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High Frequency Trading Regulation

"Earnhardt Moment:" IIT's Ben Van Vliet Discusses AT 9000, A Proposed Quality Management System for Automated Trading

High Frequency Trading Regulation - White Papers

CFTC Interpretive Guidance: Disruptive Trading Practices, May 2013

Disruptive Trading Practices Regulation

High-frequency trading (or "high-speed trading") encompasses a variety of trading strategies, all of which involve a high velocity of portfolio turnover and the need for extremely fast, high-capacity market data feeds and trade matching and quoting engines.

High-frequency trades are executed on electronic algorithmic trading systems at lightning speed. This type of trading occurs when traders position very fast computers as close as possible to the market's computer servers. The proximity minimizes the time it takes for an order to pass through telecom lines. Traders program those computers to analyze and react to incoming market data in fractions of a second. If the trades are done in large enough volume, they can add up to significant profits. It was estimated that as of 2010, high-frequency trading accounted for an estimated 50 to 70 percent of trading.

High-frequency traders make markets in equities, exchange-traded funds, options and futures, providing liquidity to markets. However, they have no obligation to support liquidity in difficult market conditions. The super-fast electronic trading systems allow them to arbitrage between minute pricing differences on trading platforms.

Definition of HFT

At a meeting of the CFTC Technology Advisory Committee meeting on June 20, 2012, a subcommittee working group submitted its draft definition of HFT. According to the subcommittee, high frequency trading is a form of automated trading that employs:

• algorithms for decision making, order initiation, generation, routing, or execution, for each individual transaction without human direction;
• low-latency technology that is designed to minimize response times, including proximity and co-location services;
• high speed connections to markets for order entry; and
• high message rates (orders, quotes or cancellations).

HFT and Exchange Volume

Rosenblatt Securities Inc. estimated in September 2009 that high-frequency traders accounted for 66 percent of the trading volume in the U.S. equity markets but by 2013 the percentage had fallen to about 50 percent.

Though the percentage of volume attributed to HFT has fallen in the equity markets, it has remained prevalent in the futures markets. According to a study in 2010 by Aite Group, about a quarter of major global futures volume came from professional high-frequency traders. In 2012, according to a study by the TABB Group, HFT accounted for more than 60 percent of all futures volume in 2012 on U.S. exchanges.

Regulation

High-frequency trading came under scrutiny in the late summer of 2009 when regulators tried to determine whether this type of trading had too much influence over the markets. Some members of Congress asserted that these types of traders were manipulating prices and "front running" customer orders. Others complained that high-frequency traders have better access to the markets than traditional investors.

Since then, regulators such as the CFTC and SEC in the U.S. and ESMA in Europe have begun to investigate certain HFT tactics such as "spoofing," "flash trading," and "quote stuffing." Quote stuffing, in which large numbers of orders are sent and immediately canceled, has been suspected as one of the reasons behind the May 6, 2010 "Flash Crash."

CFTC staff reviewed the roles of rapid electronic trades in the May 6, 2010 short-term plunge in equity and stock-index futures. At a committee meeting on the matter, CFTC Chairman Gary Gensler, said, "While market participants have the technology to automate trading, we’re really just now moving towards 21st century technology to have automated surveillance looking at trade practices."

CFTC commissioner Bart Chilton has pushed for increased supervision of high-frequency trading. He made a comment in July 2011 in which he referred to high-frequency traders as "financial cheetahs." In response to this comparison, CME Group chairman emeritus Leo Melamed wrote in January 2012 that high-frequency trading was not only in need of regulation, but also protection.

On May 16, 2013, the CFTC approved a final rule that sets out interpretive guidance on disruptive trade practices, which includes practices that violate bids or offers, demonstrate intentional or reckless disregard for orderly execution, or 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 execution).

In 2013, the FBI began investigating whether high-speed trading firms were engaging in insider trading by taking advantage of fast-moving market information unavailable to other investors. The types of trading under scrutiny include quote stuffing and using high-speed trading to conceal that certain transactions are based on an illegal tip. The FBI, which is working with the SEC and other agencies, is also focusing on whether the waves of orders that flood the market from high-frequency firms are being used to manipulate prices to their benefit.

New York Attorney General Eric Schneiderman's office is also investigating whether high speed traders are engaged in what he called "insider trading 2.0."

A study released by the Futures Industry Association in August of 2013 found that there was "no evidence to suggest that realized return volatility in electronically-traded futures markets has changed through time." Volatility had instead remained mostly stable despite increased participation from high-speed and algorithmic traders. The study examined volatility from roughly 2006 to 2011 in 15 futures contracts traded on platforms run by CME Group, Intercontinental Exchange, Eurex, and NYSE Liffe. The exchange operators sponsored the study.

In June 2014, executives from Intercontinental Exchange, Bats Global Markets and TD Ameritrade, among others, were questioned by the Senate's Permanent Subcommittee on Investigations about some of the more controversial aspects of HFT, including rebate fees and payments for order flow. Brad Katsuyama, president and CEO of IEX Group Inc. whose concerns about high speed trading were highlighted in the Michael Lewis book “Flash Boys,” was one of the first witnesses questioned by the senators. They also questioned NYSE Group President Thomas Farley and Bats Global Markets Inc. CEO Joseph Ratterman. The subcommittee's chairman, Sen. Carl Levin (D-Mich), who called the hearing, said retail brokers have conflicts of interest when they accept payments from wholesale brokers to place their trades with them and that conflicts arise under the maker-taker trading model.

In July 2014, Reuters reported that the SEC was investigating Allston Trading LLC; Hudson River Trading LLC; Jump Trading LLC; Latour Trading LLC, (an affiliate of Tower Trading); Merrill Lynch, Pierce, Fenner & Smith, owned by Bank of America Group; Octeg LLC, which has been merged into a unit of KCG Holdings Inc; Tradebot Systems Inc; Two Sigma Investments LLC; Two Sigma Securities LLC; and Virtu Financial.

A number of lawsuits have been brought against various stock exchanges for alleged discrimination involving high-frequency trading. A high-profile attorney named Michael Lewis (no relation to the author) filed a class action lawsuit against 13 stock exchanges for high-frequency trading in May of 2014. The exchanges include the NYSE, BATS, NASDAQ and CBOE. The case, on behalf of Harold Lanier, was filed in the U.S. District Court for the Southern District of New York. It charges that the exchanges sold “advance access” to market data through private feeds and co-location services. In September 2014, three big law firms joined a legal action against major U.S. stock exchanges, claiming the exchanges gave unfair advantages to high-frequency traders to the detriment of regular investors. That lawsuit was also filed in the U.S. District Court of the Southern District of New York. The firms leading the case, Robbins Geller Rudman & Dowd LLP, Motley Rice and Labaton Sucharow LLP, are seeking class-action status. Another lawsuit, against CME Group Inc., alleges that it "engaged in agreements with certain high-frequency trading firms to erode the integrity of the marketplace and manipulate prices."

For more information on HFT regulation, visit the HFT page in MarketsReformWiki.

John Lothian News Interviews

HFT Rules: Three Part HFT Harmony
High frequency trading (HFT) has been in the financial press a lot over the past several years. From the Flash Crash of 2010 to the collapse of Knight Capital in 2012, trading glitches and the negative impact of HFT on markets and investor confidence is well-documented. In this segment of the Restoring Customer Confidence series, Mayer Brown attorney Zachary Ziliak outlines the three sources that will address HFT and help restore customer confidence.

Ziliak says regulatory bodies will likely continue to address HFT guidelines, exchanges are imposing new fees on HFT practices and AT 9000, standards system for HFT practices, will help establish a higher bar for HFT participants. Visit the Restoring Customer Confidence video series page >

HFT Rules: Rules for the Algo Highway
Customer confidence has been hit by a number of different events over the past several years and high frequency trading (HFT) problems have been among them. Ben Van Vliet, assistant professor of finance, Stuart School of Business, Illinois Institute of Technology has been looking the creation of a standard set of rules high frequency trading participants can use to ensure safer markets. Van Vliet has helped initiate the AT 9000 system, which would implement standards for HFT design, backtesting, implementation and portfolio and risk management. Van Vliet says its important that the industry support such a project, rather than wait for regulators to dictate new standards and rules for participants. Visit the Restoring Customer Confidence video series page >

• "Earnhardt Moment:" IIT's Ben Van Vliet Discusses AT 9000, A Proposed Quality Management System for HFT

Other Video

The University of Chicago Booth School of Business hosted a video panel discussion about high frequency trading with Booth faculty members and Stephen Brodsky of Spot Trading.

Are high frequency traders ruining the market?

Stealing High-Frequency Code

In 2009 two financial market participants were arrested for stealing high-frequency trading code. First, Goldman Sachs programmer Sergey Aleynikov was arrested for allegedly stealing proprietary code from the bank’s high-frequency trading platform. Nine months later, Societe Generale trader Samarth Agrawal, was arrested on similar charges that he, too, stole his employer’s source code for software used to make sophisticated, high-speed, high-volume stock and commodities trades.

Aleynivov was convicted in 2010, and sentenced to eight years in prison, but the conviction was overturned by an appeals court in February 2012. The overturned conviction has tested the boundaries of the Economic Espionage Act, which makes it a crime to steal company secrets. The challenge came on grounds that Goldman's HFT code was not "produced for interstate commerce," and thus does not constitute a crime under the act. The State of New York prosecuted Aleynivov for "unlawful use of secret scientific material". This resulted in a conviction on May 4th, 2015.

In May 2012, programmer Bo Zhang plead guilty to stealing software code from the Federal Reserve Bank of New York. Also that month, former Citadel Investment Group engineer Yihao Pu was indicted on charges of stealing HFT code.

In June 2012, Citadel accused HFT firm Jump Trading of stealing some of its trading algorithms. In its court petition, Citadel asked that Jump turn over its algorithms and trading records. Jump called the request "frivolous" and "an effort to win competitive information through the courts." A Cook County Circuit Court judge eventually dismissed Citadel's petition.