Interesting article:
http://www.valuewalk.com/2017/06/high-frequency-traders/
Are High Frequency Traders Violators Of Securities Fraud?
By Mark Melin on June 9, 2017 12:41 pm in Business
High frequency traders (HFTs) are escaping the law and should be the target of increased regulatory enforcement actions, a paper released by Decimus Capital Markets analyst and HFT critic Stanislav Dolgopolov stated. If regulators won’t enforce rules on high frequency traders, specifically related to trading venues allowing HFTs the ability to create “hidden” order types, he encourages private firms to take legal action, outlining how it can be done in a citation-laden 45-page document that is soon to be published in the William & Mary Business Law Review. Sources close to high frequency traders, meanwhile, say their tactics have led to the lowest cost and most liquidity in market history and that no danger to market structure exists.
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Ray Dalio
High Frequency Traders
By Banco Carregosa (Own work) [Public domain], via Wikimedia Commons
Large high frequency traders have escaped enforcement, says HFT analyst
Dolgopolov takes to task securities regulators who he says have generally allowed trading venues to create order types that are not known or explained to all market participants. He says that HFTs “need to be evaluated as potential targets in enforcement actions” for engaging in “securities fraud.” If regulators won’t take action on what he considers offending behavior, private lawsuits should be filed that cite the federal antifraud prohibitions.
Specifically pointing to Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and the corresponding Rule 10b-5 in SEC regulations, he expresses “surprise” that actions have not been taken against high frequency traders.
While acknowledging an “outlier” action filed against Chicago-based Citadel and noted Department of Justice prosecution in the Coscia HFT derivatives market spoofing incident that generated an attention grabbing prison sentence, Dolgopolov claims the equity side the business has been weak on large market participants.
“Interestingly, while the doctrine of market manipulation as a form of securities fraud has a broad reach, this charge is essentially missing, at least in securities markets, for larger players in the HFT segment, as opposed to the typical scenario of a “point-and-click” trader often aided by some automated tool,” he wrote. “HFTs have been largely absent from the ranks of parties held liable for securities fraud, despite being referenced under such monikers as ‘Trading Firm A’ and ‘Trading Firm B’ in some prominent enforcement actions against other parties,” with several court documents cited.
Dolgopolov, who has business ties with well-known high frequency trading analyst and whistleblower Haim Bodek, claims that speed is no longer the key point of differentiation “as limits have been reached.” What provides differentiation between winners and losers is rather the ability of HFTs to create order types that other market participants might not recognize.
What is the difference between unfair, illegal and market destabilizing high frequency traders?
The report says trading venues have created significant complexity that offers HFTs “unintended as well as deliberate informational advantages.”
But is this unfair or illegal? The report points out that while market participants might experience an “adverse effect of certain trading strategies,” such impacts in “the zero-sum game of short-term trading does not automatically equate to fraudulent conduct.” Unfair is not always illegal when it comes to high frequency traders
This is where quandary and nuance exists, Dolgopolov points out:
"Unfair” does not necessarily translate to illegal. In fact, the defining feature of the order type controversy is the existence of informational asymmetries combined with selective disclosure by trading venues to preferred market participants, as opposed to just disparities in market participants’ respective abilities to utilize certain order types. HFTs have not been just “better” at communicating with trading venues in a manner available to every interested market participant and investing time and effort to study the relevant documentation. In fact, individual firms have played a direct role in crafting specific order types. As this process has been described from a trading venue’s perspective, “We created all these different order types to accommodate how [some market participants] wanted to trade. We tweaked how the order would interact with our book according to what they wanted. A lot of the unique orders were created at the request of a customer, typically a high-frequency customer.”
Another significant issue is the intentional and unintentional complexity surrounding the strategies:
The problem of complexity is compounded by the very process of describing trading rules to regulatory agencies—for instance, in the process of regulatory review and approval—and market participants themselves: A significant challenge for regulators (and those trading on exchanges) is that the documentation and marketing material given to them is often imprecise. It is commonly expressed in English prose, an obviously deficient way to communicate complicated mathematical objects. English descriptions of algorithms lead to ambiguity and open up opportunities for ‘liberal’ interpretations. Indeed, the very existence of such gray areas creates some room for both unintended and deliberate informational advantages.
Dolgopolov says that if regulators won’t take action, private firms should. But there is a problem:
If anything, the availability of a private right of action to catch HFTs is critical, as securities exchanges, an important category of gatekeepers, are often sheltered from private lawsuits alleging securities fraud as self-regulatory organizations (“SROs”) by the doctrine of regulatory immunity. Moreover, other types of players are not immune in this area.
The problem extends past immunity, but rather documenting a state of mind in an algorithm:
The doctrine of market manipulation is not necessarily easy to apply to new practices, although some modern iterations of manipulative trading fit the traditional pattern. For instance, the much-discussed practices of “spoofing” and “layering” have been classified as manipulative in legal actions with at least some connection to HFT, but such instances seem to be confined to the futures and commodities space.
An important question is why HFTs have not become an important target in litigation centered on securities fraud. A potential answer lies in difficulties with demonstrating the state of mind, intent, tit-for-tat / conspiracy-like arrangements with trading venues, and knowledge of the inadequacy of formal disclosure, including specific communications that amount to a smoking gun. Furthermore, many practices in question are solely conduct-based and do not involve specific public statements. Overall, showing the intent of using the functionality in question to utilize discrepancies between documented and actual features is a high bar, although uncovering an abusive algorithm could serve as solid evidence. Of course, a threat of private litigation is not the only deterrent—and not necessarily the most effective one, and this factor stresses the significance of market reform. Also, not all problematic trading practices could pass the hurdle of being characterized as fraudulent, as illustrated by the SEC’s focus on creating regulatory restraints on disruptive trading rather than using the existing legal tools.Similarly, as a bird’s eye view of the SEC’s recent enforcement program, the regulators have often preferred identifying technical violations, as opposed to asserting the existence of deliberate wrongdoing in the form of securities fraud, and employed a cautionary approach of targeting trading venues alone instead of specific market participants.
As regulators look at the current HFT regime, which has ushered in some of the lowest trading costs in the history of modern markets, an overriding question echoes: Is the behavior market destabilizing? If that answer is a conclusive “yes,” regulators would likely take quick action, sources have said. With many institutional investors voting with their execution budgets to stick with dark pools and alternative trading venues, the question of just how dangerous HFT is to market stability lingers.
Read the entire report: Dolgopolov, Stanislav, Securities Fraud Embedded in the Market Structure Crisis: High-Frequency Traders as Primary Violators (June 3, 2017). William & Mary Business Law Review (Forthcoming). Available at SSRN: https://ssrn.com/abstract=2980136
http://www.valuewalk.com/2017/06/high-frequency-traders/
Are High Frequency Traders Violators Of Securities Fraud?
By Mark Melin on June 9, 2017 12:41 pm in Business
High frequency traders (HFTs) are escaping the law and should be the target of increased regulatory enforcement actions, a paper released by Decimus Capital Markets analyst and HFT critic Stanislav Dolgopolov stated. If regulators won’t enforce rules on high frequency traders, specifically related to trading venues allowing HFTs the ability to create “hidden” order types, he encourages private firms to take legal action, outlining how it can be done in a citation-laden 45-page document that is soon to be published in the William & Mary Business Law Review. Sources close to high frequency traders, meanwhile, say their tactics have led to the lowest cost and most liquidity in market history and that no danger to market structure exists.
Get The Full Ray Dalio Series in PDF
Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.
We respect your email privacy
Ray Dalio
High Frequency Traders
By Banco Carregosa (Own work) [Public domain], via Wikimedia Commons
Large high frequency traders have escaped enforcement, says HFT analyst
Dolgopolov takes to task securities regulators who he says have generally allowed trading venues to create order types that are not known or explained to all market participants. He says that HFTs “need to be evaluated as potential targets in enforcement actions” for engaging in “securities fraud.” If regulators won’t take action on what he considers offending behavior, private lawsuits should be filed that cite the federal antifraud prohibitions.
Specifically pointing to Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and the corresponding Rule 10b-5 in SEC regulations, he expresses “surprise” that actions have not been taken against high frequency traders.
While acknowledging an “outlier” action filed against Chicago-based Citadel and noted Department of Justice prosecution in the Coscia HFT derivatives market spoofing incident that generated an attention grabbing prison sentence, Dolgopolov claims the equity side the business has been weak on large market participants.
“Interestingly, while the doctrine of market manipulation as a form of securities fraud has a broad reach, this charge is essentially missing, at least in securities markets, for larger players in the HFT segment, as opposed to the typical scenario of a “point-and-click” trader often aided by some automated tool,” he wrote. “HFTs have been largely absent from the ranks of parties held liable for securities fraud, despite being referenced under such monikers as ‘Trading Firm A’ and ‘Trading Firm B’ in some prominent enforcement actions against other parties,” with several court documents cited.
Dolgopolov, who has business ties with well-known high frequency trading analyst and whistleblower Haim Bodek, claims that speed is no longer the key point of differentiation “as limits have been reached.” What provides differentiation between winners and losers is rather the ability of HFTs to create order types that other market participants might not recognize.
What is the difference between unfair, illegal and market destabilizing high frequency traders?
The report says trading venues have created significant complexity that offers HFTs “unintended as well as deliberate informational advantages.”
But is this unfair or illegal? The report points out that while market participants might experience an “adverse effect of certain trading strategies,” such impacts in “the zero-sum game of short-term trading does not automatically equate to fraudulent conduct.” Unfair is not always illegal when it comes to high frequency traders
This is where quandary and nuance exists, Dolgopolov points out:
"Unfair” does not necessarily translate to illegal. In fact, the defining feature of the order type controversy is the existence of informational asymmetries combined with selective disclosure by trading venues to preferred market participants, as opposed to just disparities in market participants’ respective abilities to utilize certain order types. HFTs have not been just “better” at communicating with trading venues in a manner available to every interested market participant and investing time and effort to study the relevant documentation. In fact, individual firms have played a direct role in crafting specific order types. As this process has been described from a trading venue’s perspective, “We created all these different order types to accommodate how [some market participants] wanted to trade. We tweaked how the order would interact with our book according to what they wanted. A lot of the unique orders were created at the request of a customer, typically a high-frequency customer.”
Another significant issue is the intentional and unintentional complexity surrounding the strategies:
The problem of complexity is compounded by the very process of describing trading rules to regulatory agencies—for instance, in the process of regulatory review and approval—and market participants themselves: A significant challenge for regulators (and those trading on exchanges) is that the documentation and marketing material given to them is often imprecise. It is commonly expressed in English prose, an obviously deficient way to communicate complicated mathematical objects. English descriptions of algorithms lead to ambiguity and open up opportunities for ‘liberal’ interpretations. Indeed, the very existence of such gray areas creates some room for both unintended and deliberate informational advantages.
Dolgopolov says that if regulators won’t take action, private firms should. But there is a problem:
If anything, the availability of a private right of action to catch HFTs is critical, as securities exchanges, an important category of gatekeepers, are often sheltered from private lawsuits alleging securities fraud as self-regulatory organizations (“SROs”) by the doctrine of regulatory immunity. Moreover, other types of players are not immune in this area.
The problem extends past immunity, but rather documenting a state of mind in an algorithm:
The doctrine of market manipulation is not necessarily easy to apply to new practices, although some modern iterations of manipulative trading fit the traditional pattern. For instance, the much-discussed practices of “spoofing” and “layering” have been classified as manipulative in legal actions with at least some connection to HFT, but such instances seem to be confined to the futures and commodities space.
An important question is why HFTs have not become an important target in litigation centered on securities fraud. A potential answer lies in difficulties with demonstrating the state of mind, intent, tit-for-tat / conspiracy-like arrangements with trading venues, and knowledge of the inadequacy of formal disclosure, including specific communications that amount to a smoking gun. Furthermore, many practices in question are solely conduct-based and do not involve specific public statements. Overall, showing the intent of using the functionality in question to utilize discrepancies between documented and actual features is a high bar, although uncovering an abusive algorithm could serve as solid evidence. Of course, a threat of private litigation is not the only deterrent—and not necessarily the most effective one, and this factor stresses the significance of market reform. Also, not all problematic trading practices could pass the hurdle of being characterized as fraudulent, as illustrated by the SEC’s focus on creating regulatory restraints on disruptive trading rather than using the existing legal tools.Similarly, as a bird’s eye view of the SEC’s recent enforcement program, the regulators have often preferred identifying technical violations, as opposed to asserting the existence of deliberate wrongdoing in the form of securities fraud, and employed a cautionary approach of targeting trading venues alone instead of specific market participants.
As regulators look at the current HFT regime, which has ushered in some of the lowest trading costs in the history of modern markets, an overriding question echoes: Is the behavior market destabilizing? If that answer is a conclusive “yes,” regulators would likely take quick action, sources have said. With many institutional investors voting with their execution budgets to stick with dark pools and alternative trading venues, the question of just how dangerous HFT is to market stability lingers.
Read the entire report: Dolgopolov, Stanislav, Securities Fraud Embedded in the Market Structure Crisis: High-Frequency Traders as Primary Violators (June 3, 2017). William & Mary Business Law Review (Forthcoming). Available at SSRN: https://ssrn.com/abstract=2980136
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