High-frequency trading has come under intense scrutiny in recent months. White & Case explores this latest global investigations trend
High-frequency trading (HFT), which relies on high speed data transmission technology and computer algorithms to trade securities in fractions of a second, has come under intense scrutiny following the publication earlier this year of Flash Boys: A Wall Street Revolt, by Michael Lewis. In Flash Boys, Lewis contends that high-frequency traders, along with complicit brokers and stock exchanges, have essentially "rigged" the equities markets by using superior technology to beat non-HFT investors' orders to market. Federal government regulators and the plaintiffs' bar, seizing upon Lewis's allegations, have initiated investigations of and lawsuits against high-frequency traders, financial institutions, exchanges and alternate trading venues, known as "dark pools".
Increased regulatory and legal scrutiny has put a spotlight on previously unknown and little-understood trading practices.
Paul Carberry, Partner, White & Case, New York
This increased regulatory and legal scrutiny has put a spotlight on previously unknown and little-understood trading practices, and demonstrates how technological advancement often outstrips investigatory and regulatory priorities and resources.
Shining a light on dark pools
Since its emergence roughly a decade ago, HFT has been largely unregulated and dominated by a few specialized and unknown proprietary trading shops. At its peak in 2009, it was estimated that HFT accounted for about 60 percent of average daily trading on US stock exchanges, bringing in an overall profit of almost US$5 billion. Although profits have declined in recent years, HFT still accounts for a significant percentage of average daily trading in US markets. ("Declining US High-frequency Trading", New York Times, October 15, 2012.) In the wake of the increased media and public attention triggered by Lewis's incendiary assertions regarding HFT, US regulators (and, indeed, other regulatory bodies around the world) have stepped up their scrutiny of such trading practices in an effort to allay concerns that HFT exploits ordinary investors and increases market instability. This increased regulatory focus has resulted in proposals by the SEC (and other regulators, notably in Europe) that would require high-frequency traders to, among other actions, register with regulators as broker dealers, thereby subjecting themselves to the compliance requirements and controls of these regulatory agencies.
Regulators have also now trained their sights on so-called "dark pools" — unregulated, private exchanges, often owned and operated by large investment banks, where an estimated 40 percent of US equities are now traded and which have facilitated the growth of HFT. ("SEC Chairman Targets Dark Pools, High-Speed Trading," Wall Street Journal, June 6, 2014.)
As part of its call for greater transparency in the operation of dark pools, the SEC has criticized (and, in at least one instance, sanctioned) registered exchanges for practices such as "co-location" — that is, allowing HFT firms to site their computer servers alongside exchange servers to obtain a greater speed advantage. Other activities now on the US government's radar include allowing the use of complex order types favored by high-frequency traders and orchestrating "payment for order flow" programs that incentivize brokers to divert customer trades to exchanges where high-frequency traders operate. Similarly, brokerages have been openly criticized for routing customer trades into exchanges offering the highest trading rebates, perhaps at the expense of the customer's right to "best execution" of their trade.
In addition to the SEC, in the US other regulatory bodies including the CFTC, FINRA, Department of Justice, the FBI and the New York State Attorney General's office, have each announced investigations into high-frequency traders and other industry participants, accusing them of profiting unfairly at the expense of ordinary investors through their use of sophisticated technology, speed advantage and utilization of complex order types.
As these investigations proceed, it becomes increasingly likely that additional exchanges, financial institutions and trading outfits will find themselves the subject of regulatory inquiry, if not legal enforcement action.
Stuart Willey, Partner, White & Case, London
The New York State Attorney General has been the most active so far, issuing subpoenas and letters of inquiry to exchanges and dark pool operators seeking information concerning how these trading venues have facilitated HFT. In addition, the Attorney General's Office recently filed a complaint against a major European bank, alleging that it lied to investors by claiming its dark pool was safe from "predatory" high-frequency traders when, in fact, it had deliberately courted such traders to its exchange, concealing their presence from customers. As these investigations proceed, it becomes increasingly likely that additional exchanges, financial institutions and trading outfits will find themselves the subject of regulatory inquiry, if not legal enforcement action.
A global phenomenon
European regulators have likewise taken an interest in these activities. Stuart Willey, a partner in the Capital Markets group of White & Case and head of its regulatory practice in London, notes; "European regulators now have high-frequency trading firmly in their sights, and major changes in this area are being implemented across Europe as regulators struggle to keep pace with technological advancement".
The European Commission has published legislative proposals, known as "MiFID II," which introduce closer regulation and monitoring of HFT. MiFID II will impose detailed requirements on trading venues and the firms that trade on them. HFT firms engaging in proprietary trading will need to be authorized, and the rules will impose liquidity provision requirements on market making agreements between firms and venues. Trading venues will be required to set limits on the maximum number of order messages that a market participant can send relative to the number of transactions they undertake, and venues will be able to create fee structures for excessive order cancellation and systems use. Any firm deploying a trading algorithm will in the future be required to notify its regulator and relevant trading venues and may be required to produce descriptions of its trading strategies and to provide assurance as to the controls the firm has instituted to ensure its algorithmic trading cannot spin out of control. The proportion of equity trading that can occur in dark pools without pre-trade transparency will also be limited by new (complex) EU-wide legislation.
While MiFID II remains a work in progress, there are differing views across Europe as to the appropriate regulatory approach. Germany has already implemented regulations covering HFT such that investment firms and other market players carrying out high-frequency algorithmic trading on the German market are now subject to supervision and must submit documentation to BaFin, the German regulator, in order to obtain authorization to conduct such trades. Authorities in Italy have introduced a tax on high-frequency equity and derivative trades. On the other hand, in the UK the Financial Conduct Authority (FCA), the UK regulator, has adopted what it describes as a risk-based approach. In a recent speech at the Global Exchange and Brokerage Conference, Martin Wheatley, CEO of the FCA, said that the FCA was adopting a three-pronged approach, namely, analysis-led policy work to get rules in shape with the bulk of the work being absorbed in gearing the UK up for MiFID II implementation; day-to-day supervision of relevant firms and markets applying a risk-based approach; and active market surveillance.
Nothing to see here
Despite increased scrutiny and the accusations leveled against HFT, some maintain that all is well within US markets. For instance, Mary Jo White, chairwoman of the SEC, recently insisted to Congress that "the markets are not rigged" and "the retail investor is…very well served by the current market structure". These sentiments echo the assertions of defenders of HFT who claim that their practices increase market liquidity, improve price-discovery, i.e. the ability to trade stocks at fair value, and decrease trading costs due to the narrowing of buy-sell spreads. This is consistent with the SEC's focus on enacting further reforms aimed at ensuring greater transparency and accountability in the market rather than eliminating HFT entirely.
In addition to increased regulatory scrutiny, at least in the US, the private class action plaintiffs' bar has also zeroed in on HFT by filing a number of lawsuits in federal court on behalf of investors alleging the actions of high-frequency trading firms, brokers and exchanges violated US securities laws. While the legal theories underlying these class action lawsuits appear somewhat suspect — for instance, it is not clear how a high-frequency trader's use of faster trading technology to beat another investor's order to market violates US law — we anticipate that such theories will evolve and develop as regulators uncover (and publicize) additional information concerning how HFT firms and dark pools operate.
The Plaintiff's bar is intently focused on the various regulatory investigations currently underway so they can craft the next wave of claims against various market participants.
Greg Little, Partner, White & Case, New York
"I have little doubt that the plaintiffs' bar is intently focused on the various regulatory investigations currently under way in the US and elsewhere with the objective of further developing their understanding of these trading practices so they can craft the next wave of claims against various market participants. The complaint recently filed against a dark pool operator, by one of its customers piggybacking off of the charges asserted by the New York Attorney General against the same bank, only goes to show that this is a strategy likely to be pursued by other plaintiffs' lawyers in the future," said US securities litigator and White & Case partner Greg Little.
Despite the specter of heightened regulation, further legal enforcement action and private lawsuits, HFT is likely to remain a significant feature of equities markets globally with ever-increasing influence in equity markets across Europe, Asia and Latin America. Over time, HFT is also likely to infiltrate further into non-equities markets as well. Ongoing advances in computer and data transmission technologies, such as transmitting orders by microwave, continue to promise traders the ability to profit from trades executed on the basis of increasingly small increments of a second. It is, therefore, inevitable that governmental regulators, as well as those in the media and the public at large, will demand exacting oversight and scrutiny of the new technologies and the trading practices spawned by them.
Reading the signals: HFT — future regulatory scrutiny
- Monitor activity of the US private class action plaintiff's bar
- Follow EU-wide MIFID II developments
- Be aware of differing regulatory regimes across Europe
- Be alert to the infiltration of HFT practices into non-equities markets
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