jo White testified on the practice before the House Financial Services Committee in April, indicating that the Commission was examining at least one issue: the fairness of the faster data feeds purchased by firms compared to the feeds available to the public. Her public comments a few months later proposed changes to level the fairness of the marketplace.
Unlike the law review article, which takes issue with the operations of the HFT firms themselves, most of the current cases in this arena have involved favoritism and improper disclosure by the investment banks and private stock exchanges catering to the frequent traders, their best customers. Last month, the SEC took aim at improprieties involving high frequency traders in three cases over the course of four days.
In one, UBS Group AG, a subsidiary of UBS, received a $14.4 million fine for violating rules on the execution of stock trades to favor professional market makers. UBS allowed traders to buy and sell stocks at unauthorized increments smaller than a penalty on its dark pool. It also failed to adequately disclose the handling of the trades to all investors.
In another, Bats Global Markets was ordered to pay $14 million for failure to adequately disclose the operation of price sliding rules and the handling of certain order types. We have previously discussed this action on the blog so more details can be found here.
The New York State lawsuit filed last by New York Attorney General Eric Schneiderman against Barclay’s for misleading investors about the operation of its dark pools is similar. Last week, Justice Kornreich of the State Supreme Court in Manhattan refused to dismiss the lawsuit. Although there will still be a ruling later on the issue of whether the lawsuit sufficiently states a claim under the Martin Act, the Justice did rule that traders have a right to rely on the material representations made by banks about the operation of their dark pools and their misrepresentations would shake investor confidence and undermine the integrity of the marketplace.
The defense of high frequency trading has typically claimed that it adds liquidity to the market. But as the controversial industry practices remain under the spotlight, it wouldn’t surprise me the SEC or the CFTC eventually takes a run at a firm for manipulation or deceptive practices similar to the arguments discussed in the law review article.