Economic Regulation, High Frequency Trading, and the Dodd/Frank Act

Economic Regulation, High Frequency Trading, and the Dodd/Frank ActColin HowardDecember 15, 2011University of Maine School of Law

“Technological developments have far outpaced–far outpaced–regulatory oversight, and traders who buy and sell stocks in milliseconds–capitalizing everywhere on very small price differentials in a highly fragmented marketplace––now predominate over value investors.”

Senator Kaufman

I. Introduction:

Advancements in computer and communication technology have had a

massive impact on financial markets. Developments in the speed and

efficiency of trade have created new opportunities for short-term gain, which

new strategies attempt to take advantage of. Competition for these

opportunities has resulted in their existing for shorter and shorter periods of

time. Trade must now be measured in units smaller than a millisecond,

average daily volume is increasing exponentially, and regulators are

scrambling to keep up.

One of the most significant developments is high-frequency trading

(“HFT”). The speed and volume that HFT is characterized by has made its

influence on the markets pervasive. The stability of the financial markets

requires increased regulation of HFT.

This paper will explore the current regulations HFT is subject to, and

their limited effectiveness. This paper will then describe how the newly

enacted Dodd-Frank Wall Street Reform and Consumer Protection Act may

influence regulation, and suggest how some of its provisions might be most

effectively implemented in this area. Finally, this paper will describe some

newly enacted, proposed, and possible HFT regulations.

II. Modern Markets:

a. Electronic Markets

Recent advances in computer technology and electronic

communication have “dramatically” affected the financial markets in the

United States.1 The various and important changes are largely beyond the

scope of this paper.2 But the speed, processing power, and efficiency of

computers, as well as several regulations,3 have pushed markets towards an

environment where much of trade is electronic: trades may be initiated by

computers, executed by computers, and in some cases, controlled

exclusively by computers.4

The “speed, capacity, and sophistication” of trade has “dramatically

improved.”5 In 1987, the New York Stock Exchange (“NYSE”) had the

capacity to handle about 95 trades per second. By 2007, that number had

increased to 38,000 per second.6 Trade is more efficient as well, reducing

transaction costs.7 And speed plus efficiency seems to equal a massive

increase in trading volume: consolidated average volume in the U.S.

increased from 2.1 billion shares in January 2005, to 5.9 billion shares (an

increase of 181%) in September 2009. Trades in NYSE stocks increased from

2.9 million trades in January 2005 to 22.1 million trades (an increase of

662%) in September 2009.8 Finally, and important for this paper’s

1 Concept Release on Equity Market Structure, 75 Fed. Reg. 3554, 3594 (Jan. 21, 2010) (Changes have been driven by “continual evolution of technologies for generating, routing, and executing [trade] orders.”) [hereinafter Concept Release on Equity Market Structure].2

For a detailed discussion of how computers and electronic communication have affected the markets, see generally, Jerry W. Markham, Daniel J. Harty, For Whom the Bell Tolls: The Demise of Exchange Trading Floors and the Growth of ECNs, 33 J. Corp. L. 865 (2008).3

See Emily Lambert, Flash Crash: The Regulators Did It, Forbes.com (Sep. 29, 2010) ; Tom Lauricella, et al., Investors, Regulators Laid Path to “Flash Crash,” The Wall Street Journal (Sep. 29, 2010) (describing the various SEC regulations that have pushed markets into electronic markets including requiring stocks be priced in pennies instead of 1/8 fractions). See also, Concept Release on Equity Market Structure at 3594 n.1-2 (listing regulations that have helped push markets towards an electronic environment) citing Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496 (June 29, 2005) (“Regulation NMS Release”); Securities Exchange Act Release No. 37619A (September 12, 1996) (“Order Handling Rules Release”).4

See Markham, supra note 2, at 866-67.5

Concept Release on Equity Market Structure at 3594.6

Markham, supra note 2, at 882 (citing Aaron Lucchetti, After Crash, NYSE Got the Message(s), Wall St. J., Oct. 16, 2007, at C1). 7

Manoj Narang, Submission to SEC’s Request for Comment (January 21, 2010) on Behalf of Tradeworx, Inc. 9 (April 21, 2010) [hereinafter Letter from Monoj Narang]. (explaining that “[a]s trading costs diminish, smaller and smaller opportunities become profitable to trade, leading to higher volumes.”)8

Large Trader Reporting System, 74 Fed. Reg. 21456 at 2 (proposed April 14, 2010) (to be codified at 17 C.F.R. pt. 240 & 249).

discussion, developments in computer technology have enabled automation

of trade.

These new developments have created new opportunities for gain in

the markets. Due to increases in speed and efficiency, tiny gains may now

be profitable. Firms have devised new trading strategies and revised old

ones to take advantage of these new opportunities. Several of these

strategies may be described as HFT strategies, which are based on speed,

processing power, and volume.

Developments in electronic trade and the strategies devised to meet

opportunities they have spurred a “micro-arms race,” as firms clamor for

advantages over other firms.9 Consequentially, as computers become faster,

the opportunities that these firms are competing for exist for shorter and

shorter periods of time.10 Now the opportunities last for such a short amount

of time that no one without the proper equipment can hope to participate:

the opportunities are cost-prohibitive to the average trader.11

The “proper equipment” is computer automation: only computers can

process information, make decisions, and execute trades quickly enough to

capture these opportunities. Computer automation of trade activity is called

“algorithmic trading” (“AT”), or “program trading.”12 Because HFT is a

subset of AT, a discussion of AT is helpful.

b. Algorithmic Trading9

Letter from Sen. Ted Kaufman to Mary Shapiro, Chairman, Securities and Exchange Commission [hereinafter Letter from Sen. Kaufman] (Aug. 5, 2010) available at http://sec.gov/comments/s7-27-09/s72709-96.pdf. (“[W]hile speed and efficiency can produce certain benefits, they have also created a micro-arms race that is being waged in our public marketplace by high frequency traders and others.”)10

See High-Frequency Traders: Spread Betting, The Economist (Aug. 14, 2010) (Explaining that as a result of electronic, and in particular automated trading, “bid-ask spreads have narrowed and arbitrage opportunities exist for ever-briefer periods.”)11

See Dark Pools, Flash Orders, High-Frequency Trading, and Others Market Structure Issues: Hearing Before the Subcomm. on the Securities, Insurance, and Investment of the Comm. on Banking, Housing, and Urban Affairs, 111th Cong. 8 (2009) [hereinafter Hearings] (prepared statement of Daniel Mathisson, Managing Director, Credit Suisse) (Explaining that opponents of HFT argue that “these traders have an informational advantage, since most people don’t have the technology to read and respond to market data in a split-second time frame.”) 12

Terrence Hendershott, Charles M. Jones, & Albert J. Menkveld, Does Algorithmic Trading Improve Liquidity? 1, Journal of Finance, Forthcoming (August 30, 2010).

AT, or “program trading,” is trading based upon the use of computer

software that automates trading decisions and places orders.13 The use of

programs and algorithms to automate trading has several advantages. First,

because computers can process information much more quickly than a

human, computer programs can analyze a vast quantity of market data in a

short amount of time. Second, computers can make decisions informed by

this analysis much more quickly than a human can. Third, the combined

speed and processing power of computers enables them to execute trades at

speeds much faster than humans are capable of.

These advantages have translated into several uses of AT. First, AT

can be used to break up large orders into small parts in hopes of minimizing

market impact.14 Second, AT can utilize a computer’s processing power to

analyze massive amounts of information in order to identify statistical

correlations between two different stocks.15 Third, AT can use a computer’s

speed to take advantage of certain opportunities in the market unavailable

to slower traders, like humans. This final use brings us to our discussion of

HFT.

c. High Frequency Trading

HFT is a subset of algorithmic and program trading: it is based on

sophisticated computer algorithms and software.16 But the HFT subset is

carved out of AT by its two defining characteristics: speed and high-volume.

For a number of reasons, there is confusion over what exactly the term

“high-frequency trading” means. First, HFTs keep their trade strategies

secret.17 Second, there currently is no adequate system in place to monitor

HFT activity.18

13 Id. See also, Tara Bhupathi, Technology's Latest Market Manipulator? High Frequency

Trading: The Strategies, Tools, Risks and Responses, 11 N.C. J. L. & Tech 377, 383-83 (2010). 14

Hendershott, supra note 12, at 1.15

Letter from Manoj Narang at 9.16

See Hearings (statement of Frank Hatheway, Senior Vice President and Chief Economist, NASDAQ OMX) (“High-frequency trading and algorithmic trading is automation.”) 17

See Michael J. McGowan, The Rise of Computerized High Frequency Trading: Use and Controversy 2010 Duke L. & Tech. Rev. 6, P 44.18

See below for the SEC’s proposed monitoring system.

In a recent Concept Release on Equity Market Structure intended to

solicit comment on, inter alia, HFT, the Securities and Exchange Commission

(“SEC”) said that “[t]he term [HFT] is relatively new and is not yet clearly

defined.”19 Some argue that this confusion is problematic. They worry that

regulators may enact rules that, while only intended or required for a small

portion of HFT practices, may sweep too broadly.20 The confusion over what

constitutes HFT is a result of the variety of strategies that HFTs practice. For

example, James Brigagliano of the SEC described HFT as “generally

involv[ing] a trading strategy where there are a large number of orders and

also a large number of cancellations–often in subseconds–and moving into

and out of positions many times in a single day.”21 This definition may

conflate a particular HFT strategy (i.e. “directional”)22 with HFT in general.

But despite the confusion, there are definite commonalities connecting all

HFT. Those characteristics will be discussed here. The various strategies

that differentiate the types of HFT will be discussed below.

For the purposes of this paper, HFT is defined as a computerized

trading strategy that utilizes high speed and high volume to take advantage

of opportunities in the market that are short-lived and of low-value.23

19 Concept Release on Equity Market Structure at 3606. See also, Hearings (statement of

James Brigagliano, Coacting Director, Div. of Trading and Markets, SEC) (“[T]he terms lack a clear definition.”)20

See Hearings (statement of Frank Hatheway, Senior Vice President and Chief Economist, NASDAQ OMX). (“We also believe that dark pools and flash orders are wrongly confused with high-frequency trading and algorithmic trading.”) See also, Concept Release on Equity Market Structure at 3606 (“The lack of a clear definition of HFT . . . complicates the Commission’s broader review of market structure issues.”)21

Hearings (statement of James Brigagliano, Coacting Director, Div. of Trading and Markets, SEC).22

See below.23

See Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities, Insurance, and Investment) (Explaining that basically, HFT is “the buying and selling of stock at extremely fast speeds with the help of powerful computers.”); Concept Release on Equity Market Structure at 3606 (Explaining that the term HFT “typically is used to refer to professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis.”); Staffs of the Commodity Futures Trading Comm’n and Securities and Exchange Comm’n, Rep. to the Joint Advisory Comm. on Emerging Regulatory Issues, Preliminary Findings Regarding the Market Events of May 6, 2010 Appendix A. 11 (May 18, 2010) [hereinafter Preliminary Flash Crash Report] (Explaining that in general, HFT strategies typically employ the “use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders.”); Staffs of the

While the particular HFT strategies vary, each is characterized by

speed, volume, and powerful computers. As one commentator described it,

“Regardless of the strategy these high frequency traders utilize, they all

attempt to do the same thing: Make vast profits by being smarter and faster

than everyone else.”24 HFT traders (“HFTs”) rely on “extraordinarily high-

speed and sophisticated computer programs for generating, routing, and

executing orders.”25

For HFT, speed “matters both in the absolute sense of achieving very

small latencies and in the relative sense of being faster than competitors,

even if only by a microsecond.”26 HFTs must have fast connections to

markets in order to receive data and to send their orders and cancellations

as quickly as possible.27 While beyond the scope of this paper, most HFTs

rely on expensive “colocation” for connection speed advantages. Colocation

“refers to the practice of setting up . . . trading computers in the same

physical building as the exchange’s computers, to get a time advantage over

. . . competitors.”28 It is estimated that colocation “afford[s] traders a 100-

200 millisecond advantage over other investors.”29 This seemingly tiny

advantage illustrates the time frame that HFTs operate in.

Commodity Futures Trading Comm’n and Securities and Exchange Comm’n, Rep. to the Joint Advisory Comm. on Emerging Regulatory Issues, Findings Regarding the Market Events of May 6, 2010 pg. 45 (Sep. 30, 2010) [hereinafter Final Flash Crash Report] (“HFT’s are proprietary trading firms that use high speed systems to monitor market data and submit large numbers of orders to the markets. HFT’s utilize quantitative and algorithmic methodologies to maximize the speed of their market access and trading strategies.”)24

McGowan, supra note 17, at ¶3.25


Id. at 3610 (“Many proprietary firm strategies are highly dependent upon speed - speed of market data delivery from trading center servers to servers of the proprietary firm; speed of decision processing of trading engines of the proprietary firm; speed of access to trading center servers . . . ; and speed of order execution and response by trading centers.”)27

Id.28

See Hearings (prepared statement of Daniel Mathisson, Managing Director, Credit Suisse) (Also arguing that colocation is merely “the 21st century version of traders trying to get office space close to the exchange.”); Concept Release on Equity Market Structure at 3610 (“Colocation is one means to save microseconds of latency.”) 29

Letter from Sen. Ted Kaufman at 4.

Volume is important to HFTs because each individual opportunity is of

“low reward.”30 Manoj Narang, the founder, CEO and chief investment

strategist of Tradeworx, a company involved in HFT,31 claims that each

individual share involved in a HFT strategy typically earns only a hundredth-

of-a-cent per trade.32

How prevalent is HFT? First, note that, according to one estimate,

HFTs “represent approximately 2% of the 20,000 or so trading firms

operating in the U.S. markets.”33 That percentage is impressive compared

with the every-day trade volume that is attributed to HFT. While

“[e]stimates of HFT volume in the equity markets vary widely . . . , they often

are 50 percent of total volume or higher.”34 Estimates in the higher range

attribute 75% of trade volume to HFTs.35 The various estimates of HFTs

prevalence in the market are due to confusion over HFT’s definition.36 But

“by any measure, HFT is a dominant component of the current market

30 See Letter from Manoj Narang at 9; Timothy Lavin, Monsters in the Market, The Atlantic

(August 2010) (“[HFT] . . . is a very low-margin, low-risk strategy.) But see, Concept Release on Equity Market Structure, 75 Fed. Reg. 3554, 3607 (proposed Jan. 21, 2010) (to be codified at 17 C.F.R. pt. 242) (Noting that some have raised concerns that some HFT strategies “may not necessarily involve a large number of trades.”)31

Tradeworx “develop[s] advanced technology solutions . . . based on mathematical algorithms . . . used . . . for high performance trading - by Tradeworx for its own account, by its hedge fund, and by third parties who purchase Tradeworx’s technology.” Letter from Manoj Narang at 1.32

Timothy Lavin, Monsters in the Market, The Atlantic (August 2010).33

Rob Iati, The Real Story of Software Trading Espionage, Advanced Trading.com, July 10, 2009.34

Preliminary Flash Crash Report at Appendix A. 11 (citing Jonathan Spicer and Herbert Lash, Who’s Afraid of High-Frequency Trading?, Reuters.com, December 2, 2009 (“High-frequency trading now accounts for 60 percent of total U.S. equity volume, and is spreading overseas and into other markets.”)); Scott Patterson and Geoffrey Rogow, What’s Behind High-Frequency Trading, Wall Street Journal, August 1, 2009 (“High frequency trading now accounts for more than half of all stock-trading volume in the U.S.”).35

See Hearings (prepared statement of Christopher Nagy, Managing Director of Order Routing Strategy, TD Ameritrade) (75%); Hearings (prepared statement of Larry Leibowitz, Group Executive Vice President, NYSE Euronext) (two-thirds).36

See Concept Release on Equity Market Structure at 3607 (“The lack of clarity may, for example, contribute to the widely varying estimates of HFT volume in today’s equity markets.”); Hearings (statement of Daniel Mathisson, Managin Director, Credit Suisse) (“[T]here is no clear definition of the term [HFT], making it very difficult to analyze its effects or estimate what percent of the market it is, resulting in what appear to be wide overestimates of what percent of the market [HFT] makes up.”)

structure and is likely to affect nearly all aspects of its performance.”37

Indeed, the SEC has noted that “[t]he use of certain [HFT] strategies by

some proprietary firms has, in some trading centers, largely replaced the

role of specialists and market makers.38 HFT’s role in this regard, as “market

maker,” is discussed below.

III. High Frequency Trading Strategies:

a. Statistical Arbitrage

Statistical arbitrage strategies depend on relationships and

correlations between two different securities.39 Opportunities for gain are

found by identifying these relationships, “discern[ing] historical patterns and

correlations,” and acquiring certain positions informed by the analysis.40 In

other words, statistical arbitrage is “based on mispricing in the markets or a

temporary deviation from historical trends . . . .”41 This strategy has been

termed the “least high-frequency” of the HFT strategies,42 but speed and

volume are still important.

Statistical arbitrage strategies are assisted by computers in three

ways. First, computers are required to analyze market data and identify

correlations. Second, because these opportunities last for a very short

amount of time. Third, because the gain associated with any single trade in

statistical arbitrage tend to be very low, the reduced trading cost that is

37 Preliminary Flash Crash Report at Appendix A. 11.

38 See Concept Release on Equity Market Structure at 3607.

39 See Letter from Manoj Narang at 9.

40 Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) (Explaining that

depending on the statistical analysis, firms will “buy and short the affected securities to help push them back to their traditional correlations, collecting the spread along the way.”)41

Mobis Philipose and Ravi Ananthanarayanan, Flash Orders Not Synonymous with High-Frequency Trading, LiveMint.com (September 18, 2009). See also, Concept Release on Equity Market Structure at 3608 (“An arbitrage strategy seeks to capture pricing inefficiencies between related products or markets.”) For a plain-language explanation of statistical arbitrage, see also, Jon Stokes, The Matrix, But with Money: The World of High-Speed Trading, Arstechnica.com (2009) (“Stat arbs make their money by vacuuming up mountains of historical data and looking for correlations between various datapoints and asset prices. The stat arb's trading platform, which is basically a large computer system manned by programmers and financial engineers, uses those correlations to build predictive models that take in a stream of information inputs like news reports and stock prices . . . , and output a rapid-fire stream of "buy" and "sell" orders for different assets.”)42

Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) .

associated with computer trading and automation is required for

profitability.43

b. Passive Market Making

Another common HFT strategy, which is particularly associated with

high volume and “high cancellation rates,”44 is called “passive market

making.”45 Market making is the practice, traditionally employed by

“screaming floor traders of a bygone era,”46 of, in essence, “providing

liquidity” to a market.47 Market makers are intermediaries in the markets:

they fill buy and sell orders placed by investors.48 Because of the important

role they play in the market, market makers are traditionally subject to

“affirmative and negative” obligations.49 These obligations, and the fact that

HFTs embodying the roles of market maker are not subject to them, will be

discussed below.

“Passive” market making is characterized by placing “resting orders.”50

A resting order is a type of limit order,51 meaning that it may only be

executed if its specified price is met by another party,52 that is placed in

positions to take advantage of an “anticipated price move.”53

43 See Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) (“The profits on

any one trade tend to be small but, with enough speed and volume, they can create enormous profits.”)44

Concept Release on Equity Market Structure at 3607 (stating that cancellation rates may reach 90%).45

See Concept Release on Equity Market Structure at 3607-08. But see, Letter from Manoj Narang at 9 (“It is increasingly difficult to differentiate market-making from statistical arbitrage. Statistical arbitrage techniques are often used by market-makers . . . .”) 46

Joe Flood, Adventures in Algorithmic Trading, ai5000 (Aug. 5, 2010) .47

Concept Release on Equity Market Structure at 3607. 48

See, e.g., Perrie M. Weiner et al., Catch Me if You Can: Speed Traders Under Scrutiny, 1843 PLI/Corp 341, 343 (July 20, 2010) (“When a mutual fund wants to buy 10,000 shares of Tesla, Inc, odds are a high-frequency trader will be ready to provide the shares.”)49

See Concept Release on Equity Market Structure at 3607.50

See id.51

A limit order is “[a]n order [that specifies] a minimum sale price or maximum purchase price, as contrasted with a market order, which implies that the order should be filled as soon as possible at the market price.” CFTC Glossary, CFTC.gov.52

See CFTC Glossary, CFTC.gov (defining “resting order” as a “limit order to buy at a price below or to sell at a price above the prevailing market that is being held by a floor broker.”) 53

Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic Market 14 (November 9, 2010).

HFTs using a market making strategy make profits in two ways.54 First,

by collecting the “bid-ask spread” on a given stock. A HFT will “[earn] the

spread by buying at the bid and selling at the offer . . . .”55 Basically: buy

low, sell high.56 Second, by collecting the tiny (usually 1/4 or 1/3 of a cent

per trade),57 rebate that many markets pay firms for providing liquidity.58

Why do markets offer rebates? “Most liquid stocks trade at 1 cent bid-ask

spreads[.] [B]ut in most cases, 1 cent is not a large enough” to cover the

risk of trades. “As a result, exchanges offer [these rebates as] further

inducement for traders to post orders . . . .”59 This practice is not without

detractors. “Payment for order flow is an inherent conflict of interest.

Because it encourages broker dealers to send retail order flow to the highest

bidder and not to the trading center that is necessarily best of the buyer or

seller, payment for retail order flow is a highly dubious practice.”60

c. Directional Strategies

54 Concept Release on Equity Market Structure at 3607 (“[T]he primary sources of profits [in

market making strategies] are from earning the spread by buying at the bid and selling at the offer and capturing any liquidity rebates offered by trading centers to liquidity-supplying orders.”)55

See Concept Release on Equity Market Structure at 3607. But see, Letter from Manoj Narang at 8 (“For stocks that are extremely liquid, some market-makers may be willing to buy and sell at the same price . . . . Such market-makers are said to be operating rebate-capture strategies because their only compensation is the rebate offered by exchanges for posting orders.”) (emphasis in original).56

See McGowan supra note 17, at ¶ 23 (“To make money off of the spread, market makers will buy and sell securities on both sides of the trade by placing a limit order to sell (or offer) above the current market price or a buy limit order (or bid) below the current price in order to benefit from the bid-ask spread.”)57

Id. at ¶ 26 (citing Mark Hutchinson, High Frequency Trading: Wall Street's New Rent-Seeking Trick, Money Morning, Aug. 14, 2009).58

Letter from Sen. Ted Kaufman at 5 (Explaining that, in essence, market making “generate[s] profits by capturing spreads and earning liquidity rebates under the current maker-taker pricing models used by many market centers to attract order flow.”)59

Letter from Manoj Narang at 8 (“Most liquid stocks trade at 1-cent bid-ask spreads, but in most cases, 1 cent is not a large enough spread to defray the cost of adverse selection . . . . As a result, exchanges offer further inducement for traders to post orders in the form of “rebates.” For stocks that are extremely liquid, some market-makers may be willing to buy and sell at the same price . . . . Such market-makers are said to be operating rebate-capture strategies because their only compensation is the rebate offered by exchanges for posting orders.”)60

Hearings (statement of Sen. Kaufman).

Some HFTs use “directional” strategies.61 Directional strategies, at

least in the long-term investor context, are common. They are based on

obtaining positions in anticipation of price movements, or “speculat[ion] on

the direction of the underlying market.”62 Some HFT directional strategies

are just as “straight-forward as concluding that a stock price temporarily has

moved away from its ‘fundamental value’ and establishing a position in

anticipation that the price will return to such value.”63 However, two subsets

of HFT directional strategies, recently noted by the SEC in its Concept

Release on Equity Market Structure, are more complicated and novel, and

raise particular concerns about the stability and fairness of the markets.

i. “Order Anticipation”

When large institutional traders buy or sell a large number of a

particular share, the price is affected.64 Order anticipation strategies attempt

to predict these price movements, and trade in front of them; either selling

(or shorting) before the price drops, or buying before it rises.65 To minimize

the effect that large trades can have on price, and to avoid other traders

taking advantage of that movement, institutional traders often break large

trades into small pieces.66 HFT comes into play in two different ways. First,

HFTs are thought to employ different strategies to “sniff out” large trades

disguised as a series of small ones.67 HFTs may use “sophisticated pattern

recognition software to ascertain from publicly available information the

existence of a large buyer . . . .”68 Second, HFTs may use their speed to

“trade in front of” the large investors.69 This term, “trade in front of,” does

61 See Concept Release on Equity Market Structure at 3608.

62 CFTC.gov, CFTC Glossary, Directional Trading available at

http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/glossary_d.html. 63


Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic Market 3, 17-18 (November 9, 2010).65


High-Frequency Trading: Rise of the Machines, The Economist (Aug. 1, 2009).67

See id.68


Id.

not necessarily connote illegal trade behavior. While the practice of “front

running” is certainly illegal, using sophisticated methods of analysis and high

speed is not necessarily so.70 In this context, “trade in front of” means using

high speed to capture bid-ask spreads.

ii. “Momentum Ignition”

Another form of directional strategy is “momentum ignition,” and is

most likely illegal.71 This strategy seems primarily to be targeted against

other algorithmic traders in the market.72 According to this strategy, the HFT

may send out a large number of orders and cancellations in rapid succession

in an attempt to “spoof” the other algorithms to buy or sell more

aggressively.73 “By establishing a position early, the proprietary firm will

attempt to profit by subsequently liquidating the position if successful in

igniting a price movement.”74 The speed at which HFTs operate allows them

first ignite these “sharp price movements” and second to “then profit from

the resulting short-term volatility.”75

The high volume use of orders and cancellations may be used to

manipulate the market in another way, in a practice called “quote stuffing,”

where “high volumes of quotes are purposely sent to exchanges in order to

create data delays that would afford the firm sending these quotes a trading

advantage.”76

70 See Concept Release on Equity Market Structure at 3609 (Explaining that their discussion

of order anticipation strategies excludes those that would be illegal: “The type of order anticipation strategy referred to in this release involves any means to ascertain the existence of a large buyer (seller) that does not involve violation of a duty, misappropriation of information, or other misconduct.”) See also, Letter from Manoj Narang at 15 (“Should the anticipation of the behavior of other market participants by HFTs be prohibited? No! . . . We submit that any trading signal is perfectly fair so long as publicly available data is being used in its construction. If somebody is able to build a better signal using the same data, should that be discouraged? No matter what restrictions regulators impose, some players will always be superior in terms of their ability to analyze data.”)71


Id.73

Id.74

Id.75

Hearings (statement of James Brigagliano, Coacting Director, Div. of Trading and Markets, Securities and Exchange Comm.).76

Final Flash Crash Report at pg. 79.

Both momentum ignition and quote stuffing are most likely illegal

because intentional manipulation of the market is against the law.77 But both

practices may be difficult to control.78 However, some firms have been fined

for using HFT to manipulate the market.79

d. Position Identification

An additional strategy that some opponents of HFT have identified is

characterized by the sophisticated use of orders to identify and take

advantage of another trader’s position.80 According to this strategy, an HFT

firm will send out many “immediate-or-cancel” sell orders, that if not

accepted immediately, are cancelled.81 This practice could potentially allow

an HFT firm to foil a trader’s attempt at keeping secret how much it is willing

77 See 15 U.S.C. S 78i.

78 See Concept Release on Equity Market Structure at 3609 (“[W]hile spreading false rumors

to cause price moves is illegal, such rumors can be hard to find (if not spread in writing), and it can be difficult to ascertain the identity of those who spread rumors to cause price moves.”)79

In September 2010, the Financial Industry Regulatory Authority (“FINRA”) fined Trillium Brokerage Services $2.3 million for “using an illicit high frequency trading strategy.” Press Release, Financial Industry Regulatory Authority, FINRA Sanctions Trillium Brokerage Services, LLC, Director of Trading, Chief Compliance Officer, and Nine Traders $2.26 Million for Illicit Equities Trading Strategy, (Sept. 13, 2010) available at http://www.finra.org/Newsroom/NewsReleases/2010/P121951. “Trillium, through nine proprietary traders, entered numerous layered, non-bona fide market moving orders to generate selling or buying interest in specific stocks. By entering the non-bona fide orders, often in substantial size relative to a stock's overall legitimate pending order volume, Trillium traders created a false appearance of buy- or sell-side pressure. This trading strategy induced other market participants to enter orders to execute against limit orders previously entered by the Trillium traders. Once their orders were filled, the Trillium traders would then immediately cancel orders that had only been designed to create the false appearance of market activity. As a result of this improper high frequency trading strategy, Trillium's traders obtained advantageous prices that otherwise would not have been available to them on 46,000 occasions.” Press Release, Financial Industry Regulatory Authority, FINRA Sanctions Trillium Brokerage Services, LLC, Director of Trading, Chief Compliance Officer, and Nine Traders $2.26 Million for Illicit Equities Trading Strategy, (Sept. 13, 2010) available at http://www.finra.org/Newsroom/NewsReleases/2010/P121951.80

For two somewhat sensational discussions on the potentially nefarious uses of “probing quotes,” see generally, Alexis Madrigal, Explaining Bizarre Robot Stock Trader Behavior, The Atlantic (August 6, 2010) available at http://www.theatlantic.com/technology/archive/2010/08/explaining-bizarre-robot-stock-trader-behavior/61028/; Ellen Brown, Computerized Front-Running: Another Goldman-Dominated Fraud (April 21, 2010) available at http://www.webofdebt.com/articles/computerized_front_running.php.81

Concept Release on Equity Market Structure at 3607 n.69.

to pay for a certain stock.82 Some believe that HFTs are able to “game the

system using repeated and lightning-fast orders to quickly identify other

traders’ positions and take advantage of that information, potentially

disadvantaging retail investors.”83 “HFTs attempt to uncover how much an

investor is willing to pay (or sell for) by sending out a stream of probing

quotes that are swiftly cancelled until they elicit a response. The traders

then buy or short the targeted stock ahead of the investor, offering it to

them a fraction of a second later for a tiny profit.”84

IV. Regulation:

a. Need for Regulation

This section will discuss regulation of HFT. First, it will discuss several

reasons why HFT needs to be regulated. Second, it will discuss the

regulations that HFT is subject to now. Third, it will discuss why those

current regulations are ineffective. Fourth, it will explore new legislation,

and suggest how it might be implemented to most effectively regulate HFT.

Finally, it will examine proposed and potential regulation.

HFT must be regulated because it “exert[s] tremendous influence over

trading.”85 Because “HFT is a dominant component of the current market

structure, [it] is likely to affect nearly all aspects of its performance.”86 An

aspect of trading that, by all estimates, comprises at least 50% of daily

trading volume has “a tremendous capacity to affect the stability and

integrity of the equity markets.”87

HFT’s largest potential for impact on systemic stability is its association

with liquidity. Proponents of HFT claim that it provides the markets with

82 “To avoid signaling their intentions to the market, institutional investors trade large orders

. . . within specified price ranges.” High-Frequency Trading: Rise of the Machines, The Economist (Aug. 1, 2009).83

Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities, Insurance, and Investment).84


Mary L. Schapiro, Chairman, Securities and Exchange Comm’n, Remarks Before the Security Traders Ass’n (Sept. 22, 2010).86

Preliminary Flash Crash Report at Appendix A. 11.87

Mary L. Schapiro, Chairman, Securities and Exchange Comm’n, Remarks Before the Security Traders Ass’n (Sept. 22, 2010).

liquidity.88 Indeed, some go so far as to say that “HFTs are the liquidity

backbone of the market.”89 But according to critics, this is the precisely the

concern, and the very reason why HFTs must be regulated closely.

As major suppliers of liquidity to the market, many HFTs act as de facto

market makers. Traditional market makers are important for maintaining

market stability, and are thus subject to affirmative90 and negative

obligations.91 The most important obligations imposed upon registered

market makers require them to continue providing liquidity, whether markets

are up or down, and to “assist in the maintenance, insofar as reasonably

practicable, of fair and orderly markets.”92 Unlike market makers, however,

HFTs “are subject to very little in the way of obligations either to protect that

stability by promoting reasonable price continuity in tough times, or to

refrain from exacerbating price volatility.”93 This lack of obligation is

especially worrisome given that many HFT strategies profit during times of

volatility.94

Concerns about systemic stability thus center around the liquidity that

HFTs supply. For example, one HFT proponent, Manoj Narang, in a

88 For a study on whether HFT provides liquidity to markets, see Terrence Hendershott,

Charles M. Jones, & Albert J. Menkveld, Does Algorithmic Trading Improve Liquidity? available at http://faculty.haas.berkeley.edu/hender/Algo.pdf89

Letter from Manoj Narang at 7. But see, Hearings (statement of Sen. Kaufman). (arguing that liquidity is not the only consideration in matters of market stability and fairness; “[l]iquidity as an end seems to have trumped the need for transparency and fairness. We risk creating a two-tiered market that is opaque, highly fragmented, and unfair to long-term investors.”)90

“Affirmative [market maker] obligations might include a requirement to consistently display high quality, two-sided quotations that help dampen price moves . . . .” Concept Release on Equity Market Structure at 3607 n.70. 91

“[N]egative obligations might include a restriction on ‘reaching across the market’ to execute against displayed quotations and thereby cause price moves.” Concept Release on Equity Market Structure at 3607 n.70.92

Preliminary Flash Crash Report at Appendix A. 9. But see, id., (explaining that market makers may use “stub quotes,” an offer to buy or sell a stock at, for example, a penny, during times of volatility when they do not wish to trade.)93

Mary L. Schapiro, Chairman, Securities and Exchange Comm’n, Remarks Before the Security Traders Ass’n (Sept. 22, 2010). See also, Hearings (prepared statement of Peter Driscoll, Chairman, Security Traders Association) (“Market makers . . . have traditionally had significant obligations to the markets and generally position risk for longer than milliseconds.”)94

Letter from Manoj Narang at 4 (“HFTs benefit from volatility . . . .”) (emphasis in original).

misguided attempt at assuaging fears that HFT algorithms could trigger a

“hot potato” effect,95 explained that if an HFT algorithm detected an

“anomalous period,” it would “simpl[y] ‘turn off’ its strategy . . . .”96 Indeed,

Narang, who runs an HFT operation through his Tradeworx Inc. firm, did shut

down his HFT algorithm on May 6, 2010, during the height of the “Flash

Crash.”97 This is precisely the fear: if HFTs provide 50% of liquidity in the

markets every day, they also stand in a position to remove (or more

accurately, cease to provide) 50% of liquidity whenever they choose.

“Critics [thus] accuse high frequency traders of being fair-weather

market makers who, unlike the former . . . [market makers] they’ve largely

replaced, don’t have a legal obligation to trade during periods of stress.”98

Indeed, at the height of the May 6, 2010 Flash Crash, “offers to buy stocks

vanished from underneath the market:” on the morning of May 6, there were

hundreds of offers above $51 to buy shares of a certain stock that, hours

later, during the height of the Flash Crash, showed just four bids above

$14.99 The Flash Crash Report100 found that six of the twelve HFTs it

interviewed scaled back their trading on May 6th, and that two of the larger

ones withdrew completely.101

95 See Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency Trading on an

Electronic Market 3, 17-18 (November 9, 2010) (explaining the “hot potato” effect, where HFTs “rapidly buy and sell contracts from one another many times,” driving prices down. Also explaining how the hot potato effect played into the May 6, 2010 “Flash Crash.”)96

Letter from Manoj Narang at 10.97

See Scott Patterson & Tom Lauricella, Did a Big Bet Trigger “Black Swan” Stock Swoon? The Wall Street Journal (May 10, 2010) available at http://online.wsj.com/article/SB10001424052748704879704575236771699461084.html. The prevalence of algorithmic trading in the markets amplifies the problems that could be caused by a faulty program. Indeed, it is believed that the May 6, 2010 “Flash Crash” was initiated by a faulty sell order from an algorithmic trader. See Final Flash Crash Report at pg. 2 (explaining that the sell algorithm was programmed to target an execution rate of “9% of the trading volume calculated over the previous minute, but without regard to price.”)98

Michael Peltz, Inside the Machine: A Journey into the World of High-Frequency Trading, InstitutionalInvestor.com (Jun. 10, 2010). 99

Scott Patterson & Tom Lauricella, Did a Big Bet Trigger “Black Swan” Stock Swoon? The Wall Street Journal (May 10, 2010). The “certain stock” was the iShares Russell 1000 Growth Index exchange-traded fund. Id.100

Final Flash Crash Report at pg. 45. 101

Id. See also, America’s Stockmarket Plunge: A Few Minutes of Mayhem, The Economist (May 15, 2010) (“Another factor [in the May 6th Flash Crash] was the sudden retreat by the

A second source of instability is the volatility that some fear HFT may

induce. Automated traders pursuing short-term gain may be more easily

“spooked” into aggressive trade by sudden price changes than humans or

long-term traders. And the speed at which they might react could be

problematic. Senator Kaufman worries that the “convergence” of multiple

HFTs on a single, short-lived opportunity “may leave the marketplace

vulnerable to sudden price swings.”102 Such convergence could ignite a “hot

potato” effect (alluded to above), where HFT algorithms rapidly trade

between each other,103 “magnif[ying] changes.”104

Critics of HFT also argue that some HFT strategies make profits at the

expense of long-term investors,105 who the markets and regulators are meant

to primarily serve.106 They point to the HFT practice of identifying large

investors and their positions as particularly unfair. A New York Times article

argued that the profits HFTs make through use of their speed and processing

power are translated into additional costs for the long term investor. The

article provided an example where “[t]he result [of HFT activity] is that the

slower-moving investors paid . . . $7,800 more than if they had been able to

move as quickly as the high-frequency traders.”107

b. Current Regulation

‘high frequency’ firms whose algorithmic trading has come to dominate equity markets. In normal times they play a crucial role in providing liquidity. But unlike market makers, they are not obliged to do so during bouts of turbulence. Regulators think that some high-frequency traders switched off their programs when prices began to spiral, fearful that their trades would be cancelled because of the severity of the declines.”)102

Letter from Sen. Ted Kaufman at 1. 103

Andrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency Trading on an Electronic Market 3, 17-18 (November 9, 2010).104


See Jason Zweig, The Market War Between Traders and Investors Heats Up, The Wall Street Journal (September 25, 2010) . 106

See Letter from Sen. Ted Kaufman at 1. See also, Elimination of Flash Order Exception From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01, 48636 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242) (“If . . . the interests of long-term investors and professional short-term traders conflict, the Commission previously has emphasized that ‘its clear responsibility is to uphold the interests of long-term investors.’”) citing Securities Exchange Act Release No. 51808 (June 9, 2005) 70 FR 37496, 37500 (June 29, 2005).107

See Charles Duhigg, Stock Traders Find Speed Pays, in Milliseconds, The New York Times (July 23, 2009).

HFT is currently regulated in some ways. First, some firms operating a

HFT strategy are registered as broker-dealers,108 and are subject to certain

obligations as such.109 Second, all traders must comply with various laws

and regulations that control fraud, market manipulation, insider trading, and

front-running.110 In addition, every exchange is required to enact rules to

prevent fraudulent and manipulative practices and protect investors and the

public interest.111

c. Ineffectiveness of Current Regulation

However, the effectiveness of the laws and regulations that HFTs are

subject to is lessened by the current inability of regulatory bodies to

adequately monitor HFT activity.112 It is difficult to monitor HFT activity

because of the fragmentation of trade across various markets, fragmentation

of regulatory authority, and the massive volume of data that such monitoring

would entail.113 Also, the current monitoring system does not even have the

capability of discerning which trades originate from algorithmic programs.

The inability to adequately monitor HFT activity is illustrated by the

confusion over just what HFT entails. While speculation abounds, there is

frustratingly little reliable information about HFT strategies.

d. The Dodd-Frank Wall Street Reform and Consumer Protection Act

108 Broker-dealer is defined in §§ 3(a)(4)(A) and 3(a)(5)(A) of the Securities Exchange Act of

1934.109

See Concept Release on Equity Market Structure at 3606; Financial Industry Regulator Authority, Comment Letter to Elizabeth M. Murphy, Secretary, Securities and Exchange Comm’n. at 4 (April 23, 2010). See also, Louis Loss, Fundamentals of Securities Regulation, 676 (1983, Supp. 2010) (describing the capital requirements of registered broker-dealers).110

See, e.g., 15 U.S.C. § 78i (banning manipulation of security prices); 15 U.S.C.A. § 78t-1 (banning insider trading).111

See Financial Industry Regulator Authority, Comment Letter to Elizabeth M. Murphy, Secretary, Securities and Exchange Comm’n. (April 23, 2010) (citing Securities and Exchange Act §§ 6(b)(5), 15A(b)(6)).112

See id.113

See id.

In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection

Act (“DFA”) was passed.114 In it are several provisions that might bear upon

the regulation of HFT activities.

i. SEC

The DFA instructs the SEC to conduct a study of “the effect of high-

frequency trading and other technological advances on the market and what

the SEC requires to monitor the effect of such trading and advances on the

market.”115 The SEC is then to present its findings along with

“recommendations for legislative, regulatory, or administrative action.”116 In

accordance with these instructions, the SEC has released a Concept Release

on Equity Market Structure, cited frequently in this paper, which seeks to

solicit comments from the industry on how HFT and other technological

advancements are affecting the markets.117

The DFA also increases the SEC’s ability to monitor hedge funds.118

Because hedge funds are typical users of HFT strategies,119 this new

development could be significant in HFT regulation. Now the SEC may

require hedge funds to maintain and produce records “as necessary and

appropriate in the public interest and for the protection of investors, or for

the assessment of systemic risk by the Financial Stability Oversight Council”

(described below).120 The information required may include the amount and

types of assets held, trading and investment positions, trading practices, and

any other information that the SEC determines is necessary.121 The

114 Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong.

(2010) (“DFA”).115

DFA § 967(a)(2)(D).116

DFA § 967(b)(2).117

See generally, Concept Release on Equity Market Structure, 75 Fed. Reg. 3554 (Jan. 21, 2010).118

See DFA §§ 403 (removing registration exemption for “private investors”); 404 (increasing reporting requirements).119


DFA § 404(b)(1)(A).121

DFA § 404(b)(3). But see DFA § 404(b)(10)(B) (reserving from public disclosure all “proprietary information” such as trading data, computer or software containing intellectual property, etc.).

availability of this information will be potentially helpful to regulators,

because it is generally kept secret. Not only would the information help keep

such firms accountable for their practices, it would help shed light on how

HFT practices might affect the markets. However, a provision in the DFA

exempting hedge funds managing less $150 million in assets will lessen the

helpfulness of these reporting requirements.122

The SEC should first use both of these powers to gain a more thorough

understanding of HFT. HFT are currently kept

ii. Financial Stability Oversight Council

The DFA established a new Financial Stability Oversight Council

(“FSOC”),123 whose purpose it is to “identify risks to . . . financial stability,”

and “respond to emerging threats to [financial] stability.”124 The FSOC’s

duties are to “collect information,” “monitor the financial services

marketplace,” “identify gaps in regulation,” “require supervision . . . for

nonbank financial companies that may pose” stability risks, and to “make

recommendations to primary financial regulatory agencies to apply new or

heightened standards and safeguards for financial activities” that could pose

a risk to financial stability in the markets.125

Much of the FSOC’s power comes from its ability to recommend

nonbank financial companies that pose a systemic risk126 for regulation under

the Board of Governors of the Federal Reserve (“Board of Governors”).127

Some nonbank financial firms that are thought to employ HFT strategies,

such as large companies that trade in a proprietary fashion (e.g., Goldman

Sachs), will probably qualify for this FSOC recommendation because of their

122 See DFA § 408 (exempting for reporting requirements “any investment adviser of private

funds, if each of such investment adviser acts solely as an adviser to private funds and has assets under management . . . of less than $150,000,000.”)123

DFA § 111.124

DFA § 112(a)(1).125Id.126

Defined in DFA § 102(a)(4); qualifications listed in DFA § 113(a)(2) (“any other risk-related factor”).127

DFA § 112(a)(2)(H).

massive size and interconnectedness.128 However, exactly who will be

subject to this new scrutiny remains to be seen, as the DFA does not,

perhaps intentionally, provide many benchmark criteria.129

The criteria that the FSOC bases its determinations upon will have a

large impact on which HFT companies fall subject to its regulation. Criteria

that are based solely upon size of capital will not capture enough HFT firms.

Instead, the FSOC should use trade volume as criteria.

For example, Tradeworx, who has been mentioned previously in this

paper, trades with only $6 million capital.130 Through that lens, and

compared to firms the size of Goldman Sachs, Tradeworx would not seem to

qualify as a systemic risk. However, Tradeworx has reported that it makes

more than 200,000 trades everyday with over 40 million shares:131 its impact

on systemic stability comes not from the size of its capital, but how it uses it.

Tradeworx, like many HFT firms, uses its capital many times over the course

of a day by rapidly acquiring and liquidating different positions. Therefore,

concentrating on size of capital alone would miss the risk that HFTs create.

The FSOC should devise criteria to capture relatively small but nonetheless

systemically significant HFT firms like Tradeworx by concentrating on the

amount of liquidity they supply and have the ability to withhold.132

The firms that the FSOC recommends for regulation under the Board of

Governors may be subject133 to “enhanced supervision and prudential

standards,” such as risk-based capital requirements, leverage limits,

enhanced public disclosures, and overall risk management requirements.134

These standards seem based at addressing the risk of an interconnected

company’s failure; it is unclear whether these enhanced standards can

128 See DFA § 112(a)(2)(H).

129 See DFA § 113(a)(2). But see, DFA § 165(a) (intimating a benchmark of $50 billion).

130 Michael Peltz, Man vs. Machine: Inside the World of High-Frequency Trading, CNBC.com

(Sept. 13, 2010) available at http://classic.cnbc.com/id/39099331/.131 Jason Zweig, The Market War Between Traders and Investors Heats up, The Wall Street Journal (Sept. 25, 2010).132

See DFA § 113(a)(2) (listing, as a consideration, “any other risk-related factor”).133

See DFA § 112(a)(2)(I).134

DFA § 115(b)(1).

adequately address the stability risks that HFTs represent,135 which are

based not on failure but on the volatility HFT practices may create. If they

cannot, then the FSOC’s greatest impact on HFT will most likely emanate

from its duty to monitor the markets for stability risks136 and make

recommendations to primary regulators (like the SEC, who could perhaps

impose trading obligations) based on its findings.137

iii. Commodity Futures Trading Commission

Although HFT activity has been discussed solely in terms of the equity

markets so far, the DFA prohibits some commodity market activity that could

affect some of the HFT strategies described above. In Section 747, the DFA

prohibits “disruptive practices” in the commodities markets.138 In pertinent

part, the DFA defines disruptive practices as what is “commonly known to

the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid

or offer before execution).”139 The Commodity Futures Trading Commission

(“CFTC”) is currently in the process of considering whether it needs to

promulgate additional regulations to enforce these new anti-disruption

laws.140

e. Proposed and Newly Enacted Regulations

i. Prohibition of “Naked Access”

The SEC has formally enacted one regulation that will impact HFT.

While beyond the scope of this paper, the SEC has recently (November 3,

2010) banned “naked access.”141 Regulators feared that naked access,

where broker-dealers allow HFTs to have direct access to the markets by

135 See DFA § 115(b)(1) (listing the various regulations that may be imposed).

136 DFA § 112(a)(2)(C).

137 DFA § 112(a)(2)(K).

138 See DFA § 747, amending § 4c(a) of the Commodity Exchange Act (7 U.S.C. § 4c(a) as

amended).139

DFA § 747, amending § 4c(a)(5)(C) of the Commodity Exchange Act (7 U.S.C. § 4c(a)(5)(C) as amended).140

See Antidisruptive Practices Authority Contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act, 75 Fed. Reg. 67301 (November 2, 2010).141

Risk Management Controls for Brokers or Dealers with Market Access, 17 C.F.R. S 240 (2010).

bypassing certain risk-management systems, allowed HFT firms to act as

unregistered and unregulated broker-dealers.142

ii. Increased and Enhanced Market/Trader Monitoring

The SEC has proposed two rules that would enhance its ability to

monitor HFT activity. First, the SEC has proposed implementing a “Large

Trader Reporting System”143 which is essentially designed to monitor HFT

activity.144 Most HFTs would meet the definition of “large trader,” which is

any person whose transactions equal or exceed (1) two million shares or $20

million during any calendar day or (2) 20 million shares or $200 million

during any calendar month.145 After identifying themselves, large traders

would be assigned a unique identification number that would enable the SEC

and other regulators to track their activity across different markets.146 The

system “would help the [SEC] reconstruct market activity, analyze trading

data and investigate potentially manipulative, abusive or otherwise illegal

activity.”147

Second, the SEC has proposed a Consolidated Audit Trail (“CAT”),

which would replace “existing audit trails [that] are limited in their scope and

effectiveness in varying ways.”148 This proposed rule would require all

securities exchanges to “act jointly” in developing a “consolidated order

tracking system.”149 The CAT is aimed at satisfying “a heightened need for

regulators to have efficient access to a more robust and effective cross-

142 See Hearings (statement of William O’Brien, CEO, Direct Edge).

143 Large Trader Reporting System, 74 Fed. Reg. 21456 (proposed April 14, 2010).

144 See id. (“The proposal is intended to assist the Commission in identifying and obtaining

certain baseline trading information about traders that conduct a substantial amount of trading activity, as measured by volume or market value, in the U.S. securities markets. In essence, a ‘large trader’ would be defined as a person whose transactions in NMS securities equal or exceed (i) two million shares or $20 million during any calendar day, or (ii) 20 million shares or $200 million during any calendar month.”)145

Large Trader Reporting System, 74 Fed. Reg. 21456 (proposed April 14, 2010).146

Id.147

Liz Moyer, Ankle Bracelets for High-Frequency Traders, Forbes.com, (April 14, 2010). 148

Consolidated Audit Trail, 75 Fed. Red. 32556 at 1 (proposed May 26, 2010) (to be codified at 17 C.F.R. pt. 242).149Id.

market order and execution tracking system.”150 It will aid the self-regulating

markets151 in their “efforts to detect and deter fraudulent and manipulative

acts and practices in the marketplace, and generally to regulate their

markets.”152 And will benefit the SEC’s “market analysis efforts, such as

investigating and preparing market reconstructions and understanding

causes of unusual market activity. Further, timely pursuit of potential

violations can be important in seeking to freeze and recover any profits

received from illegal activity.”153

iii. Elimination of Flash Order Exception

While beyond the scope of this paper, the SEC has also proposed

banning “flash orders.”154 An SEC market rule requires markets to post their

best bids and offers to all public markets.155 But an exception156 “that was

[originally] intended to facilitate manual trading in the crowd on exchange

floors by excluding quotations that then were considered ‘ephemeral’ and

impractical to” post publicly,157 effectively enables “investors who are not

150 Id.

151 For a discussion on the self-regulation of the markets, see LOUIS LOSS, FUNDAMENTALS OF

SECURITIES REGULATION, 689-702 (1983 & Supp. 2010).152

Consolidated Audit Trail, 75 Fed. Reg. 32556 at 1 (proposed May 26, 2010).153

Id.154 Flash orders begin as marketable buy or sell orders that are placed on an exchange. If the order is not immediately filled in its entirety on that exchange it may be “flashed” to market participants who are not currently displaying quotes in that exchange for a very brief period of time. During that brief period of time receivers of the flash order may respond and execute against it if they please. Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). 155 “Rule 602 [of Regulation NMS] generally requires exchanges to make their best bids and offers in U.S.-listed securities available in the consolidated quotation data that is widely disseminated to the public.” Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). 156

An exception ((a)(1)(i)(A)) to Rule 602, however, “excludes bids and offers communicated on an exchange that either are executed immediately after communication or cancelled or withdrawn if not executed immediately after communication.” Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). 157

Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242).

publicly displaying quotes to see orders before other investors . . . .”158

Critics fear that flash orders enable front-running by HFTs.159 The proposed

rule would eliminate the exception, effectively banning flash orders.160

iv. Liquidity Obligations

While the SEC has made no formal proposals, Mary Schapiro, Chairman

of the SEC, has said that the SEC is interested in imposing obligations on

HFTs that act in a market maker role.161 As noted above, even though many

HFTs act as market makers, they are, unlike traditional market makers,

“subject to very little in the way of obligations either to protect that stability

by promoting reasonable price continuity in tough times, or to refrain from

exacerbating price volatility.”162 The SEC “will consider carefully,” according

to Schapiro, “whether [HFT] firms should be subject to an appropriate

158 Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities, Insurance, and

Investment). 159

“[T]he flashing of orders to many market participants creates a risk that recipients of the information could act in ways that disadvantage the flashed order. With today’s sophisticated order handling and execution systems, those market participants with the fastest systems are able to react to information in a shorter time frame than the length of the flash order exposures. As a result, such a participant would be capable of receiving a flashed order and reacting to it before the flashed order, if it did not receive a fill in the flash process, could be executed elsewhere. For example, a recipient of a flash order that was quoting on another exchange would be capable of adjusting its quotes to avoid being hit by the flash order if it subsequently were routed to that exchange. Alternatively, a recipient would be capable of rapidly transmitting orders that would take out trading interest at other exchanges before an unfilled flash order could be routed to those exchanges. In both cases, a flashed order that did not receive an execution in the flash process would also be less likely to receive a quality execution elsewhere.” Elimination of Flash Order Exception From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). However, whether an order will be flashed is a voluntary decision on the part of the order-maker. Those who choose to flash their orders are probably sophisticated enough to consider the extent to which doing so would enable others to act against their interests. Elimination of Flash Order Exception From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242). “Although flashes show the intentions of investors, it’s doubtful most flashed orders are big enough to move markets, disqualifying them from traditional front-running.” Jonathan Spicer, Analysis: Have “Flashes” Spawned Front-Running?, Reuters News (Aug. 7, 2009). “Most mutual funds do not allow their orders to be flashed, primarily because the process of displaying the orders to a select group of market participants could result in information leakage.” Hearings (prepared statement of the Investment Company Institute).160

Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242).161

Mary L. Schapiro, Chairman, Securities and Exchange Comm’n, Remarks Before the Security Traders Ass’n (Sept. 22, 2010).162

Id.

regulatory structure governing key aspects of their market behavior,

including both their quoting and trading strategies.”163 Such obligations

could potentially require HFTs to continue trading in volatile periods, as

market makers must.

V. Conclusion:

Due partly to the current inability of regulators to monitor it effectively,

there is an inadequate understanding of HFT. But it is clear that HFT is not

regulated in proportion to its prevalence in the financial markets or the

attendant stability risks it represents. The newly enacted Dodd/Frank bill will

help impose more effective regulation on HFT. Its focus on financial stability

will most likely result in imposition of trading obligations on HFT, and may

prevent the most manipulative HFT practices. But most importantly, more

robust and comprehensive monitoring of HFT practices in needed; effective

regulation of HFT requires that it be informed by HFT practices and how they

might influence fairness and stability in the markets.

163 Id.

Documents

Economic Regulation, High Frequency Trading, and the Dodd/Frank Act