William F. Johnson ()
On Wall Street in 1792, 24 stockbrokers stood under a buttonwood tree and negotiated terms for trading stocks and bonds.1 The Buttonwood Agreement memorialized this precursor to the New York Stock Exchange, and set forth early, and very basic, parameters for their trading: The brokers were to deal solely with each other, not auctioneers, and commissions were to be at least .25 percent.2 At that time, the brokers traded with each other by gathering outdoors on Wall Street or at a nearby coffee house and dealing face-to-face.3 The curbside trading of the early Buttonwood brokers contrasts starkly with today’s trading strategies that use algorithms executed by massive computers co-located in trading data facilities to maximize the speed of executing orders. In 1792, neither the telephone or telegraph as we know them had been invented, and horses were not only the primary means of transportation, but also the fastest means of distributing information.4 We now have smartphones, electric cars, and fiber-optic cable that can transmit huge amounts of data around the world in seconds. In the 200+ years since Buttonwood, evolution in the equity market structure has mandated the need for continuous reform and regulation, with recent technology spurring further discussion.
The latest regulatory debate has centered around so-called “high frequency trading” (HFT), an undefined and ambiguously categorized form of trading that relies on powerful computers to conduct large numbers of trades at high speeds. The U.S. Securities and Exchange Commission has commented that HFT is one of the “most significant market structure developments in recent years,”5 and concluded that “[b]y any measure [HFT] is a dominant component of the current market structure and likely to affect nearly all aspects of its performance.”6 As the SEC wades into the regulatory pool (“dark” or “lit”) on HFT, all eyes will be focused on whether subsequent regulations are appropriately and narrowly tailored to promote market stability without limiting the advances that technology has provided for market access and structure.
Although traders have enlisted the assistance of computers for decades, the use of more sophisticated forms of computer algorithms to execute trades at high speeds is a relatively recent phenomenon.7 There are many components of the current market structure that involve elements of computerized trading, including algorithmic trading, HFT generally, “dark pools,” “light pools,” alternative trading systems, electronic communications networks, and flash orders. Although most of these are beyond the scope of this article, they are all a significant part of the current regulatory debate. Indeed, just days ago, New York Attorney General Eric Schneiderman’s office filed a complaint alleging that Barclays Capital engaged in fraud through its operation of a “dark pool,” a type of trading venue that is privately operated and through which many participants conduct trading in today’s markets.8 The New York Attorney General’s allegations focus more on whether Barclays operated its dark pool consistent with representations made to investors and clients, rather than taking issue with the “dark” trading venue itself.
As the prominence of HFT has increased in recent years, the regulators at the SEC have taken note. On May 6, 2010, the Dow Jones Industrial Average plunged 1,000 points in five minutes during an event dubbed the “Flash Crash.” According to a joint SEC/CFTC report following an investigation of the incident, the crash occurred after a mutual fund sold a large number of securities and high frequency traders subsequently bought and sold those same securities at high volume and speed.9 Although some argued that HFT did not play any role in causing or exacerbating that temporary market instability, ultimately the SEC concluded that HFT was at least, in part, to blame.10 In September 2010, then SEC Chair Mary Schapiro reported that HFT accounted for more than 50 percent of the equity market trading volume, and noted the need for “close review” of such trading and eventual regulations to curb it.11
Recent Regulatory Proposals
Current SEC Chair Mary Jo White recently rolled out the SEC’s regulatory agenda regarding market structure and HFT. During a speech in New York on June 5th, her marching orders were clear: Review, change, implement, and regulate. White defended the current market structure as sound, but acknowledged that many market structure rules and industry practices were developed with manual markets in mind. With the prominence of algorithmic trading and its subcategory HFT (which represents a large subset but not all algorithmic and computer-assisted trading), the debate has turned to whether the old rules remain adequate. White said modern technology has “transformed the nature of trading” and as such, must be addressed by a sweeping agenda for reform. White cautioned that the SEC was not out to prohibit algorithmic trading, and accepted the recent increased market share of HFT12 as an inevitable advancement in technology, but she also said the SEC was “assessing the extent to which specific elements of the computer-driven trading environment may be working against investors.” White did state, however, that “[e]mpirical evidence shows that investors are doing better in today’s algorithmic marketplace than they did in the old manual markets,” noting that costs, intraday volatility, and spreads are lower.13
To assess and mitigate the risks associated with HFT, White proposed a number of measures: (1) forming a committee to review proposals for additional oversight of HFT; (2) mandating the registration of high frequency traders as broker dealers; (3) gathering information on dark trading venues or “dark pools;” (4) brainstorming “more flexible, competitive solutions that could be adopted by trading venues” to avoid predictive regulation that attempts to identify an optimal trading speed; (5) reviewing the risk of market instability; (6) requesting development of proposed data feed rule changes by the exchanges; and (7) developing an anti-disruptive trading rule designed to curb the perceived negative aspects of HFT.14 In a nod to the relatively recent past—when specialists on the stock exchange floors had time and place advantages, but also special obligations to maintain market stability—White noted that new rules applicable to electronic trading could well include “affirmative or negative obligations for high-frequency trading firms that employ the fastest, most sophisticated trading tools.”15 Strategic and restrained, White’s data-driven agenda has generally been well-received as a “well-measured, principles-based review of the entirety of the US Equities market.”16 But one of the more controversial provisions is the development of an “anti-disruptive trading rule,” a potential quagmire of definitional parameters that could cloud the regulatory landscape.
Anti-Disruptive Trading Rule
White indicated that the anti-disruptive trading rule would “apply to active proprietary traders in short time periods when liquidity is most vulnerable and the risk of price disruption caused by aggressive, short-term trading strategies is highest.”17 To support this measure, White noted that some HFT firms have been found to have engaged in aggressive, destabilizing trading strategies that are associated with increased price volatility.18 With the market heavily populated by algorithmic and HFT, White appeared concerned with the timing and scale of instability and disruption, which could “simultaneously affect hundreds or thousands of stocks, triggering many trading pauses and reopenings over a short period of time.”19 Technology has changed our measurement of time, and although instability in the market could be easily triggered in manual markets, the time span at issue is now noticeably smaller—fractions of seconds instead of minutes or hours. Ultimately, the SEC wants to avoid market disruptions like the 2010 “Flash Crash” described above. Computerized and HFT allows traders to execute extremely large numbers of trades in a very short time period. This volume-frequency combination was simply not possible with manual trading, so technology has exacerbated the fear of market instability.
The Regulatory Debate
On one hand, the SEC makes a valid point—high frequency and algorithmic trading at least have the potential to work against investors by destabilizing the market and disrupting market conditions. Aggressive HFT could exert costs on other market participants, such as increased adverse selection costs on non-HFT passive traders or transaction costs of retail and even institutional investors.20 Further, HFT defined broadly—without separate assessment of aggressive and passive trading—has been associated with increased intraday volatility.21 The regulatory agenda has always gravitated towards market stability.
On the other hand, there are potential problems with the SEC’s preliminary approach. First, volatility moderators such as “limit up/limit down” and market-wide circuit breakers already exist in the market to control aggressive, destabilizing trades. Although these moderators may not protect against intentionally disruptive trading, such trading is akin to market manipulation that is already prohibited by a host of existing anti-fraud and anti-manipulation laws and regulations. The better approach may be to manage disruptive trading through enforcement of those already well-established laws rather than attempt to graft a new anti-disruptive trading rule on top of them. Second, from a trader’s perspective, speed and technology are known to increase market liquidity and price discovery, so the advances in HFT could be more helpful than disruptive. Regulatory measures focused on speed alone may undermine that advancement. Third, although White’s directive did signal a balancing of interests, the lack of a current consensus on quantifying or defining HFT remains an obstacle to effective regulation. In fact, the SEC’s own Concept Release on Equity Market Structure noted that the term “high frequency trading” was not clearly defined, which “complicate[d] the Commission’s broader review of market structure issues.”22 The Concept Release proposed a definition of proprietary firm, and identified certain characteristics often attributed to HFT, but even these refinements may not necessarily capture the essence of the negative aspects of HFT.23
For the regulation to be effective, prohibited trading strategies and techniques should be specifically identified and supported by examples derived from current market data. And since disruptive market activity can occur with no causal connection to HFT, any anti-disruptive trading rule must apply to all trading, including manual. Last, trading data indicates that the majority of high-frequency activity is attributable to aggressive, liquidity taking orders that trade immediately against passive, resting orders.24 Given this context, it will be challenging for the SEC to appropriately limit its regulation to “short time periods” when “liquidity is most vulnerable” and the risk of “price disruption” caused by “aggressive short-term trading strategies” is highest. Each of those terms is capable of various interpretations, and as technology continues to advance at a rapid pace, a short time period today could be frustratingly long a year from now. Recent history shows that the speed of technology is ever-changing. Further, as one commentator noted, an aspect of the anti-disruptive trading rule that could be difficult to craft and enforce is whether “disruptive” is defined solely as the effect of an algorithm’s output, regardless of intent, or whether the intent of the programmer was to create “disruptive” trading by the operation of that algorithm, which would require proof of bad intent.25
When the Buttonwood brokers formed their pact under a tree on Wall Street in 1792, they could never have anticipated HFT and algorithmic trading, but both are now key components of the current market structure. The debate over how to define HFT, what its effects on the market and investors are, and how it should be regulated will continue. Once regulations are proposed, including an “anti-disruptive trading rule,” the debate will advance further. Because Chair White allowed that any rule would need to be “carefully tailored,” the hope is for a rule that maintains stability while preserving the benefits of technology in the markets.
William F. Johnson is a partner in King & Spalding’s special matters and government investigations practice group. Associate Katherine Kirkpatrick Bos assisted in the preparation of this article.
1. The New York Stock Exchange, Who We Are, http://www.nyx.com/en/who-we-are/history/new-york.
2. SEC Historical Society, The Institution of Experience: Self-Regulatory Organizations in the Securities Industry, http://www.sechistorical.org/museum/galleries/sro/sro02b.php.
4. McCormick, Anita Louise, “The Invention of the Telegraph and Telephone in American History,” (Enslow Publishers 2004). See also Pony Express National Museum, About, http://ponyexpress.org/history/ (describing the historically widespread practice of relying on horses for mail delivery).
5. Equity Market Structure Literature Review Part II: High Frequency Trading, SEC, March 18, 2014, p. 4.
7. Michael J. McGowan, “The Rise of Computerized High Frequency Trading: Use and Controversy,” 9 Duke L. & Tech. Rev. 1-3 (2010), available at http://www.law.duke.edu/journals/dltr/articles/2010dltr016 (noting that, in 2005, few considered high-frequency trading more than a niche strategy).
8. Schneiderman v. Barclays Capital, N.Y.S. No. 451391/2014, available at http://go.bloomberg.com/assets/content/uploads/sites/2/Schneiderman-Barclays-complaint.pdf.
9. Findings Regarding the Market Events of May 6, 2010, Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, Sept. 30, 2010, available at http://www.sec.gov/news/studies/2010/marketevents-report.pdf.
10. Id. But see “Why HFT Did Not Cause the Flash Crash,” Modern Market Initiative, http://modernmarketsinitiative.org/hft-did-not-cause-the-flash-crash/.
11. Mary L. Schapiro, “Strengthening Our Equity Market Structure,” Economic Club of New York, Sept. 7, 2010, available at http://www.sec.gov/news/speech/2010/spch090710mls.htm.
12. See Mary Jo White, “Enhancing Our Equity Market Structure,” Sandler O’Neill & Partners, Global Exchange and Brokerage Conference, June 5, 2014 (noting that algorithmic trading likely constitutes over half the trading volume and continues to increase). See also Mary L. Schapiro, “Strengthening Our Equity Market Structure,” supra note 11 (“[n]ow, nearly all orders are executed by fully automated systems at great speed … .”)
13. Mary Jo White, “Enhancing Our Equity Market Structure,” supra note 12.
16. Market Structure Series (Part I): Current State of Markets and Preventing Market Instability, June 9, 2014, http://modernmarketsinitiative.org/market-structure-series-part-current-state-markets-preventing-market-instability/.
17. Mary Jo White, “Enhancing Our Equity Market Structure,” supra note 12.
20. Equity Market Structure Literature, supra note 5, at p. 10.
22. Concept Release on Equity Market Structure, SEC, 17 CFR Part 242, 46 (2010).
23. Id. at 45. The Concept Release identified the following characteristics attributed to HFT: (1) the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders; (2) use of co-location services and individual data fees offered by exchanges and others to minimize network and other types of latencies; (3) very short time-frames for establishing and liquidating positions; (4) the submission of numerous orders that are cancelled shortly after submission; and (5) ending the trading day in as close to a flat position as possible.
24. Equity Market Structure Literature, supra note 5, p. 9.
25. “What’s SEC’s Next Move on HFT?,” Markets Media, June 13, 2014, http://marketsmedia.com/whats-secs-next-move-high-frequency-trading/.