John Sanders*

On the afternoon of May 6, 2010, the Dow Jones Industrial Index (“Dow”), perhaps the most widely followed stock index in the world, fell 1,000 points in a matter of minutes.[1] As the fall quickened, “the sell-off seemed to overwhelm computer and human systems alike.”[2] Shares of Procter & Gamble fell nearly 40 percent without explanation.[3] Some broad-based index Exchange-Traded Funds (“ETFs”) briefly traded for a penny a share and others traded for ten cents a share.[4] Then, the stock index and individual stock values largely recovered.[5] The Dow ended the day at 4:00 p.m. down just 347.8 points.[6] Theories as to what caused the incredible event that would come to be known as the “Flash Crash” were varied.[7] Following the Flash Crash, many agencies, financial experts, and political activists examined the practices of high-frequency traders that may have caused or exacerbated the event.[8] Soon after the Flash Crash, the U.S. Securities and Exchange Commission (“SEC”) and the U.S. Commodities Futures Trading Commission (“CFTC”) jointly investigated the activities of high-frequency traders and co-authored a report.[9] In 2014, Michael Lewis’ book Flash Boys, a best seller, argued that the stock market was “rigged” by high-frequency traders.[10] More recently, Hillary Clinton offered a curious proposal to regulate high-frequency traders as part of her presidential campaign.[11]

Much of the attention given to high-frequency trading since the Flash Crash has related to sensational claims about rigged markets.[12] However, a more thoughtful examination reveals that the place high-frequency trading occupies in our market structure was a result of purposeful government action to make markets more fair and less expensive.[13] The world’s most sophisticated money managers believe that those benefits have been realized.[14] While abuses certainly must be checked, any regulation of high-frequency traders must strive to retain those benefits.

It is possible to take action against abusive high-frequency traders without losing the benefits of their activity. In fact, this article argues that there are two potent and readily available tools for limiting the excesses of high-frequency traders. Each of these tools is already at the disposal of the SEC through the 1934 Exchange Act (the “Exchange Act”).[15] This low-hanging fruit should be picked immediately to curb the abuses of high-frequency trading while retaining its benefits.

Limit Order Types

One proposal for checking the abuses of high-frequency traders is to reduce or eliminate the order types that are available to them. Special order types have proliferated along with the spread of high-frequency trading.[16] In the late 1990s, the exchanges realized “they had to cater to . . . the firms that filled their pools with liquidity”.[17] High-frequency traders took advantage of the situation by asking for special order types that would give them an advantage over competing traders.[18] Over the next several decades, they “worked hand in hand with the [exchanges] to create exotic order types.”[19]

The special order types created by exchanges in response to high-frequency trader demands are so numerous and complex that the Royal Bank of Canada (“RBC”) hired a special team of puzzle-solvers to work through them.[20] The RBC team estimated that there were around 150 order types available to high-frequency traders.[21] However, high-frequency traders often combine order types, meaning there are thousands of possible combinations.[22]

Not only are the special order types numerous, they are “fiendishly complex”.[23] For example, the “hide-not-slide” order will hide, unseen by other market participants, until the conditions are exactly as expressed in the order.[24] Those who have waited in the queue visible to the public are shocked when the previously hidden trader snaps up shares they have waited for patiently. This specially-designed order type and others like it violate the basic rule that “the first investor to place an order at the best current price generally should be the one whose order is filled first.”[25]

The advantage created by special order types might be stifled, at least in part, if all professionals understood them. However, it is clear that few people do. While there are countless order types now in existence, the Financial Industry Regulatory Authority (“FINRA”) only tests brokers on three order types and a handful of basic qualifiers as part of Series 7 licensing.[26] The disparity leaves retail investors wholly unprotected from high-frequency traders.

The SEC is reviewing the process by which all order types are developed, approved, and monitored.[27] However, a case-by-case evaluation may lead to a new breed of even more vexatious order types.[28] The more certain solution is to take away the entire field of order types as a space in which high-frequency traders can gain an advantage in the market. Perhaps counterintuitively, the fastest way to bring about a sweeping change that limits high-frequency traders may be to bring a successful enforcement action against an exchange that collaborates with them by allowing special order types.

Rulemaking by enforcement is a legitimate way for the SEC to bring about the change so long as the SEC brings the action under an existing statute.[29] 15 U.S.C. 78f(b)(5) provides a firm basis for this course of action.[30] That provision of the Exchange Act requires national securities exchanges to establish rules that “protect investors and the public interest” and “are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers.”[31] Where exchanges have aided in the systematic abuse of ordinary investors and their representatives through the creation of complex order types, the SEC is within the letter and spirit of the law to bring an action.[32]

Regulate Colocation

A second proposal to eliminate unfair advantages enjoyed by high-frequency traders is to tighten the regulation of colocation. Colocation “refers to the practice of setting up your trading computers in the same physical building as the exchange’s computers, to get a time advantage over your competitors.”[33] In recent years, “exchanges and other market centers have opened new data centers or expanded existing ones to offer colocation services” to high-frequency traders.[34] Despite the fact that it has been integrated into the market structure for years, colocation came under scathing criticism after the Flash Crash.[35]

Industry insiders explained their views on colocation in a pivotal Senate hearing in 2009. In that hearing, Credit Suisse’s head of U.S. equity trading Daniel Mathisson described the many ways in which traders have sought speed advantages.[36] Colocation is simply the latest step in an evolutionary chain, he argued.[37] This is a position with a great deal of historical support.[38] Others went further by arguing that colocation offers cost advantages to investors.[39] Retail investors can collect these benefits by simply “selecting a technology-savvy broker-dealer to transact on their behalf.”[40] Though, consensus built around the view of colocation as a neutral or positive phenomenon concerns remained over whether the oversight of colocation was fair and transparent.[41]

The key to effectively regulating colocation is the SEC’s authority over the exchanges. The exchanges, under Section 19 of the Exchange Act, are self-regulatory bodies that report to the SEC.[42] Traditionally, the SEC has allowed exchanges to “police themselves with respect to ensuring that trading takes place fairly and honestly.”[43] However, the SEC can use its power as the regulator of the exchanges to oversee rulemaking or bring enforcement actions.[44]

The SEC’s early actions indicated that the regulation of colocation “should start from a productive vantage point that, when well regulated, high-frequency trading and technology are generally healthy and positive.”[45] Still, the SEC stated that the “[p]rinciples of fair access and transparency must be applied.”[46] SEC efforts to police colocation were met with general cooperation from the exchanges.[47] However, where cooperation has not been sufficient, the SEC has used enforcement actions to compel exchanges to write and follow fair and transparent colocation rules.

In May 2014, the SEC brought an enforcement action against the New York Stock Exchange (“NYSE”) and two affiliated exchanges under Sections 19(b) and 19(g) of the Exchange Act.[48] The SEC found that the “NYSE provided co-location services to customers on disparate contractual terms without an exchange rule in effect that permitted and governed the provision of such services on a fair and equitable basis.”[49] The subsequent multi-million dollar settlement indicated that the SEC took unfair colocation practices seriously.[50] The SEC should continue to reinforce that message.

Conclusion

It has been said that the introduction of high-frequency traders helped create “the most leveled playing field ever” in the securities market.[51] While high-frequency trading is generally good for investors, there is evidence that high-frequency traders have begun to abuse their position in the market structure.[52] Whenever high-frequency traders abuse their position, the SEC should act forcefully in order to preserve market integrity. It can begin by implementing the proposals set forth in this article.

—–

* J.D. Candidate, 2016, Wake Forest University School of Law.

[1].   Graham Bowley, U.S. Markets Plunge, Then Stage a Rebound, N.Y. Times (May 6, 2010), http://www.nytimes.com/2010/05/07/business/07markets
.html.

[2].   Id.

[3].   Stock Selloff May Have Been Triggered by a Trader Error, CNBC (May 6, 2010), http://www.cnbc.com/id/36999483.

[4].   Sheryl Nance-Nash, ETF Lessons From the May 6 Flash Crash, Daily Finance (May 20, 2010), http://www.dailyfinance.com/2010/05/20/etf-lessons-may-6-flash-crash/.

[5].   Bowley, supra note 1.

[6].   Id.

[7].   Stock Selloff May Have Been Triggered by a Trader Error, supra note 3 (offering a trade error, unusual trading in futures contracts, and the specter of a Greek debt default as possible causes).

[8].   SIFMA, High Frequency Trading: Post-Flash Crash Studies Matrix (2013) (setting out a list and synopsis of fifty-three published studies on high- frequency trading after the May 6, 2010 Flash Crash); see, e.g., Jonathan Ahlstedt & Johan Villysson, High Frequency Trading (2012); Jonathan Brogaard et al., High-Frequency Trading and Price Discovery, 27 Rev. Fin. Stud. 2267 (2014). See generally John I. Sanders, Spoofing: A Proposal for Normalizing Divergent Securities and Commodities Futures Regimes, 51 Wake Forest L. Rev. (forthcoming 2016).

[9].   CFTC & SEC, Findings Regarding the Market Events of May 6, 2010, at 1–7 (2010), http://www.sec.gov/news/studies/2010/marketevents-report.pdf.

[10].    Michael Lewis, Flash Boys (2014). Lewis is inclined to hyperbole and misstatements of law and regulation. For example, the practices of high-frequency traders that Lewis describes are not actually within the definition of “front-running” as it is currently used in Financial Industry Regulatory Authority (“FINRA”) Rule 5270 because the information used is obtained through public data feeds from the exchanges, not “material, non-public market information.” Misuse of a charged term like “front-running” is one reason Lewis’ book has been so controversial and profitable.

[11].   John I. Sanders, Hillary Clinton’s High-Frequency Trading Mistake, Huffington Post (Oct. 9, 2015, 10:00 AM), http://www.huffingtonpost.com/john-i-sanders/hillary-clintons-highfreq_b_8269350.html.

[12].   See generally Lewis, supra note 10.

[13].   See generally Scott Patterson, Dark Pool: The Rise of the Machine Traders and the Rigging of the U.S. Stock Market (2012).

[14].   Phil Albinus, The HFT Believer: Mark Gorton of Tower Research, Traders Magazine (Feb. 25, 2015), http://www.tradersmagazine.com/news/people/the-hft-believer-mark-gorton-defends-hft-113515-1.html; Nina Mehta, SEC Second Guesses Trading Crusade as Market Makers Disappear, Bloomberg (Sept. 13, 2010, 7:01 PM), http://www.bloomberg.com/news/articles/2010-09-13/sec-second-guesses-its-stock-trading-crusade-as-u-s-market-makers-vanish.

[15].   Securities Exchange Act of 1934, 15 U.S.C. §§ 78b, 78i, 78j (2012).

[16].   See Lewis, supra note 10, at 169.

[17].   Patterson, supra note 13, at 205.

[18].   Id.

[19].   Id.

[20].   Lewis, supra note 10, at 169–70.

[21].   Id.

[22].   Id. at 170.

[23].   Patterson, supra note 13, at 50.

[24].   Scott Patterson & Jenny Strasburg, How ‘Hide not Slide’ Orders Work, Wall St. J. (Sept. 18, 2012, 10:40 PM), http://www.wsj.com/articles/SB10000872396390444812704577605840263150860.

[25].   Id.

[26].   Series 7, Investopedia, http://www.investopedia.com/exam-guide/series-7/securities-transactions/types-orders.asp (last visited Apr. 15, 2016).

[27].   Laurie Carver, Exchange Order Types Prompt Fears of HFT Conspiracy, Risk Magazine (Apr. 23, 2013), http://www.risk.net/risk-magazine/feature/2261626/exchange-order-types-prompt-fears-of-hft-conspiracy.

[28].   Mehta, supra note 14.

[29].   See NLRB v. Bell Aerospace Co., 416 U.S. 267, 294 (1974) (holding that the decision of whether to act by adjudication or rulemaking lies in the first instance with the agency empowered by the enabling statute).

[30].   15 U.S.C. § 78f(b)(5) (2012).

[31].   Id.

[32].   For the “spirit” of the federal securities laws, refer to the works of former SEC Chairman and U.S. Supreme Court Chief Justice Douglas. Douglas wrote that the idea of federal securities laws was that, “Government would keep the shotgun, so to speak, behind the door, loaded, well oiled, cleaned, ready for use, but with the hope it would never have to be used.” William Douglas, Democracy and Finance 82 (J. Allen ed. 1940).

[33].   Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues: Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Comm. on Banking, Hous., and Urban Affairs, 111th Cong. 67 (2009) (statement of Daniel Mathisson) [hereinafter Mathisson Testimony].

[34].   Ivy Schmerken, High-Frequency Trading Shops Play the Colocation Game, Wall Street & Technology (Sept. 29, 2009, 11:30 AM), http://www.wallstreetandtech.com/trading-technology/high-frequency-trading-shops-play-the-colocation-game/d/d-id/1262506.

[35].   Opening Statement By Senator John McCain at the PSI Hearing on High-Frequency Trading, McCain.Senate.Gov (June 17, 2014), http://www.mccain.senate.gov/public/index.cfm/2014/6/opening-statement-by-senator-john-mccain-at-the-psi-hearing-on-high-frequency-trading.

[36].   See Mathisson Testimony, supra note 33, at 68–69.

[37].   See id. at 70–71.

[38]. See, e.g., Jerry W. Markham, High-Speed Trading on Stock and Commodity Markets—From Courier Pigeons to Computers, 52 San Diego L. Rev. 555, 578 (2015).

[39].   Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues: Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Comm. on Banking, Hous., and Urban Affairs, 111th Cong. 97 (2009) (statement of Larry Leibowitz).

[40].   Mathisson Testimony, supra note 33, at 71.

[41].   Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues: Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Comm. on Banking, Hous., and Urban Affairs, 111th Cong. 2 (2009) (statement of chairman Jack Reed).

[42].   15 U.S.C. § 78s (2012).

[43].   Jonathan R. Macey & Maureen O’Hara, From Markets to Venues: Securities Regulation in an Evolving World, 58 Stan. L. Rev. 563, 585 (2005).

[44].   See NLRB v. Bell Aerospace Co., 416 U.S. 267, 294 (1974) (holding that the decision of whether to act by litigation or rulemaking lies in the first instance with the agency empowered by the enabling statute).

[45].   Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues: Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Comm. on Banking, Hous., and Urban Affairs, 111th Cong. 11 (2009) (statement of William O’Brien).

[46].   Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues: Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Comm. on Banking, Hous., and Urban Affairs, 111th Cong. 17 (2009) (statement of Robert Gasser).

[47].   See SEC Issues Concept Release on Equity Market Structure, DavisPolk (Jan. 19, 2010), http://www.davispolk.com/SEC-Issues-Concept-Release-on-Equity-Market-Structure-01-19-2010/.

[48].   SEC Charges NYSE, NYSE ARCA, and NYSE MKT for Repeated Failures to Operate in Accordance With Exchange Rules, SEC (May 1, 2014), http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370541706507#.VNldqC53HfY.

[49].   Id.

[50].   Id.

[51].   Albinus, supra note 14.

[52].   See generally John I. Sanders, Spoofing: A Proposal for Normalizing Divergent Securities and Commodities Futures Regimes, 51 Wake Forest L. Rev. (forthcoming 2016); Lin Tong, A Blessing or a Curse? The Impact of High Frequency Trading on Institutional Investors, Eur. Fin. Ass’n Ann. Meetings 2014 Paper Series, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2330053 (describing attempts by high-frequency traders to capture profits on price through order anticipation as well as bid-ask spreads).

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