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High Frequency Trading – insider dealing in disguise?

This blog was written by Bobby Reddy, University Lecturer in Corporate Law at University of Cambridge and fellow of Churchill College, Cambridge.

It is the 18th of June, 1815 – the Battle of Waterloo is approaching its bloody denouement, as employees of Nathan Rothschild prime the super charged horses and carrier pigeons along a conduit of elaborate changeover points and links to convey news from the Battle back to London (1) . Rothschild, himself ensconced at the Stock Exchange in London, receives the news on 19th June, 1815, days ahead of anyone else operating in the market. With this information at hand, Rothschild proceeds to trade in government bonds making a small fortune. 200 years on, was this the first high frequency trade? I have just finished reading the new paperback version of the book “Flash Boys” by Michael Lewis (2) – the origin story for high frequency trading (“HFT”) which paints a somewhat pernicious picture of the industry. Although the account of Rothschild’s success may be slightly apocryphal, by analogy, it brings to mind the initiative of high frequency traders to use technological advances to gain an advantage in the market. The basic premise of HFT is that HFT firms are able to use smart computer-controlled algorithms to analyse market information (in some cases obtained by paid access to banks’ proprietary trading systems) in less than the blink of an eye, and almost instantaneously act upon that information to deal in securities before the rest of the market (and price) is able to catch-up; essentially jumping ahead and front-running other investors’ orders. The prosecution of Navinder Sarao in West London in relation to, amongst other things, the 2010 Dow Jones Industrial Average “flash crash” has been widely reported, highlighting that the authorities are now focused on tackling high frequency trading. Equally, law makers on both sides of the Atlantic are putting in place rules to regulate HFT firms – for example, the SEC has proposed new rules to require HFT firms to register with the Financial Industry Regulatory Authority (3) , and the EU will be implementing the MiFID II Directive (4) and the Markets in Financial Instruments Regulation (5) (both of which will come into effect in January 2017) requiring HFT firms to be authorised and prohibiting the sending of erroneous orders or functioning in a way that may create or contribute to a disorderly market. To a certain extent, taking the analogy further, one of Rothschild’s horses has bolted before the exchange has closed the stable door. In any case, though, such regulations are welcome to combat some of the more egregious elements of HFT; but do they go far enough? To what extent does HFT below the level of market abuse require further regulation, and should the authorities, instead, be looking at ways to limit the advantages of, or even prohibit, HFT firms? Abstractly, the technological advantage possessed by HFT firms involves the HFT firm dealing in securities on the basis of information that is not, in that very microsecond, available to the wider market. The book Flash Boys alleges that HFT firms have been involved in the past in making a false market in securities by, for example, entering into orders that are cancelled within microseconds purely for the purpose of manipulating the market – this is clearly market abuse. However, even below this level of nefariousness, the very fact that HFT firms habitually possess information in relation to the trading of securities not widely available to the rest of the market smacks of unfairness at best; and at worst, is this insider dealing? We are now seeing how the rapid advance of technology is outpacing regulation. The law was not crafted envisaging an environment where information flow would be valued on the basis of microseconds. Simplifying the notion, “inside information” is information that is not yet publicly known and which would affect the price of the securities if it were made public. At what stage is that information “public” – technically, the information that HFT firms are using is “public” in that it has been released by the exchanges, but the HFT firms are, as was Rothschild, more adept at hearing about, and acting upon, such information quicker than anyone else. Taken to its logical conclusion, it would set a difficult precedent from a conceptual perspective to characterise as insider dealing the use of technology to be better informed; but from a fairness perspective, should legislation be put in place to either discourage HFT or create a level playing field? There may be certain benefits of HFT such as increased liquidity, reduced volatility, price discovery and reduced transaction costs (6), but the inequity of the situation must outweigh such purported benefits. Various proposals have been put forth, and, in some jurisdictions, implemented. One sledgehammer to crack this particular nut is a financial transaction tax (“FTT”). However, FTT is part of a much broader discussion with intentions (and implications) beyond just HFT. As ever, though, public (and investor) opinion is driving the markets to innovate practical solutions. Two new securities forums have recently been established – IEX, an alternative trading system in New Jersey, and Aequitas Neo, a regulated exchange which recently opened for trading in Toronto. Both incorporate “speed bumps” in the electronic information flow which make it impossible for traders using IEX or trading in securities on Aequitas Neo to trade ahead of other investors using those exchanges and ahead of the markets catching-up. Aequitas means “fairness” in Latin. If the implication of this name is that the rest of the industry is unfair, it must be time, to restore the credibility of the markets, for all regulated markets to incorporate mechanics to eliminate the advantage conferred to HFT firms. (1) Speech by Martin Wheatley, CEO, the FCA, at the Global Exchange and Brokerage Conference, New York – “Regulating high frequency trading” published on the FCA website on 4 June, 2014 (2)  Flash Boys, Cracking the Money Code by Michael Lewis (published by Penguin Books, 2015) (3)  SEC Press Release 2015-48 on 25 March, 2015 – “SEC Proposes Rule to Require Broker-Dealers Active in Off-Exchange Market to Become Members of National Securities Association” (4) 2014/65/EU (5) Regulation 600/2014 (6) These benefits were outlined in the Foresight Report into the Future of Computer Trading in Financial Markets published by the Government Office for Science on 23 October 2012

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