In the fallout from Michael Lewis’s new book “Flash Boys: A Wall Street Revolt,” many in the financial industry have grown concerned that some aspects of high-frequency trading might be illegal. Last week, Attorney General Eric Holder Jr. told the House Appropriations Subcommittee on Commerce, Justice, Science and Related Agencies that the Department of Justice was investigating the practice to determine whether it violates insider trading laws.
“The Department is committed to ensuring the integrity of our financial markets—and we are determined to follow this investigation wherever the facts and the law may lead.” he told the committee.
Holder is not the first to suggest that some aspects of high-frequency trading are akin to insider trading. Back in September 2013, New York State Attorney General Eric Schneiderman raised the issue at the Bloomberg Markets 50 Summit.
“Small but powerful groups within the market are able to use soon-to-be-public information combined with high-frequency trading in a way that distorts our markets far more than Albert Wiggin or Ivan Bosky or even Gordon Gekko could ever have imagined,” he said. “And this combination of high-frequency trading with access to nonpublic information with a tiny sliver of advanced notice is what we call Insider Trading 2.0 in my office.”
However, as Peter Henning writes in his White Collar Watch column for the New York Times this week, it is very difficult to fit high-frequency trading into any of the boxes traditionally used to categorize different types of securities fraud, which could make it very difficult to regulate or police.
One method often used by high-frequency trading firms is paying stock exchanges for swifter access to information about the flow of orders so that they can use that information to attempt to predict the direction of the market. On the face of it, this looks a lot like insider trading; the firms are using information not available to others to trade profitably.
However, Henning explains that in all likelihood, high-frequency trading firms fall outside the ban on insider trading under its current definition, because their actions do not constitute a breach of fiduciary duty. If they are using information for which they have legitimately paid stock exchanges, then there’s no violation.
It’s also unlikely that most high-frequency traders are violating the Financial Industry Regulatory Authority’s rule prohibiting brokers from trading ahead of their clients. If the firms are only trading for their own accounts and not on behalf of clients, then this rule doesn’t apply, Henning writes.
High-frequency traders also do something that closely resembles “spoofing”; they send out multiple orders into the market to try to determine the direction of a stock. Estimates suggest more than 90 percent of these are subsequently canceled, Henning reports.
However, according to Henning, to prove market manipulation the government must prove intent to artificially affect stock prices or to defraud others. Neither of these are the goal for high-frequency traders.
Henning believes when it comes to addressing high-frequency trading, criminal law is not the best mechanism for doing so.
“The question is how to restore at least the perception of fairness in the markets without undermining what the firms argue are the benefits brought by high-frequency trading—increased liquidity and narrower spreads between the bid and ask prices,” Henning writes. “Investors often lose out on the best possible price, but at the same time may be getting better prices than they would have without this type of trading.”