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Bates Research  |  05-01-15

HFTs Create New Risks for BDs

Last week, we discussed the new allegations brought by the DOJ and CFTC against a UK trader for alleged market manipulation. This week, we've invited one of our experts to discuss the issues raised for Broker-Dealers and exchanges who now regularly deal with clients who are high frequency traders.

Guest Post by Expert Alison Jimenez

Market Manipulation

High Frequency Trading (“HFT”) exposes Broker-Dealers, exchanges and futures companies to a range of risks relating to market manipulation. A common allegation is that the firm itself engaged in manipulative activity such as spoofing, wash trades, and marking the close. Spoofing and layering were covered in last week's post, and wash trades occur when the same entity is on both sides of a transaction in a non-bona fide trade. Manipulation could occur if the transaction was done above or below current market prices in order to influence future market movements or to indicate higher trading volume. Marking the close takes place at the end of the trading day, wherein large, imbalanced buy or sell orders are used to influence the closing price in the security at issue.

Another spoofing case, although not as high profile as the Flash Crash example discussed last week, was brought by the CFTC against Panther Energy. The CFTC's case against Panther was ultimately settled for $2.8 million. An example of a case involving marking the close can be found in the SEC's recent $1 million fine of Athena Capital Research. The SEC alleged that Athena issued waves of orders in the last two seconds of the trading day to manipulate prices in its favor. Athena agreed to a settlement without admitting or denying the allegations.

More enforcement actions should be expected as the CFTC reported last year that it had 10 open investigations into allegations of spoofing. In May 2014, FINRA stated that they had 170 open investigations into high frequency trading. Manipulative trading strategies existed long before the rise of HFT, but have gained new life using the technology available today.

Lack of Internal Controls/Anti-Money Laundering

Broker-Dealers also run the risk of being held accountable for market manipulation schemes undertaken by their HFT customers. Financial institutions are required to monitor against and report suspicious activity. The high level of activity and speed of trading can pose a significant challenge for firms trying to adequately monitoring customer activity. FINRA Chief Richard Ketchem said that “the failure to monitor what those clients are actually doing is the source of many high frequency trading complaints.”

Regulators have cited Broker-Dealers for HFT customer-related violations including inadequate risk management, poorly trained staff, lack of pre-trade controls and ineffective trade surveillance.

Improper Information

Many HFT firms rely on information advantages to gain an edge in the markets. High speed communication lines, co-location of servers and fast algorithms are all part of the how these firms generate their position relative to the rest of the market. A recent $14 million fine by the SEC against Direct Edge (owned by the BATS exchange) unveiled that part of the competitive edge enjoyed by some firms was due to the exchange providing additional information on unusual order types available only to HFT firms. The SEC alleged that while a single type of price sliding order was described to all members for buy and sell orders, there were actually three different types of price sliding orders available. This information was disclosed to certain members, and that knowledge was used to trade profitably against others.

Conclusion

The potential impact of High Frequency Trading market manipulation and related regulatory litigation is quite large. Broker-Dealers and exchanges need to be cognizant of the new risks posed by high frequency trading.