REGULATING HIGH­FREQUENCY TRADING: MAN V. MACHINE Alyse L. Gould * Cite as 12 J. HIGH TECH. L. 273 (2011) I. Introduction Today’s financial markets are light years away from those operating when the Securities Act of 1934 (“1934 Act”) established the Securities and Exchange Commission (“SEC”). 1 The implementation of computers and advanced mathematics into trading has changed the way the United States and the world do business. 2 High‐frequency trading and sophisticated algorithms are a product of the emergence of the internet and quantitative analysis in the 1990s, where speed and accuracy were necessary for best execution of orders. 3 Suddenly, a huge *
J.D. Candidate, Suffolk University Law School, 2012. Alyse Gould is the Managing Editor of the Journal of High Technology Law and will graduate with a concentration in Business Law & Financial Services. 1 See Securities Exchange Act of 1934, 15 U.S.C. § 78d(a) (codifying the creation of the Securities and Exchange Commission in order to regulate U.S. securities markets); Jonathan R. Macey & Maureen O’Hara, From Markets to Venues: Securities Regulation in an Evolving World, 58 STAN. L. REV. 563, 569 (2005) (acknowledging the drastic change in securities markets based on advanced technology). 2 See CFA INST., Regulatory Update (Sept. 2010) (recognizing that the significant change in equities markets happened quickly over just a few years); Irene Aldridge, What is High­Frequency Trading, Afterall?, THEHUFFINGTONPOST.COM, July 8, 2010 [hereinafter What is High­Frequency Trading], archived at http://www.webcitation.org/61e96tL76 (stating that “‘high‐frequency trading’ became a buzz word in 2009.”). 3 See Larry Tabb et al., US Equity High Frequency Trading: Strategies, Sizing and GROUP, Sept. 2009, archived at Market Structure, TABB http://www.webcitation.org/61eCa0mPb (describing the emergence of high‐ Copyright © 2011 Journal of High Technology Law and Alyse L. Gould. All Rights Reserved. ISSN 1536‐7983. 274
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amount of shares could be traded quickly at a low cost. 4 Among the many benefits are high profits, low cost and accuracy in trade execution. 5 It is no surprise that today high‐frequency trading techniques account for over fifty percent of trade volume. 6 The SEC has had the difficult task of keeping up with the changing market conditions and tools. 7 The risks of many technologically advanced trading tools, including high‐frequency trading, as of the beginning of 2010 had yet to be realized while others such as “flash orders” garnered proposed SEC regulation. 8 frequency trading as “the lovechild of 12 years of SEC rulemaking and advances in trading technology.”). In the 1990s, traders with degrees in mathematics and physics developed models that would seek best price execution, computerizing the world of trading. See IRENE ALDRIDGE, HIGH‐ FREQUENCY TRADING: A PRACTICAL GUIDE TO ALGORITHMIC STRATEGIES AND TRADING SYSTEMS 15 (John Wiley & Sons, Inc. 2010) [hereinafter ALDRIDGE]. 4 See Mara Der Hovanesian, Cracking the Street's New Math: Algorithmic Trades Are Sweeping the Stock Market. But How Secure Are They?, BUSINESSWEEK, Apr. 18, 2005, archived at http://www.webcitation.org/61eDn0Lko (analogizing the large size of high‐frequency trades to putting an elephant through a keyhole). 5 See id. (explaining that these large algorithmic trades cost less than a penny, whereas traditional trades could cost six cents or more). See also ALDRIDGE, supra note 3, at 16 (replacing traditional traders with algorithms is a product of the low cost and high return of high‐frequency trading). 6 See Jonathan Spicer & Jennifer Kwan, High­frequency Trading Surges Across Dec. 2, 2009, archived at the Globe, REUTERS, http://www.webcitation.org/61h98uaEm (estimating that high‐frequency trading accounts for sixty percent of stock trading in the U.S. and is continuing to surge around the globe). The low cost and large size of high‐frequency trades makes it the trading practice of choice for many firms while accumulating approximately $21.8 billion dollars in profits annually. See Perrie M. Weiner et al., Catch Me If You Can–Speed Traders Under Scrutiny, 1843 PLI/CORP 341, 343 (July 29, 2010). 7 See Macey & O’Hara, supra note 1, at 569 (noting that regulation has been difficult because the nature of the trading business itself has changed and the way the SEC could erode profits). 8 See Gerard Citera Robert et al., Current Issues in the U.S. Equity and Options Markets, 1845 PLI/CORP 309, 315‐26 (2010) (listing the various practices under high‐frequency trading that are creating issues and giving rise to concerns for the SEC). Examples of high‐frequency trading practices that are giving rise to concern are flash orders, naked access and co‐location, all of which could create an unfair advantage for participating firms and market instability. See id. The Dodd‐Frank Act, passed in July 2010, contains language 2011]
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Given the perceived benefits and unrealized risks, high‐frequency trading has been left largely unregulated. 9 The market events of May 6, 2010, popularly known as the “flash crash,” caused stock prices to plummet falsely and then sharply rise. 10 While the market stabilized itself rapidly after the faulty algorithm of a single trader took its toll, the event caused many to cry out for regulation of high‐frequency trading. 11 The SEC quickly implemented circuit breakers reminiscent of the “Black Monday” market crash of 1987 and erroneous‐trade rules. 12 These measures were swiftly implemented and have yet to become permanent. 13 requiring research into these high‐frequency trading practices in order to control market stability. See id. 9 See Der Hovanesian, supra note 4 (contrasting the reliance of firms on the practices of high‐frequency trading with the concerns of regulatory authorities). Firms will either prosper or fail based on the strength of their trading programs, but the practice raises many concerns, such as front‐
running, with regulators. See id. The practice is currently not regulated but regulatory authorities are in full support of probes into the practice. See id. 10 See SEC AND CFTC, 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 1, 1 (Sept. 30, 2010) [hereinafter FINDINGS] (detailing the market events of May 6, 2010, which led to the rapid fall and then rise of stock prices in the short span of just a few minutes). 11 See Jeremy Grant, High­frequency Trading: Up Against a Bandsaw, FIN. TIMES, Sept. 2, 2010, archived at http://www.webcitation.org/61qfViXXS (demonstrating the damaging effect the association with the “flash crash” has on high‐frequency trading). In the wake of the flash crash, Congress is beginning to turn its attention to possible reform and regulation of the practice. See id. The “flash crash” exposed the flaws in the high‐frequency trading system and Congress will now be probing into the various issues affected market stability. See id. 12 See U.S. SECURITIES AND EXCHANGE COMMISSION, 2010‐98, SEC APPROVES NEW STOCK‐BY‐STOCK CIRCUIT BREAKER RULES (June 10, 2010), archived at APPROVES] http://www.webcitation.org/61olS2RSf [hereinafter SEC (sanctioning circuit breakers as a quick response to try and prevent a repeat of the “flash crash”); Andrea M. Corcoran, The Lessons of 1987: Thinking Back After a Decade of Response, 17 No. 7 FUTURES & DERIVATIVES L. REP. 14, 16 (Oct. 1997), archived at http://www.webcitation.org/62A5ZshRo (stating that the implementation of circuit breakers in response to Black Monday was groundbreaking at the time). 13 See SEC APPROVES, supra note 12 (approving circuit breakers was done only on a pilot program basis and will have to be extended or made permanent if 276
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Despite an earlier concept release in January 2010 on high‐tech market tools, the SEC is now required by the Dodd‐
Frank Act to conduct research and propose legislation on high‐
frequency trading regulation. 14 The “flash crash” attributed to high‐frequency trading practices caused market instability and dried up liquidity in a matter of minutes. 15 Regulation is required to prevent repeat occurrences based on algorithmic mistakes. 16 Part I discusses the evolution of the financial markets and provides an explanation of the benefits and risks of high‐frequency trading. Part II provides background on the SEC’s ability to regulate the financial markets and historical responses to advancing technology. Part III will explain specific legislation and regulations regarding high‐frequency trading. Part IV details the market events of May 6, 2010 and explains the cause of the “flash crash.” Finally, Part V will examine whether the SEC’s proposed regulations and implemented pilot regulation are an effective way to deal with high‐frequency trading. The “flash crash” is reminiscent of the 1987 “Black Monday” crash and so are the SEC’s responses. In order to create effective regulation the SEC needs to look ahead in creating responses instead of providing a quick fix, band‐aid that will be ripped off in the near future. Regulations should be flexible in order to allow the positive effects of high‐frequency the SEC intends to move forward with the program); SEC Expands Stock­by­
Stock ‘Circuit Breakers’, 25 No. 6 WESTLAW J. DEL. CORP. 11, 11 (Oct. 4, 2010) [hereinafter SEC Expands] (expanding circuit breakers slowly to include more stocks on various exchanges). 14 See Dodd‐Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111‐203, § 967(a)(2)(D), 124 Stat. 1376, 1913 (2010) [hereinafter Dodd‐Frank Act] (requiring an inquiry into high‐frequency trading practices as a part of the initiative to create market stability to prevent further future economic downturn). 15 See FINDINGS, supra note 10, at 2 (finding that an incorrect algorithmic trade triggered the chain reaction that caused the “flash crash”). As the algorithm for the E‐Mini dumped the large trade in just twenty minutes, creating a mismatch of buy and sell orders, liquidity quickly dried up before rebounding minutes later. See id. at 2‐6. 16 See FINDINGS, supra note 10, at 6 (highlighting the need for harmonized regulation). 2011]
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trading to continue and provide room for new technologically advanced tools in the future. II. From Trader to Computer: A Glance at How the World Trades Trading floors and broker‐dealer influence in the market is becoming obsolete. 17 Technology has knocked down barriers that once made the trading process slow and only possible through the use of a middleman. 18 These advances are, in large part, thanks to the invention of the Internet and direct connectivity from electronic communication networks (“ECNs”). 19 High‐frequency trading has made it possible to replace human traders with sophisticated algorithms that can work under the direction of analysts and portfolio managers at a fraction of the cost. 20 The benefits of high‐frequency trading are 17 See ALDRIDGE, supra note 3, at 16 (trading is now easily completed by sophisticated algorithms, which can trade more quickly and accurately than their human counterparts and are therefore replacing traditional traders); Jerry W. Markham & Daniel J. Harty, For Whom the Bell Tolls: The Demise of Exchange Trading Floors and the Growth of ECNS, 33 J. CORP. L. 865, 866 (2008) (opining that the traditional trading floors one images are fast fading into history as technology is making them obsolete). 18 See ALDRIDGE, supra note 3, at 10‐11 (using technology to trade changed the traditional hierarchical system from one where a person would have to go through a broker‐dealer for access to the market to a system where there is direct connectivity in pools of liquidity); Markham & Harty, supra note 17, at 903 (transforming into a system that largely operates on ECNs using algorithmic trades has brought about the “democratization of the financial markets”). 19 See ALDRIDGE, supra note 3, at 16 (“replacing expensive trader headcount with less expensive trading algorithms along with other advanced computer technology” allowed firms to reduce costs and increase profits); BRIAN R. BROWN, CHASING THE SAME SIGNALS: HOW BLACK‐BOX TRADING INFLUENCES STOCK MARKETS FROM WALL STREET TO SHANGHAI 27 (2010) (creating direct market access through ECNs eliminated the need for firms to go through brokers in order to match buy and sell orders); Markham & Harty, supra note 17, at 903‐
04 (explaining that “quants” became the new kids on the trading block replacing the trading floors of the past with sophisticated algorithms). 20 See ALDRIDGE, supra note 3, at 15 (implementing a quant model quickly was the best way to gain a competitive advantage because the firm was about to “identify and trade upon a market inefficiency,” producing the largest profit). 278
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enormous to investment firms, but the risks can create a domino effect that proves the true interconnected nature of high‐
frequency trading algorithms. 21 A. Financial Markets: Evolving from Paper to the Click of a Button The stock exchanges of the 19th century required buyers and sellers to purchase seats on the floor of the exchange and be present in order to sell or bid. 22 Those with seats became market makers and were the only ones with access to the securities through the call method. 23 Competition among exchanges created twenty‐four hour access to trading and an increased number of listed securities. 24 Additionally, competition caused market makers to eventually evolve into specialist firms in charge of certain securities who would keep a two‐sided market In order [t]o ensure optimal execution of systematic trading[,] algorithms were designed to mimic established execution strategies of traditional traders. To this day, the term ‘algorithmic trading’ usually refers to systematic execution process—that is, the optimization of buy‐and‐sell decisions once these buy‐and‐sell decisions were made by another part of the systematic trading process or by a human portfolio manager. Id. Portfolio managers still make portfolio allocation decisions, while the algorithm simply determines the best execution of the manager’s allocation orders more accurately and quickly than a human trader could. See id. 21 See FINDINGS, supra note 10, at 1‐6 (finding that the failure of one algorithm that did not take into account quantity and time caused failures across the market in terms of liquidity and confidence). 22 See Markham & Harty, supra note 17, at 869 (seating was reserved for exchange members only). “Members were assigned chairs (hence the reference to exchange ‘seats’) and were required to be present for each session.” Id. 23 See Markham & Harty, supra note 17, at 869 (explaining the method by which stocks used to be bought or sold on an exchange). A call market consisted of reading a list of securities at the exchange and members would make bids or offers for the securities. See id. 24 See Markham & Harty, supra note 17, at 869‐70 (increasing the number of available exchanges created a continuous market‐making system and led to the development of evening markets). 2011]
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– a bid price for themselves and a sell price for the investor instead of the old fashion call method. 25 The broker‐dealer became the middleman through this two‐sided market for investors buying and selling securities on a given exchange. 26 Those on the floor had a distinct advantage over the average investor with no access. 27 Broker‐dealers in this manner were able to make a great deal of money by charging fees for their services in acquiring securities. 28 This hierarchy remained the framework for the U.S. financial system through the 1990s. 29 Meanwhile, technology in the form of the telegraph, then stock ticker, and finally the telephone, increased the capability of market information sharing. 30 25 See Markham & Harty, supra note17, at 870 (creating a margin on the security by which the firm would make a profit). This system was a product of exchanges and firms’ desire to eliminate the competition of “curb markets” operating outside of the major exchanges. See id.. Specialists initially competed with each other, but eventually a single firm would monopolize a particular security allowing the firm to exclusively reap the benefits of the stock – this changed with the emergence of electronic trading systems. See id. 26 See ALDRIDGE, supra note 3, at 10 (illustrating the lucrative position of broker‐dealers in the traditional market system). “Until the late 1990s, it was the broker‐dealers who played the central and most profitable roles in the financial ecosystem; broker‐dealers controlled clients’ access to the exchanges and were compensated handsomely for doing so.” See id. 27 See BROWN, supra note 19, at 27 (providing “direct market access” through ECNs to clients who were historically at the mercy of their brokers). “The right to execute an order has historically been a privilege for a minority of designated financial professionals.” Id. See also ALDRIDGE, supra note 3, at 10 (positioning themselves between clients and the exchanges allowed broker‐
dealers to have a price advantage over the average investor). 28 See ALDRIDGE, supra note 3, at 10 (describing how broker‐dealers would be paid handsomely by their clients for their access to the exchanges and stocks). 29 See Markham & Harty, supra note 17, at 902 (emerging in the 1990s, ECNs were originally utilized as automated trading systems for institutional investors); ALDRIDGE, supra note 3, at 10 (attributing the current decentralized trading network to the emergence of electronic trading systems). Technological advances have been attributed to flattening the rigid hierarchy of the traditional trading system into one that is more democratic and decentralized. See Markham & Harty, supra note 17, at 903. 30 See Markham & Harty, supra note 17, at 870 (detailing some various technological advances that morphed exchange trading floors into a system of decentralized electronic trading networks). 280
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By the 1980s, investment firms were using computers for program trading to move large quantities of stock. 31 The electronic trading systems “aggregated market data across multiple dealers and exchanges, distributed information simultaneously to a multitude of market participants, allowed parties with preapproved credits to trade with each other at the best available prices displayed on the systems, and created reliable information and transaction logs.” 32 The sophisticated electronic trading systems were initially reserved for select exchanges and networks and were not the trading norm. 33 It was not until the 1990s that the systematic computer‐based trading associated with high‐frequency trading emerged as the method of choice. 34 By the 1990s the Internet was introduced to the world and it changed the face of trading. 35 The Internet enabled investors to go out on the web and match buyers and sellers without the use of broker‐dealers. 36 This process created electronic communications networks (“ECNs”). 37 ECNs work through algorithms in order to quickly match buyers and sellers at an optimal price. 38 The ability of ECNs to allow trades over the 31 See Markham & Harty, supra note 17, at 902‐13 (providing overview of ECN development); ALDRIDGE, supra note 3, at 8 (appearing for the first time in the 1980s, electronic dealing systems were considered revolutionary for the market system). 32 ALDRIDGE, supra note 3, at 8. 33 See ALDRIDGE, supra note 3, at 8 (developing algorithms as a form of systematic trading did not gain popularity until the 1990s). 34 See ALDRIDGE, supra note 3, at 8 (attributing the stalled growth of high‐
frequency trading to the high‐cost and low output of the computer technology at the time). 35 See Mark Borrelli, Market Making in the Electronic Age, 32 LOY. U. CHI. L.J. 815, 826 (2001) (considering the Internet as a factor that spurred the growth and popularity of ECNs and electronic trading). 36 See BROWN, supra note 19, at 29 (defining an electronic communication network as “a computerized marketplace that automatically matches buyers and sellers” without a broker‐dealer middleman). 37 See BROWN, supra note 19, at 29 (summarizing the origins of ECNs). 38 See ALDRIDGE, supra note 3, at 23 (programming algorithms to analyze quote data is part of what makes high‐frequency trading successful). High‐frequency trading produces profits because of fast stock turnover that capitalizes on 2011]
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internet lead to the creation of online broker shops offering direct access to trading for investors, and essentially eliminated the need for investors to go through broker‐dealers. 39 Additionally, the Internet created savvy new trading techniques to capitalize on the technology of the Internet. 40 Suddenly, traders and analysts became mathematicians and physicists in order to produce sophisticated algorithms to go out into these “liquidity pools” created by ECNs and place high volume trades quickly. 41 Speed in trading became essential to profit and high‐
frequency trading emerged. 42 B. Today’s Tools of the Trade: High­Frequency Trading High‐frequency trading (“HFT”) is becoming one of the most popular trading tools around the world. 43 HFT accounts for over fifty percent of trading volume and those countries and investors who do not engage in the practice are at a disadvantage. 44 HFT functions on the “idea that properly changes of a fraction of a cent in a stock’s price, thus without accounting for the best price the practice would not be feasible. See id. 39 See BROWN, supra note 19, at 27 (quantifying the positive effect of ECNs on the average investor). In 2008, investors completed thirty‐five percent of all trades by themselves, versus just one percent a decade earlier. See id. 40 See Robert et al., supra note 8, at 315‐26 (summarizing the various techniques firms use to optimize high‐frequency trading practices). Practices such as co‐location, flash orders and naked‐access were all developed as ways for firms to gain an advantage in speed and price over one another. See id. 41 See Phil Wahba & Emily Chasan, Geeks Trump Alpha Males as Algos Dominate Dec. 2, 2009, archived at Wall St, REUTERS, http://www.webcitation.org/61osUENXa (trading is now run by “[e]xpert mathematicians, physicists, computer scientists, engineers and economists [who use] technical skills to excel in trading.”). 42 See id. (comparing high‐frequency trading to using high‐speed fighter planes). High‐frequency trading requires speed and precision in order to be successful in trading, just as it does to operate a high‐speed fighter jet. See id. 43 See Charles Duhigg, Stock Traders Find Speed Pays, in Milliseconds, N.Y. TIMES, July 24, 2009, archived at http://www.webcitation.org/61oskc178 (exploding trading volume can be attributed to high‐frequency trading). High‐frequency trading is “the hot new thing on wall street” for a select group of traders. See id. 44 See Spicer & Kwan, supra note 6 (demonstrating that high‐frequency trading is growing in popularity and is quickly spreading across the globe); Weiner et 282
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programmed computers are better traders than humans.” 45 Put simply, HFT uses sophisticated quantitative computer programs and algorithms to execute large quantity trades rapidly. 46 HFT traders hold positions in securities for a very short period of time and make profits by collecting fractions of a penny on each share of a large quantity trade. 47 Positions are not held overnight by these investors, which further reduces the cost and risk of the position as they return to cash. 48 Traditional securities traders and exchanges are feeling the pressure from the success of HFT. 49 The functionality of the algorithms used to execute trades varies depending upon the trader’s goals. 50 Trading generally al., supra note 6 at 343 (utilizing high‐frequency trading increases U.S. stock trading volume and generates billions in profits for firms). 45 What is High­Frequency Trading, supra note 2. “Computers can easily read and process amounts of data so large it is inconceivable to humans.” Id. The human brain is no match for the capabilities of a computer and a single algorithm can outwork a team of traders. See id. 46 See What is High­Frequency Trading, supra note 2 (operating based on short‐
term positions that generate profits off the smallest increase in stock price); Tabb et al., supra note 3 (generalizing the strategy of high‐frequency trading hedge fund as engaging in “short‐term trading opportunities rather than bona fide liquidity‐based strategies”); ALDRIDGE, supra note 3, at 23 (holding positions short term allows the firm to turnover quickly for profits); Robert et al., supra note 8, at 315 (allowing firms to “end the day with little or no exposure to the market”). 47 See Weiner et al., supra note 6, at 343 (generating profits of one penny per share still creates huge profits because high‐frequency trading increasing the amount of stock that can be sold at a single time); Letter from Kurt N. Schacht & James C. Allen to Robert W. Cook, Director, Division of Trading and Markets, SEC (Jan. 6, 2010), archived at http://www.webcitation.org/61ouLv0f8 (foreseeing sub‐penny trading as a potential problem for the U.S. securities markets in the future). 48 See ALDRIDGE, supra note 3, at 16 (holding a position overnight is not a common occurrence for high‐frequency trading). 49 See ALDRIDGE, supra note 3, at 16 (replacing traditional traders with algorithms is easy as high‐frequency trading is significantly cheaper than using a human trader); Duhigg, supra note 43 (practicing high‐frequency trading techniques gives an advantage over traders using traditional methods because they have better access and control over pricing information). 50 See ALDRIDGE, supra note 3, at 16‐17 (recognizing that not all algorithms are the same and that some algorithms are not even high‐frequency). High‐
frequency trading is more complex than simple electronic trading systems, and a single trade can be comprised of multiple algorithms, some of which are 2011]
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employs a variety of algorithms, however not all algorithms are meant for high‐frequency trading. 51 Successful HFT requires, in particular, two types of algorithms: optimization algorithms and signaling algorithms. 52 Optimization algorithms seek to execute trades in the right amount, at the proper time and at the best price after the decision to transact in a security has been made by the trader or portfolio manager. 53 The signal algorithm, on the other hand, determines whether to trade a particular security or not – otherwise known as portfolio allocation. 54 Firms that utilize high‐frequency algorithms enjoy the benefits of lightning‐
quick trading speeds in vast quantities, accuracy in execution and trading methods that cost significantly less than employing a human trader – all while generating large profits for the firm. 55 high‐frequency and some of which are not. See id. at 17. High‐frequency trading algorithms are characterized by short‐holding positions and low execution latency. See id. at 17. 51 See ALDRIDGE, supra note 3, at 17 (explaining that an execution algorithm, which determines the best method of buying and selling the stock, may or may not be high‐frequency). 52 See ALDRIDGE, supra note 3, at 17 (implementing a successful high‐frequency trade requires both types of algorithms to be utilized by the trader). 53 See ALDRIDGE, supra note 3, at 15 (executing orders at the optimal price and time are main components of algorithmic trading). 54 See ALDRIDGE, supra note 3, at 17 (designing algorithms that are searching for signals is much more complex than designing those that operate for execution alone). “These supercomputers and algorithms look for signals ‐ such as the movement of interest rates, miniscule economic fluctuations, news and other subtleties ‐ to take advantage of these indications before anyone else in the market is even aware of them. The computer systems being used in the markets today can break down large orders into extremely small slices and ‘execute them across different trading venues at close to the speed of light.’” Michael J. McGowan, The Rise of Computerized High Frequency Trading: Use and Controversy, 2010 DUKE. L. & TECH. REV. 16, *2 (2010). 55 See McGowan, supra note 54, at *3, *22 (showing that executing trades with immense speed with barely any human interaction in the process is cost efficient). Trading on high‐frequency signals helps to minimize risk and “‘posting small deal sizes that enable [HF traders] to move in and out of trades extremely quickly, arbitraging between spreads available on different exchanges and platforms, and even between the speed of trading available on them’” enabling firms to accumulate vast profits. See id. at *3. See also Duhigg, supra note 43 (calling the drive for firms to get the best signal seeking algorithms a technological arms race because those with the best algorithms can bully slower traders into giving up profits); Der Hovanesian, supra note 4 284
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In addition to the various benefits HFT provides to the trader, it also provides a level of efficiency to the market as a whole. 56 For example, HFT is made possible because of ECNs, which are known as “liquidity pools.” 57 HFT occurs on ECNs avoiding exchanges and broker‐dealers, allowing the traders to transact in large quantities, adding liquidity to these pools. 58 With the addition of liquidity, reduced costs, and the typically error‐free way in which HFT traders operate, it creates a more stable market through smoother operation. 59 Finally, in the interest of making profits and securing the best prices, traders are making technological advances driving the market into the future. 60 Despite the many perceived benefits of HFT, the practice is not free from flaws, risks and unwanted off‐shoot practices. Flaws include decreased communication between traders and secrecy. 61 Decreased communication hurts interpersonal (boasting that an algorithmic trade costs less than a penny, significantly reducing the cost of trading). 56 See Liz Moyer & Emily Lambert, The New Masters of Wall Street, FORBES, Sept. 21, 2009, archived at http://www.webcitation.org/61rrCzmme (claiming that technological innovation can make the financial markets more efficient). 57 See ALDRIDGE, supra note 3, at 12 (using algorithms to match buyers and sellers creates pools of liquidity in an electronic platform outside of an exchange). When the traders’ identities and orders remain unknown until the order is complete the liquidity pools are referred to as “dark pools.” See id. 58 See ALDRIDGE, supra note 3, at 12 (diagramming the electronic trading process, placing ECNs between the exchanges and the traders). Algorithms used to match buy and sell orders in large quantities take the securities listed on the exchange and make them available anonymously without the middleman broker‐dealer. See id. 59 See Moyer & Lambert, supra note 56 (noting that “[h]igh‐frequency trading adds liquidity, speeds execution and narrows spreads”). Contrary to much criticism the positive attributes of high‐frequency trading practices may in fact make the market better for all players. See id. 60 See Moyer & Lambert, supra note 56 (crowning high‐frequency traders as the “new masters of wall street” replacing the likes of “junk bond king pins, corporate raiders and private equity powerhouses who reigned before them”). 61 See Wahba & Chasan, supra note 41 (viewing the black box techniques of algorithm traders as a negative trait to the practice); BROWN, supra note 19, at 8‐10 (attributing high‐frequency trading to the emergence of black box trading). 2011]
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relationships as computers and algorithms replace the need for human interaction. 62 Further, the silence surrounding algorithms creates secrecy in the market. 63 The secrecy is often referred to as trading in the “black‐box,” which is popular in hedge funds, which are mostly unregulated. 64 Algorithms are unique and therefore need to be kept secret. 65 For example, Goldman Sachs recently filed suit against a former employee who allegedly stole a successful algorithm from the investment bank. 66 Outside investors do not know what happens in the black box and therefore in the case that the algorithm causes a financial upset it would be difficult to decipher the cause. 67 Conversely, investment firms fear that their algorithms are predictable and 62 See Wahba & Chasan, supra note 41 (contrasting the desire to keep successful high‐frequency trading algorithms a secret to the very social traditional trading floor). Firms fear having their best algorithms reversed engineered by competitors thereby losing their profits, which creates a secretive and anti‐social environment. See id. 63 See BROWN, supra note 19, at 10‐11 (outlining the emergence of black box trading in hedge funds). Black box trading plays on the secrecy and lack of investor understanding of the trading methods of hedgefunds, which revolved around sophisticated signal seeking algorithms designed to profit off of price discrepancies. See id. at 8‐10. 64 See Wahba & Chasan, supra note 41 (placing a great deal of emphasis on keeping algorithms a secret is important to a firm’s ability to keep their competitive advantage). The shelf life of a high‐frequency algorithm is limited to the period of time that it is successful and it is further shortened if a competitor reverse engineers it. See id. 65 See U.S. v. Aleynikov, 737 F. Supp. 2d 173, 175 (S.D.N.Y. 2010) (illustrating the lengths an investment firm is willing to go to protect a profitable algorithm). 66 See id. (accusing a former employee of using Goldman Sachs’s high‐
frequency trading program to build the platform for a competitors high‐
frequency program). The algorithm platform employed by Goldman Sachs was considered by the court to be a trade secret within the meaning of the Economic Espionage Act and considered property under the National Stolen Property Act. See id. at 185‐87. The motion to dismiss the case was denied on these two counts. However, the third count of unauthorized computer access was dismissed. See id. at 194. 67 See BROWN, supra note 19, at 9 (realizing that investors do not understand what goes into a high‐frequency trade or how algorithms operate). “The language ‘black box’ originated out of the obscurity of the investment strategy.” Id. 286
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can be deconstructed. 68 In this case, a competing firm can figure out the competitor’s move before it happens and “front‐run” on the trade to produce a favorable and profitable outcome. 69 The main risks associated with HFT are the feared algorithm “gone wild,” and liquidity mismatches. 70 An algorithm “gone wild” would become unpredictable and disrupt market stability through erroneous trades destabilizing securities prices, therefore triggering a negative reaction throughout the markets. 71 Securities would theoretically trade at falsely inflated or deflated prices because other algorithms would be triggered to buy or sell. 72 As algorithms need to be entered into the computer, erroneous trades could be the product of human error or “fat fingering” the mathematical formula. 73 Associated with 68 See Der Hovanesian, supra note 4 (quoting an executive at an investment firm saying “[w]e live or die by how well we trade….”). Firms like to pretend that there are no information leaks, but it is a fact that there are people or other companies that seek to reverse engineer others’ algorithms. See id. 69 See Der Hovanesian, supra note 4 (hypothesizing that if a competitor could piece together enough algorithmic information, it could front‐run on competition competitor’s or customer’s trades). Front‐running is trading ahead of a customer in order to generate profits by capitalizing on a better price. See id. 70 See Wahba & Chasan, supra note 41 (noting that although computers have a significant advantage over their human trader counterparts, algorithms are not foolproof and are capable of malfunctioning); McGowan, supra note 54, at *39, *45 (detailing certain high‐frequency trading practices that may actually remove liquidity from the traditional exchanges and allow some people to trade while freezing others out of the market). 71 See Grant, supra note 11 (attributing algorithms run amok to at least three public exchange spirals and noting that there may be more that were not public). 72 See FINDINGS, supra note 10, at 1‐3 (finding that an improperly executed algorithm caused other algorithms to malfunction driving the price of securities down even though the fundamental value of the securities never changed). “Quote stuffing” enables traders to overwhelm the markets with price information, and is now being reviewed as a form of market abuse. See Grant, supra note 11. 73 See FINDINGS, supra note 10 (assessing the cause of the “flash crash” led to the discovery that an improperly executed algorithm by a single trader at Waddell & Reed triggered the downward spiral of the market). See also Jesse Westbrook & Nina Mehta, Waddell & Reed Trades Said to Help Spur May 6 Crash, BLOOMBERG BUS. WK., Oct. 1, 2010, archived at http://www.webcitation.org/61zSfWe1e (identifying Waddell & Reed as the 2011]
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the risk of an algorithm gone wild is a liquidity mismatch, which occurs when buyers and sellers do not properly match‐up based on the volume of stock trading. 74 Liquidity for a security could potentially dry up and allow the price to free‐fall. 75 HFT has lead to the innovation of other market tools that have been points of concern for regulators. 76 For example, co‐
location, the practice of renting space near trading servers in order to reduce trading times, emerged as a trading tactic in response to the need for speed to be successful in HFT. 77 The concern with co‐location is that it creates an unfair advantage due to increased access to the market that the office is located near. 78 Another tool that has emerged, raising cause for concern, is naked‐access trading. 79 Naked‐access trading, in short, allows responsible party); Darryl Isherwood, Dow Plunge: Program Trading's Role, May 6, 2010, archived at FOXBUSINESS.COM, http://www.webcitation.org/61zS4rq6W (blaming a bad trade in a single security for a downturn felt across the market). 74 See FINDINGS, supra note 10, at 1‐3 (creating a sense of panic in the market caused some traders to stop dead in their tracks leaving more shares for sale than there were buyers, causing a freeze in liquidity and downfall in price); Robert et al., supra note 8, at 325‐40 (describing proposed rules that try to persuade firms to have steady streams of liquidity as a goal of SEC regulations going forward). 75 See Grant, supra note 11 (criticizing high‐frequency trading for the extreme volatility it can cause, and the potential market abuse it can enable). 76 See Robert et al., supra note 8, at 315 (identifying the various strategies used in high‐frequency trading that will be marked for investigation and regulation under the new Dodd‐Frank Act). 77 See Robert et al., supra note 8, at 315‐17 (outlining the concerns associated with co‐location that could affect market stability and fairness); Tara Bhupathi, Technology’s Latest Market Manipulator? High Frequency Trading: The Strategies, Tools, Risks, and Responses, 11 N.C.J.L. & TECH. 377, 390‐91 (2010) (allowing a trader to be as close as possible to the exchanges because it decreases their latency when trading). 78 See Robert et al., supra note 8, at 316 (describing legislation that would give equal access to close proximity housing, equitable fees, increase latency transparency and third party provider oversight). The goal in regulating co‐
location would be to even the playing field for all participants so that it no longer provided an advantage for the few who would afford the real estate. See id. 79 See Bhupathi, supra note 77, at 390 (contrasted with direct market access, naked‐access allows orders to flow directly into the market by passing the brokerage system altogether). 288
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traders to trade without broker codes or supervision, which produces a cost‐efficient and confidential trading practice.80 However, naked access is unregulated and breaks down the traditional financial market system. 81 Flash orders are large, quick orders produced through algorithmic program trades and advanced information that occur before the general public can make the trade. 82 Each of these spin‐off tools, while providing an enormous benefit to the employer of the technique, produces and unfair advantage that could disrupt market stability. 83 III. SEC Prior to the 1934 Exchange Act (“Exchange Act”), investment firms themselves were largely the only source of regulation for the financial markets for which they were market makers. 84 After the market crashed in the 1920s and scandals emerged on Wall Street, the Exchange Act established the SEC as a means to regulate the financial markets and protect the average public 80 See Robert et al., supra note 8, at 317 (defining “Unfiltered or ‘Naked’ access” as “sponsored access without any external pretrade risk‐management systems reviewing the orders being transmitted to the markets.”); Bhupathi, supra note 77, at 390 (allowing “the customer to bypass both the broker‐dealer’s pre‐
trade filters and the pass through review.”). The main benefits are that the practice reduces latencies, reduces costs and fees and increases the speed of the trade under a protected veil of anonymity. See id. 81 See Robert et al., supra note 8, at 317 (raising “a series of supervision, compliance and risk‐management issues.”). “The key problem is that the exchange member sponsoring the trader may not see or control the trader who they have connected to the exchange, and trader is not an exchange member subject to exchange regulation. Sponsored access raises the risk of overwhelming waves of unauthorized trades sweeping the market.” Id. 82 See McGowan, supra note 54 (providing firms with a sneak peek at a price before it is sent to the public). The practice was born out of the competition for exchange volume, and gives traders an advantage for a fee. See id. at *27‐8. 83 See Weiner et al., supra note 6, at 343‐44 (observing that the SEC has put large investment banks and hedge funds on notice, announcing its intention to probe the area of high‐frequency trading because of the unfairness and threat to market stability). 84 See Markham & Harty, supra note 17, at 911‐13 (noting that firms and exchanges implement regulatory measures over their members); see also JESSE H. CHOPER ET AL., CASES AND MATERIALS ON CORPORATIONS 302 (Wolters Kluwer Law & Business 7th ed. 2008) (establishing a national “continuous disclosure system” for companies traded on exchanges). 2011]
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investor. 85 The SEC has faced the challenge of growing and adapting to the way the market works, and has recently faced criticism for failing to keep up with technological advances. 86 It is perhaps the reactive, rather than proactive, nature of the SEC that warrants cause for complaint. 87 The SEC, in moving forward, should employ foresight into the future of the financial market through solid research before a financial crisis occurs in order to produce more sound and long‐lasting policy. A. How the SEC deals with Broker­Dealers Under the recent stress of the financial markets, in part due to faulty mortgage and credit derivative schemes, the SEC reiterated that its purpose is to serve the public in order “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” 88 These abilities were 85 See CHOPER ET AL., supra note 84 (regulating the secondary market, “i.e., trading activity among investor, either on an exchange or among securities dealers operating today through a computerized link‐up.”). 86 See James D. Cox, Coping in a Global Marketplace: Survival Strategies for a 75­
Year­Old SEC, 95 VA. L. REV. 941, 942‐43 (2009) (questioning whether the SEC, an insulated regulatory agency created in a solely U.S. financial market, has the ability to operate in a globalizing economy). But see Macey & O’Hara, supra note 1, at 570‐71 (noting that evolving characteristics of the market, which make it more decentralized, ensure that self‐regulation by firms would certainly fail). 87 See Nina Mehta, SEC Renews Focus on Equity­Market Structure, Director Cook Says, BLOOMBERG BUS. WK., Sept. 23, 2010, available at http://www.webcitation.org/64LaA5sNm(announcing the intention of the SEC to identify problems on the front end unlike past reactions to crises). 88 See William M. Prifti, Financial Crisis and Impact on SEC and TARP, 24 SEC. PUB. & PRIV. OFFERINGS § 1A:11.02 (2010) (providing the regulatory objective of the Securities and Exchange Commission); Onnig H. Dombalagian, Requiem for the Bulge Bracket?: Revisiting Investment Bank Regulation, 85 IND. L.J. 777, 796 (2010) (attributing the inability of the SEC to handle the collapse of investment banks in 2008 in part to structural deficiencies in the SEC). The Inspector General attributed the inability of the Division staff to address these ‘red flags’ in part to a lack of staffing, a lack of an effective process for tracking material issues to ensure that they were resolved, and a lack of coordination with other divisions and other regulators. It is not clear, however, what steps the Division staff or other personnel at the Commission could have taken to address these deficiencies, at least after the Commission had permitted Bear Stearns 290
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envisioned under the 1934 Act in order to give the SEC broad authority to regulate US securities markets as necessary. 89 The immediate threats following the Great Depression were thought to be the product of a lack of transparency. 90 The secondary markets would be controlled through regulating trading activity among investors on an exchange through broker‐dealer activities. 91 The means to the SEC’s ends are achieved through securities law, mandated disclosure of financial statements, and the ability to enforce securities law through federal lawsuits. 92 In 1975, the SEC made amendments to the 1934 Act in response to the threat of a fragmented market system that would create inequities for investors. 93 The 1975 amendments created a “national market system” (NMS) in order to ensure the customers receive the best execution for their trades on the market, thereby trying to eliminate the inherent advantage broker‐dealers and large institutional investors had over the average investor. 94 Additionally, the SEC put pressure on the to participate in the CSE program. Id. 89 See 15 U.S.C. § 78b (stating the necessity for regulation of the US securities markets); CHOPER ET AL., supra note 84 (authorizing broadly the regulation of registered companies and the secondary securities market). 90 See Markham & Harty, supra note 17, at 874‐77 (analyzing the failure of the self‐regulation of the exchanges and the need to implement a national regulatory scheme). 91 See CHOPER ET AL., supra note 84 (explaining how the SEC would regulate the secondary markets within the framework of the Securities Exchange Act of 1934). 92 See Prifti, supra note 88 (listing the duties of the SEC under its 1934 Act mission statement); Cox, supra note 86, at 959 (regarding disclosure specifically, one of the four basic functions is to “enhance the allocational function of capital markets”). 93 See Markham & Harty, supra note 17, at 878‐79 (commenting that a 1971 study on institutional investing ultimately led to implementation of the National Market System legislation). The concern driving the study was that market was turning into a three‐tiered system in which the small investor was at the informational disadvantage. See id. at 879. The system ultimately created “an electronic link among the specialists trading the same stock on different exchanges.” Id. 94 See Markham & Harty, supra note 17, at 879 (attempting to “prevent market fragmentation by requiring that retail customers receive the ‘best execution’ available on any market for their trades.”). 2011]
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NYSE to limit Rule 390, which requires that securities listed on the NYSE only be traded on the exchange, to securities registered prior to 1979. 95 This was a step toward leveling the hierarchy of the broker‐dealer system and the power of the exchanges. 96 The 1980s brought the innovation of new trading techniques, including dynamic hedging used to protect portfolios from loss of liquidity in market downturns, and program trading. 97 Program trading is a type of signal trading that uses computers to buy and sell based on algorithms. 98 Program trading became popular, but also gave rise to concerns. 99 The fear was that a program trade could produce a signal that would oversell, driving down prices of securities and as a consequence cause the market to tumble. 100 On October 19, 1987, many speculated these exact events caused the market to take its worst crash since 1929. 101 95 See Markham & Harty, supra note 17, at 880 (opening the door to trading securities across various platforms to pave the way for ECNs). 96 See Markham & Harty, supra note 17, at 879‐80 (implementing rules that were aimed at equal access for small investors, and allowing the same security to be traded over different exchanges at once). 97 See Ayesha Khanna, Program Trading: Strategies and Technology Infrastructure, EGO MAGAZINE, Jan. 21, 2006, archived at http://www.webcitation.org/624EuKJiz (operating on arbitrage opportunities in price differentials); see also Markham & Harty, supra note 17, at 881 (defining program trading as “trading on the basis of trading signals generated by computer programs that seek to predict market changes by mathematical models….”). 98 See Khanna, supra note 97 (incorporating program trading into modern day trends of using algorithmic signal trades to push through large trades in small amounts of time at the best price). 99 See Markham & Harty, supra note 17, at 881 (noting that the practice of program trading became popular quickly, but concerns regarding the practice existed as early as the 1980s); Khanna, supra note 97 (acknowledging the popularity of program trading as early as the 1980s). 100 See Markham & Harty, supra note 17, at 881 (fearing that program trade sell signals could push prices lower and lower until there is a meltdown in the market). 101 See Corcoran, supra note 12, at 14 (marking the largest single day decline in the market value at that point in time—nearly twice that of the crash in 1929, which lead to the Great Depression); Markham & Harty, supra note 17, at 881 292
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The crash on October 19, 1987, later referred to as “Black Monday,” caused the Dow to drop 508 points in a single day. 102 The most shocking part of the crash, perhaps, was that it occurred in the last few moments the market was open for the day. 103 The crash was due in large part to the inability of the market to keep up with the volume and liquidity of trades. 104 There was a public outcry and the SEC felt immediate pressure to react to the event. 105 The official SEC report attributed the lost cost of program trades to create the “illusion of liquidity,” which falsely inflated prices, and therefore meant that the crash was a sudden and nasty readjustment. 106 However, it was far too difficult to pin the blame on any one cause, and it was ultimately attributed to market malfunctions. 107 In 1988, exchanges implemented circuit breakers as a means to prevent a repeat of the Black Monday crash. 108 Circuit (realizing the fears of the early critics of program trading when the NYSE was unable to handle the trading volume produced by program trades). 102 See Corcoran, supra note 12, at 14 (demonstrating how quickly a program trade can overwhelm the market, and also remarking on the overall increase in trading volume since the 1929 market crash). 103 See Corcoran, supra note 12, at 14 (illustrating the cause of not only the largest crash in the market since the Great Depression, but noting that the drop in the market occurred within minutes). 104 See Markham & Harty, supra note 17, at 881 (explaining that the crash “paralyz[ed] the NYSE because it simply did not have the capacity to handle that unexpected volume.”). 105 See Corcoran, supra note 12, at 15 (recounting that, in response to demands for explanations, several reports were produced on the crash including one by the SEC that was completed in time for market reforms in 1990). 106 See Corcoran, supra note 12, (finding that the “difficulty of assigning ultimate causes, most of the reports' recommendations focused on assessing and addressing perceived malfunctions in the ‘plumbing’ or operational features of the markets.”); McGowan, supra note 54, at *25 (reviewing the mechanisms used to explain the cause of the crash). “Stock index arbitrage was utilized heavily in the 1980s by program traders to make money off of the inconsistencies in the NYSE between futures prices and the S&P stock index; it was blamed by some as contributing to the crash in 1987.” Id. 107 See Markham & Harty, supra note 17, at 881‐82 (summarizing that conducting a lot of back‐and‐forth on the issue of what caused the crash ultimately yielded few results). 108 See Corcoran, supra note 12 (regarding the circuit breaker program as groundbreaking for its time); Markham & Harty, supra note 17, at 881‐82 2011]
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breaks would prevent extravagant single‐day price swings in securities; the circuit breakers would be triggered “when prices moved a predefined, and largely arbitrary, amount.” 109 The ultimate goal was to halt the program trade process in order to allow human traders the opportunity to act in a calm, rational manner to volatile market conditions. 110 As technology increased throughout the 1990s and into the turn of the century, circuit breakers as employed by the NYSE lost their purpose. 111 Capacity for high‐frequency and volume trading increased, and the threat was considered mitigated. 112 As regulators would soon find out, the introduction of the Internet into trading would bring new challenges to face resembling the crash of 1987. B. Dealing with Advancing Technology High‐frequency trading is implemented through the utilization of ECNs. ECNs emerged in the late 1960s as a means of allowing institutional managers to transact directly with one another, which avoided the need for a regulatory middleman. 113 The low commercial use of ECNs left them largely unregulated for more than twenty years until the late 1990s, at which point they were treated like broker‐dealers rather than the exchanges they resembled. 114 The SEC viewed ECNs as a potential threat to the (viewing the circuit breaker regulation of 1987 as a minor response considering the significance of the crash). 109 Markham & Harty, supra note 17, at 882. 110 See Corcoran, supra note 12 (expressing that the circuit breaker program “permit[ted] the absorption of new price information in an orderly fashion.”); Markham & Harty, supra note 17, at 882 (engaging the circuit breaker program when there were periods of high volatility in the market). 111 See Markham & Harty, supra note 17, at 882 (noting that new technologies implemented by the NYSE negated the necessity of circuit breakers). 112 See Markham & Harty, supra note 17, at 882 (creating a market platform that was able to deal with higher trading volumes appeared to address the concerns that were raised during the 1987 crash). 113 See Borrelli, supra note 35, at 826‐27 (tracing the first ECN back to 1969 when Instinet was created by institutional money managers). 114 See Borrelli, supra note 35, at 852 (increasing trade volume by way of ECNs created concerns among regulators that there was not enough surveillance of the practice). “By 1998, alternative trading systems, primarily ECNs, accounted for more than twenty percent of orders for Nasdaq securities and almost four percent of orders for exchange‐listed securities.” Id. at 851. 294
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National Market System they created in 1975. 115 ECNs possessed pricing advantages over major exchanges, lacked fraud surveillance, and were not required to report on their volume capacities. 116 In 1999, the SEC released an alternative trading systems (ATSs) regulation to address the growing concerns of ECN trading called The Regulation of Exchanges and Alternative Trading Systems. 117 The new regulations focused on self‐regulation and volume of trades, aiming to integrate large, self‐regulating ECNs into the NMS. 118 The ATS regulation puts forth clear definitions of “exchange” and “broker‐dealer” in order to corral ECNs into one category or another. 119 Those ATSs that self‐regulate are required to register as exchanges and adhere to exchange regulations as set forth by the SEC. 120 ATSs that do not self‐
regulate are able to register as broker‐dealers. 121 Those ATSs that deal in a security that makes up more than five percent of a NMS must also register as an exchange. 122 However, as the 115 See Joel Seligman, Rethinking Securities Markets: The SEC Advisory Committee on Market Information and the Future of the National Market System, 57 BUS. LAW. 637, 672‐73 (2002) (placing part of the blame of the erosion of the National Market System on ECNs, which have led to market fragmentation that the 1975 NMS sought to avoid). 116 See id. at 674‐76 (listing some of the regulatory advantages ECNs have enjoyed over traditional exchanges and broker‐dealers). 117 See Regulation of Exchanges and Alternative Trading System, Exchange Act Release No. 34‐40760 (Dec. 11, 1998) [hereinafter, Release No. 34‐40760] (providing alternative trading systems (ATSs) with a choice in regulatory treatment as either an exchange or a broker‐dealer). 118 See id. (trying to keep the National Market System intact by integrating the use of ATSs into an already existing form of trading, i.e., exchanges or broker‐
dealers). 119 See id. at (II)(A) (noting that advancing technology has blurred lines of what an exchange or broker‐dealer is, and attempting to give a solid definition of what being an exchange entails). 120 See id. at (II)(B) (allowing the ATS to choose whether it will be regulated as an exchange or a broker‐dealer based on certain criteria). An ATS that chooses to be self‐regulating may also choose to be regulated by a national securities association. See id. 121 See id. (noting the limitations implemented by the Act). 122 See id. (observing that using trading volume limits could force some ATSs to register as an exchange, but the SEC does not foresee enforcing this type of regulation in the immediate future). 2011]
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regulation and current market conditions note, few ECNs will actually every qualify as exchanges. 123 The SEC website addresses ECNs, stating that they are treated as broker‐
dealers. 124 Since 1998, HFT, and the ECNs they operate on, have become the trading method of choice, accounting for nearly sixty percent of all trading volume. 125 Naturally, with this increase of use from twenty percent at the time of the 1999 regulation, the SEC has released many amendments to the original legislation. 126 As early as 2000 it may have been clear that the original ATS regulation would not be sufficient for long because then‐SEC Chairman Arthur Levitt held a conference on how to handle the ever‐growing use of ECNs. 127 No such regulation has since replaced the 1998 regulations. 128 In recent years, however, the SEC has proposed regulations pertaining to specific HFT practices such as Flash Orders. 129 123 See Release No. 34‐40760, at (II)(B) (clarifying that while measures are available for ATSs to choose to register as exchanges, the SEC does not plan on having many, if any, operate as exchanges). 124 See ECNs/Alternative Trading Systems, U.S. Securities and Exchange Commission, Feb. 20, 2011, archived at http://www.webcitation.org/62BgulqFu (explaining to the public in the informational release that ECNs register as broker‐dealers, not exchanges). 125 See Spicer & Kwan, supra note 6 (recalling that high‐frequency trading already accounts for the majority of trading volume as it allows huge amounts of stock to be traded in the blink of an eye); Weiner et al., supra note 6 (executing trades in such high volumes, even though the profits per share may be a fraction of a total share, means that the sheer amount of stock being traded makes the practice extremely profitable). 126 See Borrelli, supra note 35, at 848 (reviewing the various changes the SEC has made to its different regulations in order to keep up with the advancement of ECNs). 127 See Borrelli, supra note 35, at 906 (cautioning that allowing ECNs to self‐
regulate could be a failure given that they are for‐profit and have dollar signs in mind). 128 See SEC Requirements for Alternative Trading Systems, 17 C.F.R. § 242.301 (2011) (implying that the more current regulations may supplement, but do not replace, the 1998 regulations). 129 See Press Release, U.S. Securities and Exchange Commission, SEC Proposes Flash Order Ban, (Sept. 17, 2009) [hereinafter Flash Order Ban], archived at http://www.webcitation.org/62BlRA67E (proposing to ban the practice as 296
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In September of 2009, the SEC issued a concept release for the regulation of Flash Orders. 130 The proposed legislation would ban the use of flash orders, removing the exemption from Rule 602 that currently makes the practice legal. 131 Flash orders, which allow large and quick trades based on prices released in a “flash” before the information becomes public, create a two‐
tiered market system. 132 In a sense, flash orders harm investors because it has become unnecessary to make the order publicly available and gives some investors a head start, thereby creating inequities. 133 While this proposal has not yet been enacted, it demonstrates the SEC’s method of amending problems on an individual and retroactive basis. 134 This retroactive regulatory method would change with the SEC’s concept release on HFT issued in January of 2010. 135 The SEC’s proposal, entitled “Concept Release on Equity Market Structure,” was released on January 14, 2010. 136 The SEC unfair and harmful to market stability). 130 See id. (seeking public comment on the proposal of eliminating flash orders, specifically on a cost/benefit analysis of such a regulation). 131 See id. (preventing “all markets—including equity exchanges, options exchanges, and alternative trading systems—from displaying marketable flash orders.”). 132 See id. (quoting Chairman Mary Schapiro, “[f]lash orders may create a two‐
tiered market by allowing only selected participants to access information about the best available prices for listed securities.”). “Currently, flash orders are permitted as result of an exception to Rule 602 of Regulation NMS that exempts these orders from requirements that apply generally to other orders.” Id. 133 See id. (considering that giving users a head‐start puts the average investor at a disadvantage). 134 See id. (acknowledging that the Flash Order practice is a result of an SEC‐
created exception in regulation, and the correction comes after the practice has become popular). 135 See Concept Release on Equity Market Structure, Exchange Act Release No. 34‐61358, at 1 (Jan. 14, 2010) [hereinafter Concept Release], archived at http://www.webcitation.org/62Bn7Ma3s (seeking comments on proposed regulation of high‐frequency trading and its associated practices before any market‐wide incident occurred). 136 See id. at 1 (announcing the SEC’s proposal intended to “invite public comment on a wide range of market structure issues, including high‐frequency trading, order routing, market data linkages, and undisplayed, or ‘dark,’ liquidity.”). 2011]
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released the proposal in the wake of such individual proposals as the regulations on Flash Orders and “dark pools.” 137 The purpose of the concept release was to conduct a review “of equity market structure performance in recent years and an assessment of whether market structure rules have kept pace with, among other things, changes in trading technology and practices.” 138 The concept release posed questions and sought comments on HFT and related practices concerning the effect on the NMS. 139 The focus of the proposal is for the protection of long‐term investor interests versus those trying to make a quick dollar on short‐term trades through HFT. 140 The SEC received comments through the end of April 2010, but has not yet released a proposed set of regulations. 141 IV. The Market Events of May 6, 2010 and Responses On May 6, 2010 the U.S. markets opened to a rocky start. 142 Economic information regarding the debt crisis in Europe caused a negative attitude toward the markets and volatility in the markets spiked. 143 At 2:32 p.m., an HFT trader 137 See id. at 19 (recognizing that dark pools should be registered as broker‐
dealers under Regulation ATSs and therefore registered and regulated by FINRA); Flash Order Ban, supra note 129 (proposing the elimination of the practice of Flash Orders for all markets). 138 Concept Release, supra note 135, at 1. 139 See Concept Release, supra note 135, at 31 (listing the various areas of market structure on which the SEC wishes to receive comments and information). 140 See Concept Release, supra note 135, at 32 (realizing that in the months before this release, there were concerns about the current market structure in place). In explaining the need for this market release, the SEC expressed that “the Commission believes it is important to assess more broadly the performance of the market structure, particularly for long‐term investors and for businesses seeking to raise capital.” Id. 141 See Concept Release, supra note 135, at 1 (accepting comments through April 21, 2010, just a few weeks before the market events of May 6, 2010). 142 See FINDINGS, supra note 10, at 1 (indicating that at the beginning of the day on May 6, 2010, the market that was already showing signs of turbulence). 143 See FINDINGS, supra note 10, at 1 (recounting that troubling news from across the globe created some doubts in the financial markets). The negative global outlook created “broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities.” Id. 298
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entered an algorithm designed to sell shares of the E‐Mini S&P 500 futures contracts (E‐Mini). 144 When an algorithm is produced by an HFT trader, the trader typically takes into account price, time, and volume, and the trade will execute over an extended period of time in order to reach an optimum price and to maintain liquidity levels. 145 However, this particular trade algorithm took neither price nor time into account, and instead the HFT trader set the algorithm to execute at nine percent (75,000 shares). 146 Accordingly, the algorithm triggered a series of volatile actions throughout the markets. 147 The algorithm sold approximately 35,000 E‐mini contracts with a value of 1.9 billion dollars. 148 At 2:45 p.m., just thirteen minutes after the initial trade began, the Chicago Mercantile Exchange—home to the E‐Mini—suspended trading on the E‐
Mini for five seconds. 149 By the time the initial trade wrapped up at only 2:51 p.m., prices of the E‐Mini stabilized, and were on the rise. 150 While the sell algorithm dealt with only one security, the 144 See FINDINGS, supra note 10, at 2 (explaining that the trader was a large fundamental trader, i.e., a mutual fund complex). The trader was attempting to hedge another equity position that he held against the turbulent market conditions. See id. 145 See FINDINGS, supra note 10, at 2 (describing the factors a trader should consider if they are to execute a trade by algorithmic operation versus manual or intermediary trading); ALDRIDGE, supra note 3, at 15 (clarifying that executing orders requires the trader to take into account the optimal price and time as main components of a successful algorithmic program). 146 See FINDINGS, supra note 10, at 2 (finding that this algorithm was “programmed to feed orders into the June 2010 E‐Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.”). 147 See FINDINGS, supra note 10, at 2 (maintaining that failing to take into account the price or time caused the algorithm to dump the shares in a matter of twenty minutes). 148 See FINDINGS, supra note 10, at 4 (assessing that, in order to prevent a further decline in prices, a pause was generated to correct the liquidity mismatch). 149 See FINDINGS, supra note 10, at 4 (reviewing the response of the Chicago Mercantile Exchange). 150 See FINDINGS, supra note 10, at 4 (explaining that implementing the five second pause allowed “sell‐side pressure in the E‐Mini [to be] partly alleviated and buy‐side interest [to] increase[].”). 2011]
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effects of the trade were broad. 151 Nearly 8,000 securities saw price swings fifteen percent outside of their expected market value, and worse, nearly 300 securities saw prices over sixty percent away from their market values. 152 The market events of May 6, 2010 saw the Dow Jones Index drop approximately 1,000 points and rise 600 points in a single day. 153 While the market rebounded as quickly as it fell, it demonstrated the volatile effect that a poorly executed algorithmic trade could have on the entire market. 154 Following the outcry and resulting market instability, the SEC combined resources with the Commodities and Futures Trading Commission (CFTC) to produce a report on what enabled a HFT algorithm to wreak such havoc on U.S. securities markets. 155 The answer found in the resulting report revolved around liquidity – both for the E‐Mini individually and the market in general. 156 The ability to use HFT techniques is due largely to 151 See FINDINGS, supra note 10, at 5 (calculating that in the twenty minute period “[b]etween 2:40 p.m. and 3:00 p.m., approximately 2 billion shares traded with a total volume exceeding $56 billion.”). 152 See FINDINGS, supra note 10, at 1 (attributing the crash to the fact that “many of these trades were executed at prices of a penny or less, or as high as $100,000, before prices of those securities returned to their ‘pre‐crash’ levels.”). 153 See FINDINGS, supra note 10, at 1 (reviewing that the crash moved prices roughly sixty percent away from their normal trading values in a matter of minutes); Isherwood, supra note 73 (explaining that dropping prices in securities caused the Dow Jones Index to fall almost 1,000 points before rebounding 600 points, bringing the market back to normal price levels). “By the end of the day, major futures and equities indices ‘recovered’ to close at losses of about 3% from the prior day.” FINDINGS, supra note 10, at 1. 154 See FINDINGS, supra note 10, at 1 (demonstrating the interconnectedness of the securities market and how a plunge in one security can cause a plunge in many); Grant, supra note 11 (arguing that runaway algorithms are a real concern that has presented itself two other times in addition to the flash crash on May 6, 2010). 155 See FINDINGS, supra note 10, at 68‐79 (building upon the initial analysis already completed in the days following the flash crash). 156 See FINDINGS, supra note 10, at 3 (describing the chain of events “in terms of two liquidity crises – one at the broad index level in the E‐Mini, the other with respect to individual stocks”). The nature of the large trade continued dumping large amounts of shares while there was no buyer on the other end to absorb the selling, thereby drying up liquidity in the security. See id. 300
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ECNs, which create liquidity pools based on the buy‐sell matching of HFT algorithms. 157 In respect to the E‐Mini, as the sell algorithm began, other HFT traders were initially absorbing the large market order based on the low price of the contracts. 158 However, based on the short‐term nature of HFT, many traders turned around and quickly sold the E‐Mini contracts in order to avoid the long‐term position associated with the security. 159 The E‐Mini became a “hot potato” and, eventually, more shares were available than were willing buyers causing the liquidity in the security to quickly and temporarily dry up. 160 Based on the volatility of the E‐Mini and associated contracts, a second liquidity crisis arose in the market generally. 161 As the prices of securities plummeted in response to the faulty algorithm selling off shares of E‐Mini without buyers on the other end, many firms paused their automated trading systems. 162 Certain securities traded at “prices as low as one 157 See ALDRIDGE, supra note 3, at 12 (explaining that when traders use high‐
frequency algorithms they are expected to match buyers and sellers rapidly and anonymously in a liquidity pool). The algorithmic signals should in theory be searching for the optimal conditions in which to make a trade. See McGowan, supra note 54, at *2. 158 See FINDINGS, supra note 10, at 3 (indentifying other high‐frequency traders as the buyers of the initial shares of the E‐Mini being dumped by the faulty algorithm). These initial traders built up long‐term positions based on the low price of the contracts, but eventually stopped because these traders do not typically hold more than four thousand contracts at a time. See id. 159 See FINDINGS, supra note 10, at 3 (finding that the same traders who initially bought the E‐Mini contracts turned around and sold their shares while there was still no fundamental demand on the buy side). 160 See FINDINGS, supra note 10, at 3 (passing the same positions back and forth generating no value in the E‐Mini contracts). “Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.” Id. The trades resulted in the price of the E‐Mini contracts dropping to intraday lows in a matter of seconds. See id. at 3‐4. 161 See FINDINGS, supra note 10, at 4 (linking the pause in trading based on the fall in E‐Mini prices to the decline in stock values market wide). 162 See FINDINGS, supra note 10, at 4 (providing traders time to stop and assess the market conditions caused liquidity to dry up and there was a mismatch in buyers and sellers). Some traders even reported that their algorithmic strategies were not equipped to deal with these type of market conditions. See id. at 4‐5. 2011]
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penny or as high as $100,000.” 163 Firms employing HFT techniques are large market players based on trade volume and speed and their automated trading systems provide a great amount of liquidity to the market. 164 The pause in trading prevents firms from trading at prices that would result in a financial loss. 165 Though the pause prevents a financial loss to a firm, it dries up liquidity in the market as demand for securities falls. 166 However, the pause allowed firms to reassess risk, re‐
strategize and ultimately resume trading at rational prices, thereby allowing the market to rebound as quickly as it fell. 167 In light of the May 6 market events, the SEC faced enormous pressure to act swiftly in preventing a repeat performance. 168 In June, the SEC’s regulatory response, sanctioned by their administrative powers under the 1934 Act, came in the form of circuit breakers. 169 The SEC‐approved circuit 163 FINDINGS, supra note 10, at 5. 164 See FINDINGS, supra note 10, at 5 (explaining that high‐frequency traders contribute to both the give and take of the liquidity pool). 165 See FINDINGS, supra note 10, at 5 (listing different strategies that traders took during their pause for assessment during the market events of May 6, 2010). 166 See FINDINGS, supra note 10, at 6 (surveying a group of traders demonstrated that some traders completely withdrew from the market based on the declining conditions). 167 See FINDINGS, supra note 10, at 6 (observing that the pauses in trading ultimately served their purpose for traders). “As market participants had time to react and verify the integrity of their data and systems, buy‐side and sell‐
side interest returned and an orderly price discovery process began to function.” Id. 168 See SEC APPROVES, supra note 12 (acting as quickly as June 10, 2010 in order to take measures); David M. Serritella, High Speed Trading Begets High Speed Regulation: SEC Response to Flash Crash, Rash, 2010 U. ILL. J.L. TECH. & POL’Y 433, 439 (2010) (evaluating the SEC’s response as “quick to react” in order to avoid future disruptions). 169 See SEC APPROVES, supra note 12 (quoting Chairman Shapiro, “[b]y establishing a set of circuit breakers that uniformly pauses trading in a given security across all venues, these new rules will ensure that all markets pause simultaneously and provide time for buyers and sellers to trade at rational prices.”); Nina Mehta & Jeff Kearns, NYSE, Nasdaq Extend Stock Circuit Breakers to April, BLOOMBERG BUS. WK., Dec. 8, 2010, archived at http://www.webcitation.org/62g6KfAzt (extending the circuit breakers past their initial December 2010 pilot program in a vote of confidence in the 302
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breakers differ from those previously implemented in that they are applied on a stock‐by‐stock basis and apply to all securities in the S&P 500 index. 170 The circuit breakers work by pausing all trading in a given security when the price rises or falls more than ten percent in a five‐minute time period. 171 The pause is to enable trading firms to reassess the risk and make a calm, rational decision regarding the sale or purchase of the security. 172 Ideally, these circuit breakers would prevent the volatile price swings witnessed on May 6. 173 The circuit breakers have recently been expanded to all U.S. stocks, but remain under a pilot test stage that was extended on August 9, 2011. 174 They are likely to become permanent in the future. 175 Based on the popularity of the circuit breaker program). 170 See SEC APPROVES, supra note 12 (applying the circuit breakers on a stock by stock basis regardless of the exchange and the pause would happen market wide); PLI, NYSE Circuit Breakers (Rule 80B) in the Real World, 6 No. 39 PLI PMBA 1 (2008) [hereinafter NYSE Circuit Breakers] (applying only to those stocks which are listed on the NYSE). 171 See SEC Expands, supra note 13 (discussing circuit breaker response for events involving between five and twenty stocks); Edward Wyatt, S.E.C. Weighs Trading Limits to Avert Extreme Volatility, N.Y. TIMES., Apr. 2, 2011, archived at http://www.webcitation.org/62VTyiEIJ (noting the five‐minute pause). 172 See SEC Expands, supra note 13 (noting the comments by SEC chief Mary L. Schapiro stressing the importance of maintaining investor and company confidence in the markets). 173 See SEC APPROVES, supra note 12 (indicating that the rules were made in response to the event on May 6th); SEC Expands, supra note 13 (highlighting the purpose and context of the erroneous‐trade rule). 174 See SEC Expands, supra note 13 (running the initial pilot program from June 2010 to December 2010); Mehta & Kearns, supra note 169 (extending the initial pilot program for the circuit breakers to April 2011); SEC Announces Filing of Limit Up­Limit Down Proposal to Address Extraordinary Market Volatility, 2011 SEC NEWS DIGEST 66 (Apr. 6, 2011), archived at http://www.webcitation.org/62Nna5aTv [hereinafter SEC Limit Up­Limit Down Proposal] (stating the pilot program will be continued through August 2011). 175 See Notice of Filing and Immediate Effectiveness of Proposed Rule Change to Amend its Rules to Extend Pilot Program Regarding Clearly Erroneous Executions, Exchange Act Release No. 34‐65067, 2011 WL 3555519 (Aug. 9, 2011) [hereinafter Rules to Extend Pilot Program] (proposing an amendment to SEC rules to continue to extend the pilot program for circuit breakers); Jacob Bunge, SEC OKs Circuit Breakers for All Stocks, WALL ST. J., June 25, 2011, 2011]
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program, however, the SEC is currently exploring limit‐up/limit‐
down trading style parameters. 176 The parameters would ban trades outside of the acceptable percentage movements and are said to be more accurate and less disruptive to trading practices. 177 Additionally, the SEC, using its regulatory authority under the 1934 Act, implemented measures against erroneous trades. 178 The erroneous trade rules remove the ability of the exchanges to set a “trade break” point—the point at which trading is suspended. 179 The trade breaking occurs when the reference price is a certain percentage away from the circuit breaker triggering price. 180 There are three main levels: for stocks trading under twenty‐five dollars, trade breaks occur ten percent away from circuit breaker trigger price; for reference prices between twenty‐five and fifty dollars, the trade breaker will be triggered at five percent away from the trigger price; and for reference prices over fifty dollars, the trade breakers trigger when the price is three percent away from the circuit breaker archived at http://www.webcitation.org/63Aet0d6g (“Broadening the existing plan will afford protection to more stocks while the new program is finalized.”). 176 See Donna Kardoes Yesalavich, Global Finance: ‘Limit’ Proposal See Its Stock Rise, WALL ST. J., Oct. 14, 2010, C3 (reporting the continued efforts of the SEC to implement “flash crash” protections); Wyatt, supra note 171 (exploring the option of limit up/limit down parameters as additional measures to stabilize markets with as few pauses as possible). 177 See id. 176 (placing a band around trades that provides a safety net from a sudden drop in prices); Kristina Peterson & Jacob Bunge, ‘Limit Up/Down’ System May Replace Circuit Breakers, WALL ST. J., Sept. 24, 2010, archived at http://www.webcitation.org/62VU3gCqP (seeing the success of limit up/ limit down parameters in the futures exchange as a indication that the program may replace circuit breakers as a more appealing option). 178 See SEC Expands, supra note 13 (announcing the plan to break erroneous trades in conjunction with the circuit breaker pilot program). 179 See SEC Expands, supra note 13 (removing the limits from the exchanges provides the SEC with a uniform way to regulate the trade breaking point). These trading breaks would apply initially to only stocks that are contained in the S&P 500. See id. 180 See SEC Expands, supra note 13 (“[a]ccording to the SEC, the flash crash gained momentum partly because the exchanges did not break trades until they were 60 percent away from the reference price.”). 304
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price. 181 These trade breakers will also apply where circuit breakers are not in place for events caused by multiple securities. 182 There are two classes in the category: for between five and twenty stocks, the price needs to be ten percent away from the reference price, and for events with over twenty stocks it needs to be thirty percent away from the reference price.183 These measures are to prevent inaccurate trading from causing irrational price swings in securities. 184 The erroneous trade rules are also being applied on a pilot basis. 185 The SEC is also facing new pressure from the Dodd‐Frank Act passed by Congress in July 2010. 186 The Dodd‐Frank Act came in response to the market events following the collapse of such financial institutions as Bear Sterns and Lehman Brothers and the bailout of many investment banks by Congress. 187 Further, the SEC has faced scrutiny over its handling of blunders such as the Bernie Madoff Ponzi scheme, which caused 181 See SEC Expands, supra note 13 (outlining the various breaking points for securities on the S&P 500 stock index). 182 See SEC Expands, supra note 13 (holding the exchanges and FINRA responsible for executing this set of trade breakers). 183 See SEC Expands, supra note 13 (listing the two stages at which FINRA and the exchanges are obligated to step in and break trades to prevent a sharp market downturn). 184 See SEC Expands, supra note 13 (attempting to cover the holes from the initial circuit breaker pilot program). SEC Chairman Schapiro claims, “‘[t]hese circuit breakers and this more objective guidance on breaking erroneous trades will help our markets retain the confidence of investors and companies.’” Id. 185 See SEC Expands, supra note 13 (explaining that erroneous trade rules are running concurrently with the circuit breaker pilot program and picking up where circuit breakers leave off on individual stocks); but see Bunge, supra note 175 (expanding the circuit breakers to all U.S. stocks so that no security is left uncovered by the circuit breaker program). 186 See Dodd‐Frank Act, § 967(a)(2)(D), 124 Stat. at 1913 (providing that the SEC’s trade monitoring is a target of study in the Act). 187 See Page Perry, LLC, CNN Poll Confirms Public’s Distrust of Wall Street, INVESTMENT FRAUD LAWYER BLOG (Dec. 23, 2008), archived at http://www.webcitation.org/62VTvQ5Z2 [hereinafter CNN Poll] (blaming the ineffective policies of the SEC and deregulation by current presidential administrations as the root of public distrust in the financial system). 2011]
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extraordinary financial loss to many. 188 The public harbors negative sentiments regarding financial institutions and their risky trading practices, which attributed to the recession in the U.S. and around the world, adding additional pressure to the SEC. 189 In response to these growing concerns, the Dodd‐Frank Act requires the SEC to conduct research on HFT and related technologically advanced market making practices, produce reports, and take proactive steps to regulate the trade. 190 While the SEC concept release in January 2010 was voluntarily produced, action is now required under Dodd‐Frank, which specifically mandates that the SEC study “the effect of high‐
frequency trading and other technological advances on the market and what the SEC requires to monitor the effect of such trading and advances on the market.” 191 Mary Schapiro, the current Chairman of the SEC, addressed a group of securities traders in late September 2010 announcing plans to continue to research and review HFT practices. 192 The speech was largely in response to speculation that such high tech trading practices had outgrown SEC regulation. 193 Schapiro acknowledges the lack of 188 See OFFICE OF INVESTIGATIONS, SEC CASE NO. OIG‐509, INVESTIGATION OF FAILURE OF THE SEC TO UNCOVER BERNARD MADOFF’S PONZI SCHEME, at 20 (2009), archived at http://www.webcitation.org/62VTuCiXa (noting the failure of the SEC to uncover the harmful practices of Madoff); CNN Poll, supra note 187 (finding that the public views actions like Madoff’s as common practice in the financial industry). 189 See CNN Poll, supra note 187 (calling the actions of Wall Street “thievery” and stating the belief that without proper regulation the problems in the capital markets will persist). 190 See Dodd‐Frank Act, § 967(a)(2)(D), 124 Stat. at 1913 (targeting high‐
frequency trading practices as one of many areas that requires a study by the SEC). 191 Dodd‐Frank Act, § 967(a)(2)(D), 124 Stat. at 1913. 192 See Mary L. Schapiro, Chairman, U.S. Sec. and Exchange Comm’n, Remarks Before the Security Traders Association, (Sept. 22, 2010), archived at http://www.webcitation.org/62VTs6nL6 [hereinafter Remarks] (looking at high‐frequency trading as a market structure concern that needs to be addressed with studies and regulation). 193 See Fred Barbash, Warp­Speed Trades Outpace SEC, POLITICO, June 1, 2010, archived at http://www.webcitation.org/62VU66uYE (arguing that even though the SEC was warned that something like the flash crash might occur, 306
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regulation currently in place, but appeared mindful of avoiding unwanted consequences of regulation. 194 On February 18, 2011, the CFTC and SEC released a joint report on possible regulatory responses to the market events of May 6, 2010. 195 The report focuses on the volatility created by HFT practices, handling co‐location and direct access, improving liquidity to create stability, and improving market maker accountability and oversight. 196 The main focus of addressing volatility is improving the circuit breaker system in order to ensure that despite the breaks in trading, liquidity does not disappear from the market. 197 In dealing with the issue of liquidity, the focus of the SEC is to ensure that market makers they did not have the technological capability to prevent the occurrence of such an event). 194 See Remarks, supra note 192 (finding that the sheer trading volume and market access of high‐frequency traders gives them a “tremendous capacity to affect the stability and integrity of the equity markets.”). Currently, however, high frequency trading firms are subject to very little in the way of obligations either to protect that stability by promoting reasonable price continuity in tough times, or to refrain from exacerbating price volatility. We will consider carefully whether these firms should be subject to an appropriate regulatory structure governing key aspects of their market behavior, including both their quoting and trading strategies. In addressing these questions, the Commission's guiding principle must be to encourage a market structure that promotes capital formation and protects investors. But we must also be mindful of the risk of unintended consequences. . . . Id. 195 See JOINT COMMITTEE OF THE SEC AND CFTC, RECOMMENDATIONS REGARDING REGULATORY RESPONSES TO THE MARKET EVENTS OF MAY 6, 2010, 2 (Feb. 18, 2011) RECOMMENDATIONS], archived at [hereinafter http://www.webcitation.org/62VTndfmv (highlighting several potential changes). 196 See id. at 2‐14 (outlining the problems with each identified area and then presenting possible steps towards regulating those issues). 197 See id. at 8‐10 (providing that positive incentives to keep liquidity in the market would enable the financial system to better react in an event like the flash crash without dramatic drops in the market). Such measures include building incentives for “peak load” pricing models and changing maker/taker pricing practices. See id. at 10. 2011]
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have incentive to provide liquidity consistently. 198 Additionally, there is a proposed system to deal with the imbalance between buy and sell orders by creating a system of reporting liquidity measurements. 199 Finally, the SEC recognizes the need for more oversight into the murky practices of HFT. 200 Steps include adjusting how securities are priced, how the price information is routed, and supporting proposed regulations regarding the curbing of naked‐
access and direct access. 201 Perhaps most important suggestions made are the steps that propose the building and maintenance of a consolidated audit trail that would keep track of orders and executions across securities markets. 202 This would allow the SEC to keep pace with ever advancing technology and new trading techniques. 203 Further, the report recommends that the SEC reevaluate the privilege broker‐dealers have in order execution over customers and find ways to incentivize brokerage firms to prevent their traders from engaging in disruptive market 198 See id. at 9 (expressing the SEC belief that “the lack of liquidity on public Exchanges was the proximate cause of the trades that were subsequently broken” in the flash crash and that providing incentives for liquidity could prevent this from occurring again). 199 See id. at 14 (recognizing that the “enhanced information provision is consistent with the long‐standing view of the SEC and CFTC that market‐based solutions play a preferential role in the efficient functioning of markets”). 200 See id. at 10‐11 (examining market maker obligations and protocols when using high‐frequency trading practices). 201 See RECOMMENDATIONS, supra note 195, at 7 (acknowledging that when certain market participants use naked access to place orders through largely unregulated ECNs it creates the risk of manipulative trading practices); McGowan, supra note 54, at *41 (criticizing naked access as increasing the risk of reckless trades, thereby increasing the risk of an erroneous trade bringing down the market). 202 See RECOMMENDATIONS, supra note 195, at 14 (increasing regulator access to information on the trading that occurs in ECNs, which is otherwise well concealed). 203 See RECOMMENDATIONS, supra note 195, at 14 (attributing the difficulty in receiving and understanding information about trades on ECNs to the fragmented systems of gathering information). The SEC and CFTC recommend a meaningful cost/benefit analysis of implementing such a plan on the U.S. equities markets. See id. at 14. 308
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practices. 204 However, this report is simply a list of suggestions without a solid plan for implementation and it will certainly require more time and research on the part of the SEC. 205 Acknowledging the problems with previous regulations and the need to keep up with an advancing marketplace will only take the SEC so far. 206 Implementations of Dodd‐Frank, research into the HFT field, updating technology, and acquiring knowledgeable staff all require something the SEC does not have enough of—money. 207 The SEC staffing has always been notoriously thin and their budgetary issues do not help. 208 For example, after the “flash crash,” the SEC posted five positions to do research on the matter. 209 Due to budgetary constraints, it took over six months to even make an offer to one person. 210 The SEC has been forced to postpone investigations, hold off on research, and put proposals on the back burners due to budgetary constraints. 211 Additionally, the SEC has been criticized for staffing individuals who understand only the policy process, instead of the economic effects of the policies on the 204 See RECOMMENDATIONS, supra note 195, at 10 (concluding that under the “current rules and regulation, the benefits from making markets in good times do not come with any corresponding obligations to support markets in bad times”). 205 See RECOMMENDATIONS, supra note 195, at 2‐14 (providing recommendations without addressing specific implementation guidelines). 206 See RECOMMENDATIONS, supra note 195, at 2‐14 (failing to articulate a cohesive approach to keeping up with an advancing marketplace and taking an ancillary role to the effort). 207 See Charles Riley, SEC Starved for Reform Funds, CNN MONEY, Jan. 11, 2011, archived at http://www.webcitation.org/62fzyLnSo (indicating that Congress has failed to provide any money for the Dodd‐Frank Wall Street reform law). 208 See id. (providing that staffing with the agency has always been lean, and compared to larger law firms, the SEC lacks support and technology). 209 See id. (posting positions in an attempt to analyze the flash crash). Chairman Schapiro testified last year that, “[w]hile the markets were growing exponentially in size and complexity during the last several years, the SEC's workforce actually decreased and its technology fell further behind.” Id. 210 See id. (blaming the slow hiring process on a lack of funding). 211 See id. (explaining that capping the amount of travel for necessary investigations, limiting the number of expert witnesses it can hire, and postponing depositions in enforcement matters are all a result of the strained budget). The SEC is expected to produce proposals and act on Dodd‐Frank mandates, but does not have the funds to do it. See id. 2011]
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market system. 212 Going forward, the SEC hopes to attract more financially savvy employees, which will prove difficult as the compensation and profits in the private sector far outweigh what the public sector can offer. 213 Congressman Barney Frank acknowledges that implementing the mandates of Dodd‐Frank will not be possible without increased funding to the SEC, already facing budget constraints before the legislation was passed. 214 The SEC has taken steps to implement a few of the mandates of Dodd‐Frank but has otherwise been forced to put initiatives on hold. 215 In the spring months of 2011, SEC Chairman Mary Shapiro noted that research and proposals regarding HFT were in the works, but budget constraints were making the process slow and difficult. 216 President Obama has proposed a $300 million increase in funding for the SEC budget for 2012. 217 However, the budget 212 See Tom McGinty & Kara Scannell, SEC Plays Keep­Up in High­Tech Race, WALL ST. J., Aug. 20, 2009, at C1 (criticizing the SEC as leading “first with enforcement and then with analysis”); Barbash, supra note 193 (admitting that regulators concede they “are still living in the age symbolized by those cable business news anchors who sit above the floor of the New York Stock Exchange, screaming to be heard as though they were in the nerve center of the markets, which they’re not”). 213 See McGinty & Scannell, supra note 212 (lacking traders or employees with quantitative analytical skills has caused the SEC to fall behind in regulating trading). The SEC has had to rely on the expertise of self‐regulatory bodies like the NYSE to handle the more technologically advanced issues. See id. 214 See Riley, supra note 207 (estimating that the SEC will need about $2.25 billion to implement the mandates of Dodd‐Frank and carry out their existing obligations). 215 See Riley, supra note 207 ("[o]perating under the current budget is already forcing the agency to delay or cut back enforcement and market oversight efforts”). 216 See Riley, supra note 207 (testifying that the new obligations under Dodd‐
Frank would require hiring about 800 additional employees, but this has yet to happen). 217 See Jessica Holzer & Jamila Trindle, CFTC, SEC Get Funding Increases for Dodd­Frank Work, WALL ST. J., Feb. 14, 2011, archived at http://www.webcitation.org/62VUGR67g (allowing the agencies to hire more staff and carry out their duties). 310
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plan is expected to meet a great deal of opposition in Congress. 218 Combined, these factors leave many in the financial and political world wondering if the SEC has the ability to keep up with an increasingly technologically advanced market based economy. 219 V. Moving in the Right Direction? High‐frequency trading has emerged rapidly in the past few years as the trading method of choice. 220 The trading practice has been lucrative and profitable to its users. 221 It is no surprise then, that in the days before the “flash crash,” many critics of regulation were calling for the SEC to hold off on regulating HFT. 222 Critics noted that there had been no effect on market stability, and there was no evidence that there would be a disruption in the future. 223 After the events on May 6, 2010, it is clear that run‐away algorithms are a real threat, and could in fact 218 See id. (calling the plan a “backdoor” way to raise taxes Republicans are not likely to sign off on the plan); Riley, supra note 207 (noting that Republican opposition to the Dodd‐Frank legislation is likely to stall funding). 219 See Steven Meyerowitz, SEC Needs More Money – A Lot More – Lawyers Tell Congress, FIN. FRAUD LAW BLOG, Feb. 21, 2011, archived at http://www.webcitation.org/62VUIgwiI (implementing the SEC budget freeze comes at a time of financial crisis and at a point where the budget has been flat or decreasing while trading volume has significantly increased); McGinty & Scannell, supra note 212 (falling behind in the race for money, technology and skilled labor has caused the SEC to fall behind in the regulation of trading practices and rely heavily on self‐regulatory bodies). 220 See Spicer, supra note 6 (recognizing that high‐frequency trading practices account for approximately sixty percent of U.S. stock trading); Duhigg, supra note 43 (attributing the 164% increase in trading volume since 2005 to high‐
frequency trading). 221 See Duhigg, supra note 43 (estimating that high‐frequency traders generated around $21 billion in profits in 2008 alone). Traders are able to move in and out of large share positions quickly, making perhaps a fraction of a cent per share, but because the trades are so large, the fractions result in large profits. See id. 222 See McGowan, supra note 54, at *50 (concluding that the benefit of high‐
frequency trading may outweigh the negative effects of the practice and any regulations should come slowly). 223 See McGowan, supra note 54 at *41, *50 (acknowledging that there were potential risks in high‐frequency trading, and characterizing the destruction of overall market stability as a “doomsday scenario”). 2011]
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disrupt the market with disastrous effects. 224 The SEC has acted quickly to implement circuit breakers in an attempt to curb the danger of a rogue algorithm, but has held off on taking any additional steps to regulate HFT. 225 This note addresses whether these circuit breakers are an appropriate measure. Additionally, the analysis will look at what other steps or options the SEC has in terms of regulatory measures for dealing with HFT. Finally, this note will ask, what tools the SEC needs in order to keep up with advancing markets and technology. A. Circuit Breakers – Good Idea? Bad Idea? The SEC implemented the circuit breaker pilot program in order to provide a quick regulatory response in the midst of the flash crash. 226 The circuit breakers work by creating a momentary pause in trading on the security if triggered by a severe price swing during a five‐minute period. 227 The price swing is determined by percentages that vary based on the security in question, but the breakers begin at a ten percent price swing, either up or down, within five minutes. 228 The circuit 224 See Grant, supra note 11 (associating the “flash crash” with high‐frequency trading practices). The algorithms are essentially machinery, and therefore can break down. See id. Given the enormous trade size, a malfunctioning algorithm has a detrimental effect on the market. See id. 225 See SEC APPROVES, supra note 12 (explaining that the SEC acted within weeks of the flash crash to implement a form of regulation aimed at preventing panicked reactions and keeping up liquidity levels). 226 See SEC APPROVES, supra note 12 (implementing the circuit breaker pilot program to operate a selected number of securities). The new circuit breakers would differ from past examples in that the SEC would have them apply on a stock‐by‐stock basis, so that individual securities could be isolated for a pause in trading. See id. 227 See SEC APPROVES, supra note 12 (explaining how the circuit breaker could be triggered). The circuit breakers were intended only to prevent unusual and irrational swings in prices. See id. 228 See SEC Expands, supra note 13 (dividing securities into different pricing categories). Volatility of a security is taken into account when determining the assigned price range, which is in part possible based on the stock‐by‐stock nature of the circuit breakers. See id. See also SEC APPROVES, supra note 12 (allowing companies a moment to pause because it enables them to go 312
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breakers are intended to give companies a momentary break to reevaluate the trade and go forward with a mindset free from the panic of wildly fluctuating prices. 229 The circuit breakers are applied on a stock‐by‐stock basis, allowing other securities trading to continue in the event of a market trigger. 230 Individual brokerage firms and exchanges may have their own circuit breakers in place, but the SEC’s is the only uniform regulation. 231 The SEC is calling the circuit breaker regulation a success, which is true—for now. 232 Critics are quick to point out that the circuit breakers the SEC has implemented may block legitimate trades based on poorly planned price movement percentages. 233 Additional complaints with the program include insufficient flexibility in the percentage thresholds that not all securities fall under the purview of the program, and that uncovered derivatives of covered securities may cause market confusion. 234 It is understood that the system is not perfect and that there are flaws. Theoretically, for instance, if a firm has enough stock it could pull the trigger in an act of market abuse, should it not like forward with a rational mindset, and reduces the risk of losing liquidity in the market). 229 See SEC APPROVES, supra note 12 (improving liquidity because traders may not irrationally pull their money and shares if they have a moment to think through the situation). 230 See SEC Expands, supra note 13 (enabling other securities to continue trading is aimed at keeping liquidity available in the market). 231 See NYSE Circuit Breakers, supra note 170 (requiring NYSE members to have a form of circuit breakers in an attempt to safeguard the stability of the exchange). 232 See Mehta & Kearns, supra note 169 (demonstrating the support that the circuit breaker program is receiving from exchanges, which may already have their own circuit breaker systems in place). 233 See Peterson & Bunge, supra note 177 (proposing that limit up/limit down parameters is better than completely pausing trading because circuit breaker could be triggered in “false‐positive” situations). The limit up/down proposal demonstrates that circuit breakers may not be effective in a situation when an “‘anomalous’ quote . . . has become ‘the new normal.’” See id. 234 See Serritella, supra note 168, at 443 (noting that the lack of coverage for all securities and broad price range bands can cause confusion and result in unequal protection). 2011]
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the way it is trading. 235 Additionally, a stock might just have high volatility and hit the ten percent threshold in a matter of minutes. 236 Therefore, the technique of utilizing circuit breakers to halt trading may disrupt the market and cause prices to swing even more violently. 237 However, the regulation was implemented in a pilot program for these exact reasons, and thus far none of these fears have been realized. The SEC and exchanges are working to fix the kinks in the system, and to apply a uniform system across the market so that firms are aware of the protocol in a given situation. 238 Because it is a pilot program, amendments to a final regulation are possible for a change in percentage threshold based on market and individual security conditions, and for spreading the regulation through securities in the NMS. 239 Reports from the February 2011 SEC panel recommend extending the circuit breakers to all securities except those that are mostly inactively traded. 240 The report makes it clear that circuit breakers are perhaps one of the best ways to prevent 235 See Westbrook & Mehta, supra note 73 (exemplifying how a single company can have such a disastrous effect on the market). 236 See Serritella, supra note 168, at 442‐43 (using rigid pricing bands does not account for the individual securities’ own volatility). A one‐size‐fits‐all approach is not suitable when individual securities have different volatilities because it will be too restrictive for some and be meaningless for others. See id. 237 See Serritella, supra note 168, at 442‐43 (warning that pausing a trade may throw traders into a panic and dry up liquidity). 238 See RECOMMENDATIONS, supra note 195 (demonstrating that the SEC is aware of the potential risks of high‐frequency trading and is taking steps address them appropriately). The SEC does not “‘necessarily want to over‐fix things’ because new rules can have unintended consequences.” Mehta, supra note 87. 239 See Bunge, supra note 175 (expanding circuit breakers to all U.S. stocks as the pilot program for circuit breakers continues); SEC Expands, supra note 13 (applying the circuit breakers to the Russell 1000 and ETF indices as an increase from a sole application to the S&P 500 index). 240 See RECOMMENDATIONS, supra note 195, at 4 (realizing that fragmented implementation will not suffice). In June 2011, the circuit breakers were extended to cover all U.S. Stocks. See Bunge, supra note 175. 314
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market volatility from leading to market instability. 241 Yet, steps are being taken to quell the fears of many critics. Further, the pilot program has been repeatedly extended, demonstrating that the SEC is not rushing into a poor decision. 242 The latest extension came on August 9, 2011, after circuit breakers were in fact extended to all U.S. stocks in June 2011. 243 Wall Street has been viewing the program favorably, as it already mirrors circuit breaker programs they have already implemented, such as the NYSE 80B regulation. 244 However, the SEC regulation would provide a uniform response across all exchanges, and since ECNs are registered with the SEC as exchanges, their trades would not otherwise be subject to these circuit breakers unless firms self‐regulated in the same manner. 245 The events of May 6, 2010 demonstrated that enough firms did not self‐regulate, or did not do so quickly enough. 246 The uniform characteristics of the SEC circuit breakers also provide a level of market stability. The circuit breakers 241 See RECOMMENDATIONS, supra note 195 (emphasizing the importance of the circuit breaker program in the SEC’s mission to remedy significant market problems). 242 See Rules to Extend Pilot Program, supra note 175 (prolonging the circuit breaker pilot program once again); Bunge, supra note 175 (expanding the scope of coverage under the circuit breaker regulation while the program is still in its pilot test). 243 See Rules to Extend Pilot Program, supra note 175 (discussing the reasoning behind the most recent extension of the pilot program); Bunge, supra note175 (reporting the expansion of the safeguards, and the purpose of their implementation). 244 See Mehta & Kearns, supra note 169 (explaining that the pilot program be continued in order to allow the various exchanges to assess the best method of execution); NYSE Circuit Breakers, supra note 170 (exemplifying how the exchanges may self‐regulate in a manner similar to that of the NYSE). 245 See Release No. 34‐40760, supra note 117 (codifying the treatment of alternative trading systems under the SEC regulation by treating ECNs as broker‐dealers instead of the exchanges that they more closely resemble). The SEC circuit breaker system will apply to all U.S. stock regardless of the exchange on which they are being traded, thereby enabling them to be regulated when traded in “dark pools.” See Bunge, supra note 175. 246 See FINDINGS, supra note 10, at 3‐5 (finding that some firms halted their own trading while others scrambled to find liquidity because they had no system to take a “time‐out”). 2011]
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prevent stock values from falling infinitely down the rabbit hole, so‐to‐speak. 247 The applicable stocks and ETFs are unable to rapidly rise or fall out of their either ten, twenty or thirty percent price change, depending on the classification of the security. 248 This gives investors a sense of where the market is heading and where it can go, thereby providing confidence in market activities creating a level of market stability. 249 The momentary break in trading is intended to provide traders with an opportunity to reevaluate trading strategies, and move forward with a calm mindset. 250 The added protection of eliminating erroneous trades ensures that investors will not be harmed by faulty prices. 251 Each one of these factors bolsters confidence and stability in the market. The SEC circuit breakers serve the purpose for which they were implemented, and are good first steps in containing the effects of the “flash crash.” Ultimately, the circuit breakers are really just a band‐aid for one problem in a system of trading, which creates many problems; the circuit breakers will certainly stop run‐away algorithms from wreaking havoc on the marketplace, but it will not stop that algorithm from entering an ECN. 252 The circuit breakers are necessary as a temporary measure until a more comprehensive measure can be established for preventing erroneous trades in the market. 253 The SEC 247 See Robert, supra note 8, at 313‐14 (noting the exchanges’ imposition of circuit breakers in response to the flash crash). 248 SEC Expands, supra note 13 (establishing price‐band trading parameters by which the circuit breakers will operate). 249 See SEC Expands, supra note 13 (outlining the SEC’s goals for market stability in implementing the circuit breaker pilot program). 250 See SEC APPROVES, supra note 12 (observing that allowing a trader a moment to pause is intended to provide them an opportunity to buy and sell at rational prices). 251 See Robert et al., supra note 8, at 314 (illustrating that working in conjunction with circuit breakers, clearly erroneous trade regulations seek to provide a more comprehensive approach to prevent a problem from occurring in the first place). 252 See Robert et al., supra note 8 (explaining that utilizing circuit breakers alone is not sufficient to deal with clearly false trades). Other rules are being proposed in conjunction with circuit breakers to try and eliminate clearly erroneous trades. See id. 253 See Serritella, supra note 168, at 441‐42 (recognizing that implementing 316
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should not stop with the circuit breakers as a measure for controlling market volatility. Reviewing the history of trading practices reveals how quickly the market and trading techniques advance, often outpacing regulation. 254 If the SEC intends to keep pace with trading trends it must pursue alternate a means of stability protection. 255 Halting trading could potentially dry up liquidity in addition to stopping trades from running away. 256 Also, it is clear that circuit breakers do not prevent the erroneous trade from being entered in the first place. 257 The SEC should consider implementing the suggested “limit up/limit down” parameters with the circuit breakers in order to stabilize liquidity, and explore market wide options for oversight and accountability of those traders and firms engaged in HFT practices. B. What Else Should the SEC be Considering? The SEC recognized the necessity of circuit breakers following the events of May 6, 2010, but has not yet finished searching for the proper solution. The buzz is currently around limit up/limit down trading style parameters. 258 The limit circuit breakers was the correct measure for the SEC post‐crisis, even though the system is far from perfect). 254 See Seligman, supra note 115, at 672‐73 (discussing how SEC regulations have kept up with evolving markets). The SEC has been criticized for failing to keep pace with technology, and the once‐“stable framework for securities markets is now eroding. A key dynamic has been the rapid emergence of ECNs.” Id. 255 See Yesalavich, supra note 176 (indicating that the SEC is exploring other options besides circuit breakers as a means of ensuring market stability). 256 See Serritella, supra note 168, at 442‐43 (criticizing the circuit breaker program for failing to account for the possibility that traders may in fact panic from the pause in trading, and liquidity may disappear anyhow). 257 See Robert et al., supra note 8, at 314 (preventing potential chaos ensuing from an inappropriate algorithm does nothing to prevent the inappropriate algorithm from being entered in the first place). 258 See SEC Limit Up­Limit Down Proposal, supra note 174 (announcing a proposal to introduce limit up/limit down trading parameters in addition to circuit breakers); Yesalavich, supra note 176 (implying that the limit up/limit down system could be preferable to the circuit breaker system); Peterson & 2011]
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up/limit down parameters prevent trading beyond the circuit breaker parameters. 259 Unlike circuit breakers, the limit up/limit down rules would allow trading to continue instead of having to freeze trading on the particular security. 260 The range would potentially be tied to the national best bid and offer, which would provide additional flexibility to the parameters. 261 There are several advantages to implementing the limits system over the circuit breaker system. Most notable is the fact that trading on a security does not need to be halted. 262 This system would quell the fears of circuit breaker critics regarding restricting otherwise legitimate trades. 263 The limit up/limit down prevents the need to halt trading in false‐positive trade situations that would otherwise trigger the circuit breakers. 264 This system would certainly provide a steadier alternative to the circuit breaker, which may result in further market confidence. 265 Since the limits system provides the same safety net that circuit breakers do for run‐away algorithms without a Bunge, supra note 177 (discussing the possibility of implementing limits that already exist in the futures market in the equity markets). 259 See SEC Limit Up­Limit Down Proposal, supra note 174 (hypothesizing that the limits could altogether replace the stock‐by‐stock circuit breaker rules). 260 See Peterson & Bunge, supra note 177 (recognizing the goal of preventing trades from coming to a complete halt). Limit up/limit down parameters “allow traders to continue buying and selling stocks within those parameters and not freeze trading in that stock altogether.” Id. 261 See Peterson & Bunge, supra note 177 (agreeing that allowing trades to continue within the given price band would prevent the need to pause, which is currently required with circuit breakers). 262 See SEC Limit Up­Limit Down Proposal, supra note 174 (pausing trades only when an order cannot be completed within the set price band); Yesalavich, supra note 176 (minimizing the need to pause trading in a security). 263 See SEC Limit Up­Limit Down Proposal, supra note 174 (noting that while circuit breakers are effective in stabilizing individual securities, limit up/limit down parameters may create better market stability in extremely volatile conditions). 264 See SEC Limit Up­Limit Down Proposal, supra note 174 (preventing not only “an erroneous trade from triggering a trading pause, but keep[ing] the erroneous trade from occurring in the first place.”). 265 See SEC Limit Up­Limit Down Proposal, supra note 174 (assuring that “[u]pgrading [the] trading parameters will help our markets retain the confidence of investors and companies . . . .”). 318
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disruptive halt, the limit system adds a level of market stability that may make the method preferable to circuit breakers. 266 Further, these limits are already in operation in the future markets. 267 The SEC has a good platform to implement the systems effectively, and investors can rest assured that the measures are effective, tried, and proven. 268 The joint committee report of CFTC‐SEC recommends using the limit up/limit down system in conjunction with the preexisting circuit breakers. 269 This report indicates that implementing the measures together would prevent halting for single erroneous trade, which would allow execution and reporting of trades only within the band under the circuit breaker limits. 270 Notably, the implementation of these measures might appear as though the SEC is trying to over‐regulate because the limits trading system does everything that the circuit breaker system does without the pause in trading. The circuit breakers would be operational in case liquidity dried up. 271 The CFTC‐SEC report indicates that this protection address the concerns with 266 See SEC Limit Up­Limit Down Proposal, supra note 174 (recognizing that while the circuit breakers fulfill the purpose they were intended to serve, the SEC feels that they can further improve upon their regulatory measure to create a more stable market environment overall). 267 See Peterson & Bunge, supra note 177 (noting that the trading parameters have already been successfully implemented in the futures market). 268 See Peterson & Bunge, supra note 177 (explaining that implementing the program would simply require an extension from futures in the equities markets to equity markets as a whole). 269 See RECOMMENDATIONS, supra note 195, at 3 (evaluating the SEC’s recommendations regarding stock pauses and circuit breakers); but see Peterson & Bunge, supra note 177 (suggesting that the limit system may be superior to circuit breakers). 270 See RECOMMENDATIONS, supra note 195, at 9 (recommending that the program be run in conjunction with the existing circuit breakers as a supplement to correct the problems with circuit breakers). 271 See RECOMMENDATIONS, supra note 195, at 4 (using the limit up/limit down system as a first measure and then “only mov[ing] to a Pause if contra‐side liquidity did not appear during a relatively short set timeframe . . . .”). 2011]
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circuit breakers. 272 Consequently, it may be wise to evaluate the use of limits with and without circuit breakers in order to avoid confusion over regulation in the equity markets. 273 There are imperfections in the pilot program that need to be addressed before it becomes a permanent regulation. For example, there needs to be an exit strategy in the limits for legitimate trades that begin to pass outside the limits. 274 Under the current limits system, such a trade would be blocked, which would inhibit the market from making profitable moves. 275 If the SEC’s ultimate goal is to stabilize the equity market while bolstering the economy, then this problem would need to be solved proactively, as opposed to the pilot program’s reactive approach. That is because if there is no way that prices could legitimately vary beyond the limits set, security value can be harmed. 276 Additionally, the limits may not put liquidity in the right place at the right time, which means if another fix could not be found, circuit breakers would be necessary to realign resources. 277 Overall, the use of limit up/limit down trading 272 See RECOMMENDATIONS, supra note 195, at 4 (concluding that a limit first, pause second approach “would address many of the adverse impacts of the Pause . . . .”). 273 See Yesalavich, supra note 176 (discussing the use of limits to prevent future crashes); Wyatt, supra note 171 (recognizing the ability of limit up/limit down parameters to “improve upon the system . . . .”). 274 See Yesalavich, supra note 176 (addressing potential issues in the use of the limit up/limit down program, which may be worked out during a pilot program). 275 See Yesalavich, supra note 176 (recognizing that using the limits system would prevent the execution of trades outside of a certain price band even if it is a legitimate trade); Wyatt, supra note 171 (articulating that the limit up/limit down rule caps the next trade to a five or ten percent difference from the last legitimate trade price). 276 See Yesalavich, supra note 176 (cautioning that the limit up/limit down system may not “gather liquidity at the right price,” and a pause may be necessary for a liquidity correction). 277 See RECOMMENDATIONS, supra note 195, at 4 (reviewing the importance of circuit breakers as a fail‐safe to stabilize liquidity); SEC Limit Up­Limit Down Proposal, supra note 174 (providing that the purpose of running the pilot programs simultaneously is to allow one program to supplement the other); Yesalavich, supra note 176 (suggesting that the limits system may not always restore liquidity as hoped, in which case a pause in trading would be best). 320
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systems appears to be a promising option in regulating HFT, and is garnering support from the Financial Industry Regulatory Authority, Inc. (FINRA) and the major exchanges. 278 The limit up/limit down program should be implemented with the circuit breaker pilot program to ensure that when the regulation is made final it is complete and comprehensive. This type of action would prevent piecemeal legislation, and would allow an opportunity to work out any flaws before either program is made a finalized regulation. A joint pilot program would also ensure that the two policies work in unison, as envisioned by proponents. The comprehensive combination of limit up/limit down trading systems and circuit breakers would be able to deliver a degree of market stability not currently present. C. Building a Solid Platform for Oversight and Accountability Circuit breakers and limit up/limit down trading systems are certainly an effective way of providing a degree of market stability while ensuring that liquidity is available during triggers. 279 However, neither regulatory proposal addresses the underlying problem—stopping the erroneous trade before it happens; the SEC needs to take market‐wide regulatory measures to prevent runaway trades from occurring at all. 280 If the SEC takes necessary steps to establish oversight and accountability among those practicing HFT, it can help to prevent another large‐scale market disruption. 281 The outcome, 278 See Wyatt, supra note 171 (noting that the exchanges and FINRA originally proposed the plan for the limit up/limit down system). 279 See Wyatt, supra note 171 (illustrating that working in conjunction with each other, circuit breakers and limit systems can prevent destructive trades that have already been entered). 280 See RECOMMENDATIONS, supra note 195, at 3‐14 (proposing a variety of measures that the SEC is interested in implementing across the U.S. equities market). 281 See RECOMMENDATIONS, supra note 195 at 3‐14 (offering suggested regulations in response to the “flash crash” to effectuate market stability). 2011]
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therefore, would be a positive influence on liquidity and market stability. 282 A large part of market regulation is carried out by self‐
regulating exchanges and private organizations like FINRA. 283 Such regulations are fragmented because they only apply to members of the organizations and because firm self‐regulation is, by its nature, inconsistent. 284 A unified way to hold traders accountable nationwide should be developed. The recent report on possible regulatory responses to the market events of May 6, 2010 proposes financial incentives as a means of persuading market makers to act in a manner consistent with market stability. 285 The CFTC and SEC wish to encourage market makers to engage in peak loading trading techniques and to provide buy/sell pricing quotes that are reasonably related to the markets. 286 These lofty goals have the correct regulatory mindset, but will have to overcome two main obstacles. With the HFT practices market makers currently employ, they enjoy high profits, and are no longer subject to quoting requirements, so providing sufficient incentives will be difficult. Before any regulation can be worked out, it is necessary to engage in a cost‐benefit analysis of the plan. 287 Providing 282 See Prifti, supra note 88 (stating the SEC’s objectives are “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”). 283 See McGinty & Scannell, supra note 212 (failing to keep pace with the practices of investment firms has required the SEC to rely on the self‐
regulation of exchanges, private organizations, and the investment firms). 284 See Macey & O’Hara, supra note 1, at 571 (evaluating the evolving characteristics of the market that have led to a decentralized system of trading, contributing to the failure of self‐regulation); Markham & Harty, supra note 17, at 900‐01 (allowing for‐profit ECNs to self‐regulate can be problematic because they have dollar signs in mind). 285 See RECOMMENDATIONS, supra note 195, at 10‐11 (attempting to influence market makers to “regularly provide buy and sell quotations that are ‘reasonably related to the market.’”). 286 See RECOMMENDATIONS, supra note 195, at 10‐11 (encouraging a steady stream of liquidity and fair pricing practices for market participants). 287 See RECOMMENDATIONS, supra note 195, at 8‐11 (recommending the completion of a cost‐benefit analysis of an incentive plan to improve liquidity before implementing any such regulation). 322
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incentives to perform in a particular manner does not ensure that market makers will actually perform that way because of their self‐interested nature. 288 Also, among the benefits of such a regulation will be better pricing information and perhaps improved liquidity through peak load pricing models, but it will not ultimately stop the erroneous trades from occurring in the first place. 289 The proposed regulatory scheme is composed of piecemeal responses for specific problems, and is not a unified response to market conditions as a whole. 290 It also sheds light on the lack of regulation of today’s market makers. In 1999, the SEC decided to lump alternative trading systems in with broker‐dealer regulations. 291 Perhaps a large issue in forming regulations for ATSs is that they are not broker‐
dealers, and therefore should not be treated as such. 292 ATSs do not need to operate on an exchange platform, but instead must work on the concept of market anonymity, subjecting them to little oversight or regulation by the CFTC or SEC. 293 A step in the right direction may be to reevaluate the regulatory categorization and treatment of ATSs and ECNs. 294 The ATS regulation is now 288 See Markham & Harty, supra note 17, at 900‐01 (cautioning that competing self‐interests may cause self‐regulatory options to fail when an investment firm has its eye on big profits). 289 See FINDINGS, supra note 10, at 2 (demonstrating that human error in entering an algorithm can cause the market to spiral downward); SEC Limit Up­Limit Down Proposal, supra note 174 (lamenting that the current system breaks trades after the trade has already been entered, but does not prevent the erroneous trade from being entered in the first place). 290 See FINDINGS, supra note 10, at 2 (highlighting the specific areas of focus the limit up/limit down scheme is capable of influencing). 291 See 17 C.F.R. § 242.301(a)(4)(i) (expressing that trying to integrate ECNs into the national market system forced ECNs into already‐established categories of regulations instead of creating a newly‐tailored program). 292 See Seligman, supra note 115, at 673‐74 (pointing to the advantages ECNs enjoy over their broker‐dealer counterparts even though they are grouped under the same regulations). 293 See Borrelli, supra note 35, at 852 (fearing that the lack of surveillance over ECNs led to regulation in the late 1990s). But see 17 C.F.R. § 242.301(a) (providing exemptions for ECNs to indicate that the SEC does not plan on having many if any operate as exchanges). 294 See Seligman, supra note 115, at 676 (asking the question, “[s]hould exchanges continue to be the basic securities markets of the Securities 2011]
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twelve years old, and, given the rate of technological advancement, it may have been outpaced by technology. 295 Treating ATSs and ECNs as entirely as their own entities, rather than grouping them in as broker‐dealers, may give the SEC flexibility to keep pace with high‐frequency traders. The SEC recommendations report takes steps in the right direction, noting that Dodd‐Frank § 747 enables the CFTC to prohibit certain trading and pricing practices that were considered disruptive of fair and equitable trading.296 Certainly this could provide a platform for the SEC to also set standards for what algorithmic trades should take into account to avoid large‐
scale trades from becoming disruptive to the market.297 Effective algorithms work off of price, time, and size information, and perhaps standards as to each element should be established. 298 Additionally, given the anonymity of the way HFT works, it is difficult to unravel trades once they have been entered. 299 The time it took to discover that the firm Waddell & Reed was behind the algorithm that caused the May 6, 2010 market events demonstrates the difficulty in tracking trade information.300 Exchange Act or should a more capacious concept including, for example, ECNs succeed the earlier statutory role performed by exchanges?”). 295 See Barbash, supra note 193 (observing that the continuous stream of technological advancements in trading have outpaced regulations). The SEC notes “that no marketwide [sic] risk management systems are in place that would deal with a computer‐generated meltdown in real time.” Id. 296 See Dodd‐Frank Act, § 747(6), 124 Stat. at 1739 (granting the authority to the CFTC to regulate pricing and trading practices as they deem necessary for a stabilized market system). 297 See RECOMMENDATIONS, supra note 195, at 8 (using authority under § 747 could “ensure that algorithmic firms would have to demonstrate that there had been a careful evaluation of how an algorithm would operate in a number of scenarios that engender high market volatility.”). 298 See FINDINGS, supra note 10, 2 (listing what should ideally be taken into account when developing an algorithm); ALDRIDGE, supra note 3, at 17 (laying out that implementing a successful high‐frequency trade requires the use of both optimization and signaling algorithms in order to account for price, time, size, and an understanding of whether it is proper to sell or buy). 299 See BROWN, supra note 19, at 8 (explaining the mystery surrounding algorithm trading since it is largely done in a “black box”). 300 See FINDINGS, supra note 10 (understanding who caused the crash and how it happened took a great deal of time and effort by two separate government 324
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However, given a uniform system of tracking trades, the SEC would have a much easier time regulating ECNs and the trades that occur in liquidity pools. The CFTC‐SEC February 2011 report calls for research into an equity market wide audit trail system. 301 Currently, regulators are dealing with the difficult task of obtaining and merging “an immense volume of disparate data from a number of different markets and market participants.” 302 Establishing a single system for compiling and tracking trading data would provide the SEC with a streamlined, uniform system enabling it to keep track of market players. 303 Such a system would provide a platform for engaging in a more comprehensive regulatory scheme for HFT as it would allow the SEC to more easily ensure compliance. 304 Compiling data in a single place “would help regulators keep pace with new technology and trading patterns in the markets.” 305 The audit trail system would be able to provide valuable data regarding orders and trade executions, which would be useful in forming regulations that are more forward thinking based on patterns, and better suited to the types of tech‐savvy practices traders are beginning to implement in the U.S. equity markets. 306 Piecemeal regulations will just provide a series of band‐
aids for the equity markets. It is in the best interest of the SEC to establish a more solid platform from which to build a uniform agencies). See also Westbrook and Mehta, supra note 73 (identifying Waddell & Reed as the firm that caused the crash). 301 See RECOMMENDATIONS, supra note 195, at 14 (giving regulators “‘more efficient access to data through a far more robust and effective cross‐market order and execution tracking system.’”). 302 RECOMMENDATIONS, supra note 195, at 14. 303 See RECOMMENDATIONS, supra note 195, at 14 (recognizing the need for research into such a system given there is no consolidated place for the SEC to gather their information on trades). 304 See RECOMMENDATIONS, supra note 195, at 14 (providing valuable information to regulators on trade orders and executions). 305 RECOMMENDATIONS, supra note 195, at 14. 306 See RECOMMENDATIONS, supra note 195, at 14 (recommending that compiling the data neatly into a single place would assist regulators to make informed decisions about regulation). 2011]
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system of regulations. The best way forward is to begin by reevaluating the treatment of ATS and ECNs, as technology in the market place has advanced rapidly since 1999. It is possible that the financial markets are now outpacing twelve ‐year old regulations with advanced technology. Second, creating a consolidated audit trail system for the U.S. equity markets would make the jobs of SEC regulators easier is compiling data, forming new regulations, and staying on pace with advancing technology. The best way to keep pace with those traders taking advantage of HFT is for the SEC to employ tech‐savvy techniques of its own. D. Money Makes the World and the SEC Go­Round The SEC, as a federal government agency, is entirely funded each fiscal year by the budget set forth by Congress. 307 Its operations are at the mercy of the dollar amount assigned to it each year. 308 Historically speaking, the SEC has had a notoriously lean staff and budget. 309 However, these factors do not mean that less is expected of the agency. 310 As a matter of fact, as the economy experienced the worst recession the country has seen since the Great Depression in late 2008, the pressure has 307 See Riley, supra note 207 (expressing that the SEC expects Congress to come through with additional funding for the new mandates under Dodd‐
Frank); Meyerowitz, supra note 219 (pointing out that Congress has always been tight on the budgetary purse strings). 308 See Meyerowitz, supra note 219 (worrying that the amount of funding available to the SEC in recent years is not enough to sustain its obligations). There is a current budget freeze and funding has been flat or decreasing for some years despite increasing market activity. See id. 309 See Meyerowitz, supra note 219 (noting Congress’s unwillingness to consistently approve SEC budget proposals). 310 See Riley, supra note 207 (arguing that adding additional regulatory obligations under Dodd‐Frank has caused the SEC to halt other initiatives and cut back on enforcement procedures). The SEC “‘is being forced to cut the number and frequency of its examinations of financial firms, which were already very infrequent due to historic underfunding of the agency.’” Meyerowitz, supra note 219. “‘Its acclaimed plan to bring in Wall Street trading experts with the sophistication to understand and appropriately respond to today s complex trading and markets, including the new technologies and strategies that may have had a role in last year’s flash crash, cannot achieve its promise without funding.’” Id. 326
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mounted on the SEC to regulate the blamed giants of the financial industry, and safe guard investor interests. 311 Adding fuel to the fire were a series of Ponzi scheme scandals and the passage of the Dodd‐Frank Wall Street Reform Act. 312 People were left wondering how the SEC did not catch figures like Bernard Madoff from stealing investor funds while Congress piled more responsibility on an already strained agency. 313 Unfortunately, the simple answer to many of the SEC’s woes is money—something they do not have enough of. 314 Those on Wall Street and in Congress are recognizing that without the proper funding, initiatives will fall by the wayside, and mistakes of the past are likely to be made again. The SEC needs to increase staff size to meet the demands facing the agency. 315 However, budgetary constraints make the hiring process long and difficult, taking nearly six months to hire a single person. 316 Additionally, the SEC needs to attract more tech‐savvy individuals with backgrounds in finance and quantitative analytics to keep pace with advancing technology. 317 311 See Meyerowitz, supra note 219 (articulating that sending the right message to the investing public about the ability of the SEC to safeguard their interests is important to bolster confidence in the market system). 312 See Riley, supra note 207 (indicating that mounting responsibilities and a shrinking budget has seriously strained the SEC’s resources); Meyerowitz, supra note 219 (finding that public distrust of the market may stem from the inability of the SEC to effectively regulate the markets with its current resources). 313 See McGinty & Scannell, supra note 212 (recounting that the SEC faced criticism for its inability to discover the Madoff Ponzi scheme). 314 See Riley, supra note 207 (considering that the SEC requires an estimated $2.25 billion to continue operating under the new Dodd‐Frank mandates); Meyerowitz, supra note 219 (reporting that funding for the SEC has been stagnant for some time). 315 See Riley, supra note 207 (estimating that Dodd‐Frank would require hiring approximately 800 new staff members). 316 See Riley, supra note 207 (describing the long process the SEC went through to hire a single person in the wake of the “flash crash”). 317 See Barbash, supra note 193 (criticizing the SEC staff’s ability to understand the technology and financial data even if they were properly equipped and brought up to speed on technology); McGinty & Scannell, supra note 212 (verifying that lacking “its own traders with knowledge about cutting‐edge strategies and how the markets operate,” the SEC “long ago ceded the daily 2011]
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The best way to attract this type of talent is to have an efficient hiring system and provide more competitive salary packages. 318 Also, the SEC will need to build new technologically advanced systems to keep pace with Wall Street practices, which will require more funding for the SEC. 319 Attracting these types of employees is especially crucial in carrying out the mandates of the Dodd‐Frank Act. 320 A great deal of the legislation requires the work of financially‐competent minds. 321 In order to attract those individuals, the SEC will have to lure talent from Wall Street firms. 322 Also, without proper funding, it is extremely difficult to fund the research and time that is required to produce the regulations Dodd‐Frank is seeking. 323 Many initiatives have already been shelved due to these constraints. 324 While the $300 million requested by surveillance of trading to self‐regulatory organizations. . . .”). 318 See McGinty & Scannell, supra note 212 (emphasizing that the need for staff training and recruitment of people with Wall Street experience has become a priority for the SEC). 319 See McGinty & Scannell, supra note 212 (recognizing the need to update how the SEC functions, and that it will require quantitative and analytical skills the agency has not traditionally possessed); Barbash, supra note 193 (raising the concern that the technology the SEC currently has in place is drastically inferior to what is used on Wall Street). 320 See McGinty & Scannell, supra note 212 (espousing the opinion that attracting new financially savvy staff members is a priority, according to Chairman Schapiro). 321 See McGinty & Scannell, supra note 212 (observing that the SEC “takes a lawyerly approach to regulation and rule making that rarely employs deep analyses of real trading data.”). 322 See McGinty & Scannell, supra note 212 (prioritizing “recruiting additional professionals with expertise in securities trading, portfolio management, valuation, forensic accounting, information security, derivatives and synthetic products and risk management” because it will help make the SEC more capable). 323 See Riley, supra note 207 (demonstrating the strain on resources the SEC is already facing aside from the new Dodd‐Frank mandates). Congressman Barney Frank recognizes that the SEC cannot do its job without better funding. See id. See also Holzer & Trindle, supra note 217 (reiterating Chairman Schapiro’s concerns about meeting their existing obligations and the new mandates under Dodd‐Frank with their current budget). 324 See Riley, supra note 207 (explaining that cutting back on enforcement measures has been a side‐effect of a strained budget); Meyerowitz, supra note 328
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President Obama would be helpful, given the current disagreement over the next fiscal year’s budget, the SEC will likely not see that funding. 325 A solution may be to have the SEC become self funded. The SEC under the 1933 and 1934 Acts requires registration and affirmative disclosures from public companies. 326 The paperwork the SEC requires all have fees attached to them. 327 Additionally, fines and penalties against companies come from the SEC’s efforts, and are instead given to the federal treasury to be distributed to other agencies. 328 The SEC could use this money to fund itself rather than being at the mercy of the government budget. 329 This would also provide an incentive for the SEC to work efficiently and vigorously to generate profits for the agency. 330 The SEC deals in profit generating business, and should be allowed to use the funds to fuel itself. There is no question that without better funding, the SEC cannot keep pace with the advancing technology of Wall Street. VI. Conclusion The U.S. financial markets have undergone a technological revolution since the early 1990s. The traditional view of the exchange has fallen by the wayside and in its place is a world of 219 (concluding that dwindling budgets have caused the SEC to fall behind in regulation, enforcement, and technology, leading to catastrophic failures such as the overlooked Madoff Ponzi scheme). 325 See Holzer & Trindle, supra note 217 (arguing that an increased budget would allow the SEC to hire nearly 800 new employees, but unfortunately this plan has already been denounced by Republicans); Riley, supra note 207 (noting that there is support from the Democratic party, but opposition from the Republicans who want to repeal most of the Dodd‐Frank mandate). 326 See 15 U.S.C. § 78l‐m (granting authoritative powers to the SEC to regulate secondary markets). 327 See Holzer & Trindle, supra note 217 (asserting the possibility of raising revenues through the use of fees). 328 See Holzer & Trindle, supra note 217 (stating that the fees help to partly offset the SEC’s appropriation from Congress). 329 See Holzer & Trindle, supra note 217 (supporting budget proposals that would put the fees charged back into the SEC). 330 See Holzer & Trindle, supra note 217 (advocating for the purpose of an increased budget). 2011]
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complicated algorithms and computers acting as traders. HFT emerged as a technique firms could employ in order to generate large profits quickly. HFT occurs on ECNs, which provide anonymous liquidity to the market while keeping the trading process relatively secretive. Both HFT practices and ECNs remained largely unregulated until May 6, 2010. After a runaway algorithm created a few moments of incredible market instability, the public cried out for regulators to take action. The SEC’s response was to create a system of circuit breakers and the promise of further research and regulatory action in the world of HFT. The current SEC response appears reactive in nature and made up of piecemeal regulatory measures. If the SEC wishes to avoid reactive measures and keep pace with Wall Street it will need to implement a solid, comprehensive platform for regulating HFT as a whole, rather than individual pieces. The best starting point would be a consolidated audit trail system to track orders and executions, allowing the SEC to maintain a watchful eye on trades that are otherwise difficult to unwind. The SEC should also consider whether the regulation for ATS and ECNs is still serving the purpose it was intended for twelve years ago. Further, implementing these regulatory measures does not come cheap and if the SEC is expected to meet the goals before it, the agency will need more funding from the federal government. Moving forward, the SEC need to be forward thinking in its regulatory measures to keep abreast of advancing technology and produce legislation flexible enough to encompass problems still unforeseen.