Distance ÷ time = Speed
Speed = $
Similar to The Flash, the fastest superhero in the world, high-frequency traders leverage speed to win. High-frequency trading (“HFT”) is an algorithmic trading strategy using computer programs to transact thousands of orders in fractions of a second. Millions of tiny transactions based on human-created complex algorithms instantaneously obtain and react to market information. “In addition to the high speed of orders, high-frequency trading is also characterized by high turnover rates and order-to-trade ratios.”[1] Although this seems novel, the U.S. Securities and Exchange Commission (“SEC”) recognized — over a decade ago — that HFT was the most significant market structure developments in recent years,[2] accounting for over 50 percent of trading volume in the US equity markets.[3] Today, algorithmic trading accounts for 50–70% of all equity trading by volume in the United States equities markets,[4] increasing from 10% in the early 2000s.[5]
As with all innovations, HFT creates opportunities for exploitation by nefarious actors. Many believe HFT has resulted in a “rigged” system that jeopardizes our markets. Indeed, if retail investors lose faith, the system will collapse — and so will our economy. Consequently, market transparency and investor protection are vital. However, simply because something may be deemed advantageous to one party does not automatically equate to unfairness or illegality. Nevertheless, there is a tremendous public debate that has been born relating to HFT, primarily resulting from Michael Lewis’ bestselling book, Flash Boys: A Wall Street Revolt. This note will address HFT from a practical perspective allowing the reader to form their own opinion of high-frequency trading.
A. SEC Regulations and HFT
1. Regulation NMS
For many decades, the United States stock market was fragmented, with many exchanges compromising a “market system.”[6] The price of a stock could vary based solely on the exchange offering it. This resulted in the same stock having different prices on different exchanges. In 1975 Congress gave the SEC authority to issue rules to create a national market system based on its understanding that a national market structure was needed in order to provide timely, accurate, and widely distributed market data to all participants. The principal goal of market structure regulation was to maximize the interaction of order in the market price while preserving the value-added provided by competition among individual markets.
The specific goals of the national market systems included: (1) economically efficient execution of securities transactions; (2) fair competition among brokers and dealers, among exchange markets, and between exchange market and markets other than exchange markets; (3) public availability of quotation and transaction information; (4) opportunity to obtain the best execution; and (5) opportunity to obtain the best execution without a dealer.[7] Although various regulations were enacted between 1976–2004, in 2005, the SEC enacted Regulation National Market System, or “Reg NMS.”[8] This regulation included various provisions including, the Order Protection Rule (a/k/a the trade-through rule), the Access Rule, and the Sub-Penny rule.[9]
The trade-through rule, for example, prevents trade-throughs, or investors’ trades from being executed inferior prices of a protected quotation.[10] This ensures investors receive the best price for their orders. Further, the SEC noted that preventing trade-throughs without access to quotations is futile.[11] The Access Rule seeks to improve access to quotations by requiring greater linking, lowering access fees, and “require[ing] SROs to establish, maintain, and enforce written rules that, among other things, prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross the protected quotations of other trading centers.”[12] Finally, the Sub-Penny Rule “prohibits market participants from displaying, ranking, or accepting quotations in NMS stocks that are priced in an increment of less than $0.01, unless the price of the quotation is less than $1.00. If the price of the quotation is less than $1.00, the minimum increment is $0.0001.”[13]
Reg NMS forces exchanges to transmit real-time data to a centralized entity, consolidating that information into a unified data feed, and requires that exchanges and brokers accept the most competitive offer when matching buyers and sellers.[14] This (theoretically) ensures that investors get the best price for their orders and, at execution, they pay or receive the expected price.
2. Regulation ATS
Regulation of securities exchanges[15] plays a very important role in HFT. Although in the past entities and individuals qualified as either investors, broker-dealers, or investment advisors, with today’s technological innovations, a single entity can be all three. For example, high-frequency trading firms could theoretically act as all three by trading their own capital, having a license to trade it, and trading it on their own behalf.
“In 1998 the SEC introduced Regulation ATS as a way ‘to protect investors and to resolve any concerns’ dealing with alternative trading systems.”[16] Alternative trading systems (“ATS”) are venues for matching buy and sell orders of their subscribers. Most ATSes are registered as broker-dealers, not exchanges, and focus on finding counterparties for transactions.[17] Unlike some national exchanges, ATS’ do not set rules governing the conduct of subscribers or discipline subscribers other than by excluding them from trading. ATS’ could either be “lit” or “dark.” ATS’ that are lit are considered Electronic Communication Networks (“ECN”).[18] ATS’ that are “dark” (i.e., do not display the volume, quantity, or prices available inside an ATS) are considered Dark Pools. Ultimately, ATS’ could choose to be regulated as either a broker-dealer or an exchange.[19]
3. Anti-Fraud Provisions
Individuals and entities are always subject to the anti-fraud provisions of the Securities Acts. Under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5, it is unlawful:
[F]or any person, directly or indirectly, … [t]o use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.[20]
Further, it is:
Unlawful for any person, directly or indirectly,” “in connection with the purchase or sale of any security,” to (1) “employ any device, scheme, or artifice to defraud,” (2) “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made … not misleading,” or (3) “engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person.[21]
Allegations of violations relating to HFT have been levied against exchanges, including, without limitation, Better Alternative Trading System (“BATS”) and the NYSE. Plaintiffs allege that certain National Exchanges sell products and services to HFT allowing HFT firms to employ such services in allegedly manipulative schemes without disclosing the products and services being offered to the detriment of investors.[22]
Additionally, pursuant to §6(b) of the Exchange Act, National Securities Exchanges are required to operate in a manner that is consistent with investor protection, and in a fair and equitable manner.[23] Moreover, Section 20(a) of the Exchange Act states “that “[e]very person who, directly or indirectly, controls any person liable under any provision of this chapter or of any rule or regulation thereunder shall also be liable jointly and severally with and to the same extent as such controlled person ….” The argument follows that broker-dealers are considered control persons and are responsible for the conduct of its registered advisors when their registered advisors commit fraud or engage in misconduct.
4. Investment Advisor Act
HFT firms may qualify as investment advisors and therefore, must register as per §203(e) of the Investment Advisors Act of 1940. Likewise, they must comply with all provisions therein. §202(a)(11) of the Investment Advisor Act defines an investment adviser as any person or firm that engages in the business of providing advice to others or issuing reports or analyses regarding securities for compensation. If, however, an HFT firm registers as a broker-dealer, they are exempt from this section.
5. FINRA Rules and Regulations
HFT firms may also qualify as broker-dealers (“BD”) pursuant to §15(a) of the 1934 Exchange Act. Broker-dealers are firms that engage in the business of buying and selling securities. As a BD, HFT firms must register unless a specific exemption applies. Section 3(a)(4) of the Exchange Act defines a broker as any person engaged in the business of effecting transactions in securities for the accounts of others. Section 3(a)(4) of the Exchange Act defines a dealer as “any person engaged in the business of buying and selling securities for such persons won account through a broker or otherwise.” Unlike a broker who operates as an agent, a dealer is operating as a principal for their benefit.
BDs and investment advisors are self-regulated by the Financial Industry Regulatory Authority (“FINRA”). To legally conduct business in the United States, all BDs and registered representatives must be members of FINRA. The role of FINRA is primarily to assist the SEC in carrying out its goals of investor protection and market regulation. As such, FINRA has promulgated rules and regulations which BDs and registered representatives must comply with.
In March of 2015, FINRA addressed HFT in Regulatory Notice 15–09, titled “Guidance on Guidance on Effective Supervision and Control Practices for Firms Engaging in Algorithmic Trading Strategies.” FINRA’s guidance was directed towards member firms and market participants that use algorithmic trading strategies, including HFT, to combat “the potential for these strategies to adversely impact market and firm stability.”[24] Beyond 15–09, several FINRA rules govern HFT, including Rule 2111 (Suitability),[25] Rule 2010 (Standards of Commercial Honor and Principles of Trade),[26] FINRA Rule 3110 (Supervision),[27] Rule 5210 (Publication of Transactions and Quotations),[28] Rule 6140 (Other Trading Practices),[29] and Rule 5310 (Best Execution and Interpositioning).[30]
B. CFTC Rules and Regulations
High-frequency trading is not relegated to the securities markets; indeed, it is also prominent in the derivatives and cryptocurrency markets. For example, HFT firms have been under scrutiny for wash-trading, which has been outlawed since 1936 under CEA § 4c(a)(2).[31] Wash trading, or wash trades, are “fictitious, prearranged sales in which the same parties agree to a pair of offsetting trades for the same commodity, at no economic risk or net change in beneficial ownership.”[32] “Wash sales are ‘a powerful multipurpose tool that can be used . . . for significant frauds and market manipulations,’ and, as such, they “are considered harmful because they create illusory price movements in the markets.”[33]
Additionally, HFT firms have also been cited for “banging the close,” which is illegal as per the CEA Section 4c(a)(5)(B). Specifically, “banging the close” is “the practice of ‘buying or selling large volumes of commodity contracts in the closing moments of a trading day’ with the intent to move the price of the contract (or contracts).”[34] Another act of impropriety is dubbed “spoofing,” which is also illegal as per CEA Section 4c(a)(5)©.[35] Spoofing is an “illegal activity that briefly distorts the shape of the limit order book, with the explicit goal of misleading other traders of all frequencies.”[36]
In 2010 the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 amended the CEA to add the Spoofing Statute which provides, in relevant part:
(5) It shall be unlawful for any person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity that — (C) Is, is of the character of, or is commonly known to the trade as, “spoofing” (bidding or offering with the intent to cancel the bid or offer before the execution).[37]
Further, CFTC Regulation 180.1(a)(1) also provides in relevant part:
(a) It shall be unlawful for any person, directly or indirectly, in connection with any swap, or contract of sale of any commodity in interstate commerce, or contract for future delivery on or subject to the rules of any registered entity, to intentionally or recklessly:(1) Use or employ, or attempt to use or employ, any manipulative device, scheme, or artifice to defraud[.][38]
Rule 180.1 prohibits fraud and fraud-based manipulations in the commodities markets, including those based on “spoofing.”
Despite the issues associated with HFT in the derivatives market, the Commodities Futures Trading Commission (“CFTC”) does not have a specific regulatory scheme dedicated to HFT despite recent proposals and the same rules that apply to market participants also apply to HFT firms.
A. Speed is Everything
Stemming back to early 2010, many Wall Street traders (many of whom “would sell their grandmothers for a microsecond”[39]) suggested, “that their entire commercial existence depended on being faster than the rest of the stock market.”[40] The speed at which HFT platforms can transact can be measured by latency, or the time-lapse between the moment an order is issued and the moment that order is received. “[T]he average exchange-to-trader latency (the average time elapsed between the moment a message is sent by an exchange to the moment it is received by the firm) is 31 microseconds on average for messages pertaining to the SPDR S&P500 Exchange Traded Funds (so called SPY, traded on the NYSE).”[41] Low-latency is central to HFT efficacy because the primary advantage is speed itself, the ability to acquire information, and act upon that information, before others. Indeed, the “[s]peed of trading is important for high-frequency traders because it is key for the profitability of their strategies, in particular high-frequency market making, high-frequency arbitrage, and directional trading on very short-lived signals.”[42]
B. How HFTs Make Money
The speed of obtaining and executing information is the single most significant advantage of HFT.[43] Specifically, the ability to not only obtain information but act upon that information before anyone else is a huge advantage in today’s speculative markets.[44] Market-making is a method of capitalizing on the speed of information transfer and execution. Market makers quote both buy and sell prices resulting in market orders and are considered liquidity providers. Market making provides an opportunity to monetize (typically only a few cents per transaction) via the bid-ask spread. Due to a large number of transactions, monetization via high-frequency market making is enormous. Additionally, high-frequency arbitrage leverages speed to monetize on price disparities of different exchanges. HFT uses speed to “beat out” the official National Best Bid and Offer price updates, effectively creating its own version, and capitalizing on the latency.[45] Critics of HFT refer to arbitrage tactics as follows:
This practice relies on outdated market access technology employed by customers unable or unwilling to spend tens of thousands of dollars per month for special services from the Exchanges. Utilizing HFT strategies, HFT traders use speed to gain minuscule advantages in arbitraging price discrepancies in some particular security trading simultaneously on disparate markets. This practice alone can and has generated virtually riskless profits for Defendants. “Riskless profits” is not a speculative statement but is an industry norm for HFT firms.[46]
“Pinging” or “electronic front-running” is another method of monetizing. According to the Financial Industry Regulatory Authority, to find large buy orders “… high-frequency trading firms may place small-sized ‘immediate-or-cancel’ orders for a security to determine whether there’s interest in buying or selling it in dark pools and other corners of the investing world largely invisible to the general public.”[47] Some take a very suspect approach of pinging, calling it “legalized front running:”[48]
Electronic front-running is a practice whereby a market participant seeks to exploit large orders being placed out in the market. For example, a large order from a pension fund to buy will be broken into small parts and trading takes place over several hours or even days, and will cause a rise in price due to increased demand. An HFT firm can utilize preferred access to material trade data to try to identify this happening and then trade in front of the fund, buying the relevant security elsewhere and then profiting from selling back to the pension fund at increased prices.[49]
HFT is also used for directional trading, which relies upon future market direction. For example, it is commonly understood that Wall Street reacts positively to President Trump. If Joe Biden wins the election, however, the market will react negatively. Converted to conditional statements for an algorithm: (1) If Trump wins, then long; (2) If Biden wins, then short. Using HFT, traders can pre-program these conditions, so when the news comes out, their platforms digest and execute the orders instantaneously before other HFT firms, and well before human brokers.
Finally, the creation of dark pools is another method by which HFT monetize. Dark pools have become more renowned lately due to Robinhood, a FinTech company based in Menlo Park, California, that has raised $539 million in venture capital funding and a valuation of $7.9 billion as of July 22, 2019. Robinhood spurred the race to zero commissions as we now see the vast majority of incumbents cutting own their commissions to zero or nominal amounts. Although at first glance this may seem positive for investors, there is a more sinister side affecting market fundamentals, namely, transparency. Robinhood acts as a dark pool, a private exchange for securities trading inaccessible to the public.[50]
Typically, when an investor purchases a security, that investor’s broker will execute the orders on the primary market. Robinhood, however, keeps the trades internally, passing the order from one Robinhood customer to another. For example, if Robinhood Customer A wants to buy Apple stock, and Robinhood customer B wants to sell Apple stock, Robinhood will execute that trade internally without it ever touching the markets.
As a Dark Pool, Robinhood is obviated from many of HFT regulations.[51] Consequently, Robinhood partners with HFT firms, allowing the firms to integrate with Robinhood’s systems likely via an application programming interface (“API).[52] For example, in Robinhood’s Rule 606 Report Disclosure, Robinhood disclosed that it routes non-directed orders to various entities. “Non-directed Orders” are those that customers do not specifically instruct to be routed to a particular venue for execution. “100% of total customer orders were non-directed orders.”[53]
This type of activity is not without scrutiny, however. On December 19, 2019, Robinhood entered into a Letter of Acceptance, Waiver, and Consent with FINRA regarding charges associated with “payment for order flows” conducted between October 2016 and November 2017. Robinhood was dinged for directing its customers’ orders to specific firms that paid Robinhood for the order flow violating FINRA’s “best execution” rule.[54]
C. The Critics[55]
One of the first major public criticisms of HFT was levied in July 2009 by U.S. Senator Charles E. Schumer. Senator Schumer asked the Securities exchange Commission to prohibit “flash orders,” which allow a select group of traders to learn about buying and sell orders before the wider market. Senator Schumer noted that flashing information to some, and not others, “seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.”[56] According to Senator Schumer, if allowed to continue, these practices will undermine the confidence of ordinary investors, and drive them away from our capital markets.”[57] Since then, there has been a multitude of arguments against HFT.
First, those against HFT believe that the market is “rigged,” the stock market is a mere illusion, and unless more is done to prevent such conduct, investor confidence will continue to be eroded.[58] Confidence in the markets is central to their functionality. Without investors, the markets cannot run. It follows that if the markets are “rigged” against retail investors, there is no “winning” and, therefore, investors should allocate their monies elsewhere. This was discussed at length in Michael Lewis’ book Flash Boys,[59] which made quite a splash on Wall Street and Capitol Hill. Former SEC chief Mary Jo White was forced to respond, noting to Congress in 2014 that HFT did not harm investors or impair the integrity of the financial markets.[60]
Second, HFT may destabilize the markets, causing “flash crashes.” According to Goldman Sachs, for example, HFT machines may “withdraw liquidity” at the worst possible moment in the next financial crisis leading to extraordinarily large drops in liquidity.[61] Although there is no definitive definition of what constitutes a flash crash, the term generally refers to extreme price volatility often accompanied by spikes in trading volume in short periods, usually ranging from hours to seconds, with prices typically returning to normal.[62] According to the SEC, for example:
On May 6, 2010, the prices of many U.S.-based equity products experienced an extraordinarily rapid decline and recovery. That afternoon, major equity indices in both the futures and securities markets, each already down over 4% from their prior-day close, suddenly plummeted a further 5–6% in a matter of minutes before rebounding almost as quickly.[63]
Although many believe that HFT did not cause the 2010 flash crash directly, HFT at least “contributed to it by demanding immediacy ahead of other market participants.”[64] Again, on October 15, 2014, there was a US treasury flash crash.[65] Likewise, in 2015 there was yet another Flash Crash, this time on the NYSE.[66] The U.S. securities markets are not alone in their susceptibility to flash crashes. On June 21, 2017, the price of Ethereum[67] crashed from $319 to 10 cents in a matter of seconds.[68] Then on March 12, 2020, ChainLink (LINK) crashed by 99.99% to $0.0001, causing the crypto markets to lose $50 Billion in market capitalization in less than a day.[69]
Finally,[70] as noted above, HFT is considered by many to be a legal form of “front running.” Front running “occurs when a broker with a customer order for a large trade in a futures contract (or other derivatives) first buys or sells some of the same futures contracts for the broker’s own account before filling the customer’s order.”[71] HFT can leverage speed to intercept orders and front run the trade being executed.
For example, a broker is sitting at his desk on Wall Street and submits a buy order for 50,000 shares of Apple stock. After the order is executed, the order itself is broken into different orders via smart order router and sent to different exchanges for fulfillment. The exchange that receives the first order is typically the closest exchange by proximity. The longer the latency, the longer it takes for the order to reach the exchange. HFT firms spent (and continue to spend) exorbitant sums of money to reduce latency from milliseconds to microseconds. This reduction in time allows HFT firms to sit and wait for the first exchange to receive investor buy orders, and subsequently race to the other exchanges to (1) cancel sell orders, and (2) buy shares to sell to the original buyer at a higher price.
Although regulators and policymakers seemingly have done a deep dive on electronic front running, the practice is still facially permissible.[72] It becomes illegal, however, “when a trader trades upon ‘information not available to the public.’”[73]
The idea that one can ignore technological advances and intellectual advances driven by practitioners’ work or academics’ work is fallacious. You can wish for it, but it’s not gonna be. It’s very important to understand that — people in the markets understand it; the popular press does not — you can’t reverse technology and speed.[74]
The future is now. Despite what people believe, HFT is here to stay, and there is no slowing down innovation. Although many regulations touch upon HFT, perhaps it would be prudent to establish a framework for practitioners and innovators alike to utilize when contemplating new FinTech innovation using high-frequency trading. Innovation, however, necessitates something new or novel and, therefore, prescribing highly specific rules other than an outright ban may be impossible.
References
[1]James Chen, High-Frequency Trading (HFT), Investopedia, https://www.investopedia.com/terms/h/high-frequency-trading.asp (last visited Oct. 10, 2019)).
[2] Concept Release on Equity Market Structure, 75 Fed. Reg. 3594, 3606 (proposed January 21, 2010) (to be codified at 17 C.F.R. pt. 242).
[3] Thierry Foucault & Sophie Moinas, Global Algorithmic Capital Markets 10 (Walter Mattli ed., 1st ed. 2019).
[4] The Stockmarket is now Run by Computers, Algorithms and Passive Managers, The Economist (Oct. 5, 2019), https://www.economist.com/briefing/2019/10/05/the-stockmarket-is-now-run-by-computers-algorithms-and-passive-managers. (discussing “[a]ccording to Deutsche Bank, 90% of equity-futures trades and 80% of cash-equity trades are executed by algorithms without any human input. Equity-derivative markets are also dominated by electronic execution according to Larry Tabb of the Tabb Group, a research firm.”).
[5] See generally Anupriya Gupta, History of Algorithmic Trading, HFT and News Based Trading, QuantInsti, June 2, 2015, https://blog.quantinsti.com/history-algorithmic-trading-hft/ (“By the year 2001, HFT trades had an execution time of several seconds. By 2010 this had shrunk to milliseconds, even microseconds and subsequently nanoseconds in 2012. In early 2000s high-frequency trading accounted for less than 10% of equity orders, but this has grown rapidly. Between 2005 and 2009, according to NYSE high-frequency trading volume grew by 164%.”).
[6] It is 1972 and a few dozen folks are standing underneath the buttonwood tree near Wallstreet — 66 Wall Street, to be exact. These individuals made a pact: they would form a club and only trade with club members. No one outside the club was allowed to trade. Within a short period of time the buttonwood tree became a regular meeting place for stockbrokers to determine how best to regulate themselves, with the trading being done at a local coffee house. Back then, there were no computers. Instead, there was a chalk board with the stock name, “buy or bid,” and “ask or sale.” And all transactions were made face to face. This was the beginnings of the New York Stock Exchange (“NYSE”). Some stockbrokers, however, were unable to join the trading within the coffee shop, and were forced to trade on the curb, hence the name “curb-stone brokers.” These curb-stone brokers later became the American Stock Exchange which was ultimately acquired by the NYSE. There were others as well, some of whom were not even on the curb. It became clear that the original notion of self-regulation was ineffectual, at best, and a fraud, at worst.
[7] See 15 U.S.C. § 78k–1 (2012).
[8] See Regulation NMS, 70 Fed. Reg. 37, 496 (June 29, 2005) (to be codified at 17 C.F.R. pts. 200, 201, 230, 240, 242, 249 & 270) (“Regulation NMS”).
[9] Id. at 21–29. Additional rules include adopted amendments to the Market Data Rules and joint industry plains. Id. at 30.
[10] Id. at 22.
[11] Id. at 26.
[12] Id. at 29.
[13] Id. at 29.
[14] Id. at 501–502.
[15] There is a highly relevant defense used by market exchanges when an action is brought against them, “absolute immunity.” The majority of circuits have held that “[t]here is no question that an SRO and its officers are entitled to absolute immunity when they are, in effect, ‘acting under the aegis” of their regulatory duties.’” DL Capital Group, LLC v. Nasdaq Stock Mkt., Inc., 409 F.3d 93, 97 (2d Cir. 2005) (holding that the NASDAQ, an SRO, was entitled to absolute immunity where investors alleged that NASDAQ and its president “committed fraud when it cancelled trades in certain stock.”).
[16] Anthony B. Benvegna, A Guiding Light to A More Efficient Market: Why High-Frequency Trading Is Not A Flash in the Dark, 16 J. Int’l Bus. & L. 309, 317 (2017) (citing James Chen, Alternative Trading Systems (ATS), Investopedia, Apr. 18, 2019, http://www.investopedia.com/terms/a/alternative-trading-system.asp).
[17] An ATS must register as a broker-dealer (or be exempt), file a form ATS, would be an exchange but for not setting rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system, or, discipline subscribers other than by exclusion from trading. See 17 C.F.R. 300 (2018).
[18] An ECN is “[a]ny electronic system that widely disseminates to third parties orders entered therein by an exchange market maker or [over-the-counter] market maker, and permits such orders to be executed against in whole or in part.” 17 C.F.R. 240.11Ac1–1 (2005).
[19] As a broker-dealer, it would be subject to certain regulatory requirements in addition to those applicable to other broker-dealers, and such requirements would address the ATS’ unique activities as an electronic marketplace. As an exchange, an ATS would have to operate as a self-regulatory organization, which is responsible for overseeing and disciplining its users.” Soo J. Yim, Online Securities Trading: An Overview of Regulatory Developments, 15 №7 Andrews Del. Corp. Litig. Rep. 12 (2001).
[20] In re Barclays Liquidity Cross & High Frequency Trading Litig., 390 F. Supp. 3d 432, 442 (S.D.N.Y. 2019), motion to certify appeal denied, №14-MD-2589 (JMF), 2019 WL 3202745 (S.D.N.Y. July 16, 2019) (quoting 15 U.S.C. § 78j(b)).
[21] Id. (citing 17 C.F.R. § 240.10b-5 (2020)).
[22] See generally, In re Barclays, 390 F. Supp. 3d at440.
[23] See 15 U.S.C. §78f(a)-(b) (2011).
[24] Id.
[25] Rule 2111. Sustainability, FINRA Rules, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111 (last updated May 1, 2014).
[26] Rule 2010. Standards of Commercial Honor and Principles of Trade, FINRA Rules, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/2010 (last updated Dec. 15, 2008).
[27] Rule 3110. Supervision, FINRA Rules, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/3110 (last updated Apr. 3, 2017).
[28] Rule 5210. Publication of Transactions and Quotations, FINRA Rules, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/5210 (last updated Apr. 3, 2017).
[29] Rule 6140. Other Trading Practices, FINRA Rules, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/6140 (last updated Mar. 4, 2013).
[30] Rule 5310. Best Execution and Interposition, FINRA Rules, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/5310 (last updated May 9, 2014). For some odd reason, Rule 5310 was not included within Regulatory Notice 15–09.
[31] 7 U.S.C. § 6c(a)(2) (2012).
[32] Gregory Scopino, The (Questionable) Legality of High-Speed “Pinging” and “Front Running” in the Futures Markets, 47 Conn. L. Rev. 607, 644 (2015).
[33] Id. (citing Wilson v. Commodity Futures Trading Comm’n, 322 F.3d 555, 559 (8th Cir. 2003)).
[34] Id. at 646–47.
[35] See, e.g., United States v. Coscia, 177 F. Supp. 3d 1087 (N.D. Ill. 2016), aff’d, 866 F.3d 782 (7th Cir. 2017) (denying motion for judgment of acquittal and new trial where high-frequency trader was sentenced to three years in prison for using “spoofing,” in the commodities markets of various commodities (gold, soybean meal, soybean oil, etc.) earning profits of nearly $1.4 million).
[36] Id. (internal citations removed).
[37] 7 U.S.C. § 6c(a)(5)© (2012).
[38] 17 C.F.R. § 180.1(a)(1) (2011).
[39] Michael Lewis, Flash Boys 18 (2015).
[40] Id.
[41] Foucault & Moinas, supra note 3, at 10–11 (citing Markus Baldauf & Joshua Mollner, High-Frequency Trading and Market Performance, 75 J. of Fin., 27 (2020)).
[42] Id.
[43] “There are four channels through which a change in traders’ informational and matching speed can affect costs of liquidity provision and gains from trade: (1) search, (2) inventory risk, (3) adverse selection, and (4) competition among liquidity providers.” Foucault & Moinas, supra note 3, at 15.
[44] Compare HFT with trading on non-public information. There are securities laws forbidding trading on non-public material information (insider trading) because of the distinct advantages such trading offers to the individual (or entity) conducting the trades. Accordingly, when a party has information that the other party it’s transacting with does not, that is considered an unfair advantage (of course, there are exceptions). For every buyer there is a seller — and for every winner there is a loser. There are a number of express insider trading provisions within the United States. For example, the Securities Exchange Act of 1934 § 16(b) requires officers, directors, and 10% shareholders to disgorge profits from purchases and sales or sales and purchases within 6 months. Likewise, 17 C.F.R. § 240.14e-3 prohibits insider trading in tender officers. Further, the Insider Trading and Securities Fraud Enforcement Act provides a cause of action for contemporaneous traders. This means that if an individual is trading in the market at exactly the same time the insider trader is trading in the market, the individual has a cause of action and theoretically disgorge profits made or losses avoided. Moreover, there is also the Insider Trading Sanctions Act which provides the SEC with the authority to seek civil penalties of up to three times the insider’s profits and losses avoided.
[45] To understand the significance of this opportunity, it is important to understand the landscape. Exchanges determine the prices of securities and commodities by matching orders of buyer and sellers. When a buyer or seller places an order, they do so on an individual exchange. Simultaneously, other buyers and sellers are placing orders on alternative exchanges. To combat price differentiations, SEC-registered exchanges must send their trades and quotes to a central consolidator where that information is aggregated, consolidated and distributed worldwide. Pursuant to SEC regulations, brokers are then required “to trade at the best available (lowest) ask price and the best available (highest) bid price when buying and selling securities for customers. The National Best Bid and Offer is the bid or ask price that the average customer will see.” Will Kenton, National Best Bid and Offer (NBBO), Investopedia, September 11, 2019, https://www.investopedia.com/terms/n/nbbo.asp.
[46] Second Consolidated Amended Complaint for Violation of the Federal Securities Laws at 29, City of Providence, et al. v. BATS Global Markets, Inc., et al., (S.D.N.Y. 2014) (№252). See also Elaine Wah & Michael Wellman, Latency Arbitrage in Fragmented Markets: A Strategic Agent-Based Analysis, 5 Algorithmic Fin. 69 (2016), available at https://content.iospress.com/articles/algorithmic-finance/af060 (studying “the effect of latency arbitrage on allocative efficiency and liquidity in fragmented financial markets,” by “employ[ing] a simple model of latency arbitrage in which a single security is traded on two exchanges, with price quotes available to regular traders only after some delay,” and concluding that “[a]n infinitely fast arbitrageur reaps profits when the two markets diverge due to this latency in cross-market communication.”).
[47] FINRA Staff, Getting Up To Speed On High-Frequency Trading, FINRA, November 25, 2015, https://www.finra.org/investors/insights/getting-speed-high-frequency-trading. See also Gregory Scopino, The (Questionable) Legality of High-Speed ‘Pinging’ and ‘Front Running’ in the Futures Markets, The CLS Blue Sky Blog (Apr. 19, 2020, 6:23 PM), https://clsbluesky.law.columbia.edu/2014/05/29/the-questionable-legality-of-high-speed-pinging-and-frontrunning-in-the-futures-markets/ (discussing, inter alia, how HFT can leverage pinging to detect when institutional investors will make large trades in the futures markets, and act upon that information to “rapidly jump[] in front of the institutional investor, buying up the liquidity in the contract and selling it back at higher or lower prices (depending on if it was a buy or sell order).”).
[48] See also Scopino, supra note 47.
[49] Second Consolidated Amended Complaint for Violation of the Federal Securities Laws at 29, City of Providence, et al. v. BATS Global Markets, Inc., et al., (S.D.N.Y. 2014) (№252).
[50] Elvis Picardo, An Introduction to Dark Pools, Investopedia, Mar. 29, 2020, available at https://www.investopedia.com/articles/markets/050614/introduction-dark-pools.asp.
[51] Before founding Robinhood, the cofounders of Robinhood built software for hedge funds and high-frequency traders. See generally Halah Touryalai, Forget $10 Trades, Meet Robinhood: New Brokerage Targets Millennials With Little Cash, Forbes, Feb. 26, 2014, available at https://www.forbes.com/sites/halahtouryalai/2014/02/26/forget-10-trades-meet-robinhood-new-brokerage-targets-millennials-with-little-cash/#4abef87e7f48.
[52] Robinhood Financial SEC Rule 606 Report Disclosure Second Quarter 2019 (2019), available at https://d2ue93q3u507c2.cloudfront.net/assets/robinhood/legal/RHF%20PFO%20Disclosure.pdf.
[53] Id.
[54] Pursuant to FINRA Rule 5310, “in any transaction for or with a customer or a customer of another broker-dealer, firms [must] use reasonable diligence to ascertain the best market for the security and buy or sell in such market so the resultant price to the customer is favorable under prevailing market conditions.” Rule 5310. Best Execution and Interposition, FINAR Rules, available at https://www.finra.org/rules-guidance/rulebooks/finra-rules/5310 (last updated May 9, 2014). Robinhood has also been under greater scrutiny lately. For example, throughout a week span in March 2020, Robinhood’s website crashed multiple times as the Dow Jones, S&P 500 and Nasdaq saw some of the largest gains in recent memory. Because of the crash, users of the platform were locked out of their accounts preventing them from buying and selling securities. Because of the outages, on March 4, 2020, a class action was filed against Robinhood alleging breach of contract, breach of implied warranty of merchantability, and negligence. See generally Jack Martin, Another Class Action Suit Brought Against Robinhood Over Platform Outages, Cointelegraph, Mar. 27, 2020, https://cointelegraph.com/news/another-class-action-suit-brought-against-robinhood-over-platform-outages. Whether this lawsuit has legs remains to be seen.
[55] Despite criticism of HFT, there are arguable advantages to HFT including price efficiency, trading volume, and liquidity. As to price efficiency, “[h]igh-frequency traders (HFTs) increase price efficiency in two ways. First, by trading in the direction of permanent price changes, HFTs incorporate information in stock prices. Second, by trading in the opposite direction of transitory pricing errors, HFTs reduce long-term investors’ trading costs.” Jonathan Brogaard et al., High-Frequency Trading and Price Discovery (Digest Summary), 45 CFA Digest (2014). Likewise, commentators in favor of HFT note that they have a positive effect on the markets via market liquidity. See, e.g., Regulation NMS, Regulation NMS, 70 Fed. Reg. 37, 500 (June 29, 2005) (to be codified at 17 C.F.R. pts. 200, 201, 230, 240, 242, 249 & 270) (“Short-term traders clearly provide valuable liquidity to the market.”).
[56] Letter from Charles E. Schumer, United States Senator, to Mary Schapiro, Chairman, Securities and Exchange Commission (July 24, 2009), available at https://www.powervoter.us/Chuck_Schumer/Letter_to_Mary_Schapiro__Chairman__Securities_and_Exchange_Commission.
[57] Id.
[58] See, e.g., Sal Arnuk & Joseph Saluzzi, Broken Markets: How High Frequency Trading and Predatory Practices On Wall Street Are Destroying Investor Confidence And Your Portfolio (2012).
[59] Flash Boys follows a group of financial professionals on their quest to bring fairness back to the financial markets through the creation of IEX Inc., an exchange platform designed to equalize stock orders irrespective of speed. See Peter H. Hammer, Wall Street and SEC Chief Respond to “Flash Boys” Book, 20 №12 Westlaw J. Derivatives 3 (2014) (reviewing Michael Lewis, Flash Boys 18 (2015)).
[60] Id.
[61] Tae Kim, Goldman Sachs says computerized trading may make next ‘flash crash’ worse, CNBC, May 23, 2018, available at https://www.cnbc.com/2018/05/23/goldman-sachs-rise-of-trading-machines-could-make-next-market-crash-much-worse.html. Despite these beliefs, Goldman Sachs also engages in HFT and has been investigated by regulators, see Goldman Sachs under scrutiny for high speed trading, Hartford Bus. J., May 9, 2014, https://www.hartfordbusiness.com/article/goldman-sachs-under-scrutiny-for-high-speed-trading, and has spent over $100 million in 2019 to remain competitive in the HFT space. See Hugh Son, Goldman Sachs is spending $100 million to shave milliseconds off stock trades, CNBC, August 1, 2019, https://www.cnbc.com/2019/08/01/goldman-spending-100-million-to-shave-milliseconds-off-stock-trades.html.
[62] See Findings Regarding the Market Events of May 6, 2020: Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, Sept. 30, 2010, available at https://www.sec.gov/news/studies/2010/marketevents-report.pdf.
[63] Findings Regarding the Market Events of May 6, 2020: Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, Sept. 30, 2010, available at https://www.sec.gov/news/studies/2010/marketevents-report.pdf.
[64] Andrei Kirilenko et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic Market, 72 J. Fin. 967 (2014), available at https://www.cftc.gov/sites/default/files/idc/groups/public/@economicanalysis/documents/file/oce_flashcrash0314.pdf (“We show that HFT did not cause the Flash Crash, but contributed to extraordinary market volatility experienced on May 6, 2010. We also show how high frequency trading contributes to flash-crash-type events by exploiting short-lived imbalances in market conditions.”).
[65] See, e.g., Myles Udland, There are Still a lot of Unanswered Questions Surrounding Last October’s Bond Market ‘Flash Crash’., Bus. Insider, Mar. 30, 2015, available at https://www.businessinsider.com/october-bond-market-flash-crash-2015-3.
[66] See, e.g., Bob Pisani, What Happened During the Aug 24 ‘Flash Crash’, CNBC, Sept. 25, 2015, available at https://www.cnbc.com/2015/09/25/what-happened-during-the-aug-24-flash-crash.html.
[67] Ethereum is a very popular smart contract and decentralized application platform created by Vitalik Buterin. See Ethereum Whitepaper, A Next Generation Smart Contract & Decentralized Application Platform, Whitepaper, May 3, 2018, available at https://whitepaper.io/document/5/ethereum-whitepaper (describing Ethereum as an “open-source, public, blockchain-based distributed computing platform and operating system featuring smart contract functionality. It supports a modified version of Nakamoto consensus via transaction-based state transitions.”). Many retail investors and traders speculate with Ethereum, buying and selling tokens on platforms such as Coinbase and Binance.
[68] See generally Arjun Kharpal, Ethereum briefly crashed from $319 to 10 cents in seconds o one exchange after ‘multimillion dollar’ trade (June 22, 2017), available at https://www.cnbc.com/2017/06/22/ethereum-price-crash-10-cents-gdax-exchange-after-multimillion-dollar-trade.html (last visited Apr. 21, 2020, 2:59 PM).
[69] See generally John P. Njui, Chainlink (LINK) Worst Hit by Flash Crash, Falls to $0.0001 on Binance’s Spot Market, EWN, Mar. 12, 2020, available at https://en.ethereumworldnews.com/link-link-worst-hit-by-flash-crash-falls-to-0-0001-on-binances-spot-market/.
[70] Although there are many additional arguments against HFT, the ones addressed herein typically receive the most attention.
[71] Gregory Scopino, Preparing Financial regulation for the Second Machine Age: The Need for Oversight of Digital Intermediaries in the Futures Markets, 2015 Colum. Bus. L. Rev. 439, 492 (2015) (citing 17 C.F.R. §§155.2–155.4 (2014)). Front running is prohibited by the CFTC, see 17 C.F.R. §§155.2–155.4, and FINRA, see FINRA R. 5270 and R. 5320.
[72] See, e.g., Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues: Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Comm. on Banking, Housing, & Urban Affairs, 111th Cong. 1 (2009) (opening statement of Jack Reed, Chairman).
[73] Benvegna, supra note 16, at 311 (quoting Front Running: CNBC Explains, CNBC, Apr. 2, 2014, http://www.cnbc.com/2014/04/02/front-running-cnbc-explains.html.
[74] John J. Brennan, Remarks From the Financial Policy Joint Conference on Market Fragmentation, Fragility and Fees, FINRA, Sept. 16, 2014, available at https://www.finra.org/media-center/speeches-testimony/remarks-financial-policy-joint-conference-market-fragmentation-fragility-and-fees.
