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Are You Afraid of the Dark?

Shining Light On Black Box High Frequency Trading and Proposed Regulation SHAWN R. DURRANI The high-frequency trading environment has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment.1 I. Introduction ................................................................................2 II. Trading Markets .........................................................................5 A. Humble Beginnings for the NYSE .........................................6 B. Rise of Electronic Trading .....................................................7 C. Algorithmic Trading ........................................................... 15 D. High-Frequency Trading .16 III. HFT Strategies ..........................................................................20 A.Market Making .....................................................................20 B. Statistical Arbitrage .............................................................23 C. Directional Strategies .......................................................... 25 1. Order Anticipation ...........................................................25 2. Momentum Ignition .........................................................27 3. Quote Stuffing .................................................................27 IV. Regulatory Response ................................................................29 A. Current Regulation...30 1. Market Manipulation .......................................................30 2. Large Trader Reporting/Consolidated Audit Trail ..........31 3. Naked Access ..................................................................32 B. General Ban on Flash Orders .............................................. 33 C. Market Making Obligations ................................................ 41 V. Conclusion ................................................................................48

1 Carol L. Clark, Controlling risk in a lighting-speed trading environment, Chicago Fed Letter (March 2010, Number 272), available at



Without question, advancements in computer, communication, and internet technologies have drastically changed the landscape for doing business across the globe. One area in particular that has been significantly altered is the functioning of the financial markets. Of course, financial markets have always been characterized as having a thirst for speed and efficiency. But until recently, that speed was largely subject to human limitations. Today, technology has driven vast developments in the speed and efficiency of trading, which has created new opportunities for short-term gain. As a result, market competitors have devised strategies to take advantage of these opportunities. Fierce market competition has caused these opportunities to be available for an increasingly shorter and shorter period of time. Now market participants chase profits of a fraction of a cent over even smaller fractions of a second. Perhaps the most significant development in financial markets is high frequency trading (HFT).2 HFT is the result of this evolution of the marketplace from human inhabited trading floors to cyberspace, or, as Lewis Borsellino cleverly quipped: From the Pit to the PC.3 As of 2009, the TABB Group, a financial markets research firm, estimates that HFT accounted for up to 70% of total equity trading volume, despite the fact that only about 2% of the 20,000 U.S. trading firms engage in these transactions.4 One might ask: how can 2% of firms account for 70% of volume? To them the author responds: Welcome to the party. Until recently, very little information has been available about HFT. In fact, it remained predominantly unknown to those outside of the financial sector until an article in the New York Times in July
2 HFT will be used to refer to high frequency trading or high frequency trader. Additionally, HFTs will refer to high frequency traders throughout this paper. 3 Lewis Borsellino is a famed former trader in the S&P futures pit at the Chicago Mercantile Exchange. Despite the universal application of its title, market operations have far surpassed the transformation to the human-controlled PC trading environment discussed by Borsellino. Lewis J. Borsellino, The Day Trader: From the Pit to the PC (1999). 4 See Clark, supra note 1, at n.2.

2009 brought it into the public spotlight. 5 And it has certainly garnered the attention of many regulators and laypersons alike, including SEC Chairwoman Mary Schapiro. 6 Just as HFT is characterized by its blazing speed and high volume, coverage on HFT is quickly being disseminated to a huge amount of people. However, HFT is an extremely complex topic, which can similarly cause confusion for the regulator and the layperson alike. While there is no lack of attention to HFT, there is a lack of comprehension regarding this topic. This lack of understanding presents one of the biggest impediments to implementing effective regulation of HFT.7 Awareness of HFT became particularly acute following the Flash Crash of May 6, 2010,8 and it has been a popular subject for debate since then. Proponents of HFT generally tout its benefits in terms of lower trading costs, price and market efficiency, and increased liquidity. Some go as far as calling HFTs the new market makers in stock trading.9 Interestingly enough, to the extent that
See Charles Duhigg, Stock Traders Find Speed Pays, in Milliseconds, New York Times (July 23, 2009), available at 6 See Ronald D. Orol, SECs Schapiro eyes high frequency traders, MarketWatch, available at 7 Chris Sparrow, Why Its Hard to Know the Impact of High Frequency Trading (Nov., 27, 2011), TABB Forum, available at's-hard-to-knowthe-impact-of-high-frequency-trading (explaining that [t]o move forward in the debate about HFT and its impact on the market, we need to understand the impacts of the specific strategies being employed and avoid generalizing statements that apply to all strategies. Otherwise, the pro-HFT camp will continue to talk about strategies that [have] a clear benefit to the market while the anti-HFT camp will continue to focus on strategies that exploit the existing market structure to pick off natural liquidity providers.). 8 Towards the end of the trading day on May 6, 2010, the Dow Jones Industrial Average sharply declined more than 600 points in a matter of minutes before it quickly recovering most of the loss. A single trade was pinpointed as triggering the decline, and HFTs are said to have exacerbated the sell-off by generating a hot-potato volume effect as the same positions were passed rapidly back and forth. See Tom Lauricella, Kara Scannell, & Jenny Strasburg, How a Trading Algorithm Went Awry, Wall Street Journal (Oct. 2, 2010), available at 9 See Cyrus Sanati, Sorry, SEC. Fast Trading on Wall Street is here to stay, CNN Money (Feb. 28, 2012), available at (stating that many HFT firms claim to be acting as Designated Market Makers, succeeding the role of the Specialists); see also infra Part III.A.

HFTs engage in favorable strategies,10 academic research supports the finding that HFT generally contributes to market quality and price formation and has positive effects on liquidity and short term volatility.11 But where were the new market makers and their liquidity on May 6, 2010? In fact many HFT firms simply turned their systems off and exited the market during the Flash Crash.12 If HFTs run for the hills during times of major market volatility, their tremendous level of trade activity looks much less like the lauded market liquidity and more like just a leveraging of volumes to earn huge profits when its convenient. This evaporation of liquidity can have a destabilizing effect on the market. Considering all this, there are some important assumptions13 that should be clearly laid out for purposes of this paper. First, HFT accounts for a large share of market activity today, and it is here to stay. Second, HFT is neither inherently good nor bad. 14 To the extent they employ market friendly strategies, HFT has a positive impact on market efficiency. However, HFT firms have the potential to use manipulative strategies, as well as exacerbate volatility in times of market distress, such as in the Flash Crash, especially when firms simply turn off their systems and remove their liquidity from the market. These assumptions must be taken into consideration in formulating a regulatory response. Regulation should be carefully crafted to preserve the positive effects of HFT while addressing its potential for destruction.
10 Market making strategies tend to provide market liquidity. Arbitrage strategies improve price discovery and market efficiency. Manipulative strategies negatively impact market integrity. See infra Part III. 11 See Peter Gomber, Bjrn Arndt, Marco Lutat & Tim Uhle, High-Frequency Trading at 2, Working Paper (2011), available at 12 At least one academic research study determined that HFT exacerbated volatility in the flash crash. See generally, Andrei Kirilenko, Kyle Albert, Mehrdad Samadi, & Tugkan Tuzun, The Flash Crash: The Impact of High Frequency Trading on an Electronic Market, Working Paper (2011), available at 13 These are labeled assumptions in order to highlight the fact that, although current research does generally support these statements, they are not immutable rules. Debates between academics regarding HFT are facilitated through extensive, continued research. 14 Although, the overall trend of decreased costs due to greater use of technology and automation are generally viewed as good.

Accordingly, this paper argues that the SEC should implement a general ban on flash trading, allowing for a narrow exception for those willing to observe market making obligations. By doing so, the SEC can succeed in eliminating the potential for employing manipulative strategies and encourage stable liquidity in times of market distress. To be sure, the SEC has already taken significant steps toward achieving this goal. But they must remain fluidready to react and adjust based on the findings of continuing research conducted on HFT. It is important to remember, however, that risk can never be entirely eliminated from the marketsnor should it be. As such, this paper seeks to rationally evaluate the circumstances surrounding HFT and propose a course of action that can meaningfully reduce the chance that another Flash Crash or similar destabilizing event will occur. This paper will proceed as follows. Part II will track the evolution of trading, navigating through a web of technological and regulatory responses that took the New York Stock Exchange (NYSE) from a buttonwood tree to cyberspace. Part III will discuss automated or algorithmic trading and high frequency trading, including the important distinction between the two. Part IV will describe the major HFT strategies. Finally, Part V will conclude with my proposal conditioning the practice of flash trading on the acceptance of market maker obligations. II. TRADING MARKETS

The evolution of trading on the financial markets somewhat resembles a sci-fi thriller. At its inception, only people, with barely any help of technology, conducted activity on the trading floor. Today, trading is conducted almost exclusively though electronic mediums. A trip through this history will be helpful in understanding the current state of affairs surrounding HFT. The world-renowned NYSE shall serve as an appropriate example.

A. Humble Beginnings for the NYSE On May 17, 1792 under a buttonwood tree outside 68 Wall Street in New York City, 24 stockbrokers signed the Buttonwood Agreement, which, arguably, formed the organization that would eventually become the NYSE.15 For two decades, the first traders conducted their business outside under that buttonwood tree. In fact, the group didnt move indoors to trade until 1817.16 Despite the members zealous enthusiasm, the exchange was not an instant success. In March of 1830, the exchange experienced its slowest day in history only 31 shares were traded. At approximately 50 members, that was less than 1 share per trader.17 The method under which the original traders conducted business is referred to as open outcry trading. Open outcry trading consists of the professional traders shouting and using hand signals to communicate information about the buying and the selling stocks. This amounts to an auction where the traders buy and sell from each other. As time went on the number of NYSE members grew and so did the volume of daily trading activity.18 Nonetheless, the open outcry method remained the NYSEs favored trading structure for more than 200 years, at least until 2006. 19 Today, trading is conducted almost exclusively electronically.20
NYSE Euronext: History, available at However, the official name of the exchange New York Stock & Exchange Board was first given to it in 1817. The name was eventually shortened to New York Stock Exchange in 1863. At least one commentator has refuted the idea that the 1792 Buttonwood Agreement formed the organization that would grow into the NYSE, see generally, Peter Eisenstadt, How the Buttonwood Tree Grew: The Making of the New York Stock Exchange Legend, 19 Prospects: Annual Am. Cultural Stud. 75 (1994). Yet, that discussion is beyond the scope of this paper. 16 NYSE Facts and Figures: Historical, Chronology of New York Stock Exchange (17921929), available at 17 In 1836, it consisted of about fifty persons. See Stuart Banner, The Origin of the New York Stock Exchange, 1791-1860, 27 J. Legal Stud. 113, 116 (1998). 18 Id. at 117. 19 In 2006, the NYSE dispensed with its membership-only structure and went both public and electronic. It launched its Hybrid Market, which consisted of electronic trading and preserved the traditional open outcry, floor-based system. See Paul L. Davis, Michael S.

B. Rise of Electronic Trading The conversion to electronic trading was not an overnight phenomenon. Technological advances were present far before the NYSEs transformation in 2006.21 These advances, characterized by continual evolution of technologies for generating, routing, and executing orders, have dramatically affected the U.S. financial markets.22 The results are significantly improved speed, capacity, and sophistication of trading functions available to current market participants.23 Of course, this mention of market development begs the question: How did we get here? In short, the combination of these advanced computer and communication technologies and certain regulations have driven the transformation towards exclusively electronic markets. 24 A quick walk through these developments will provide context for this papers discussion.25
Pagano, & Robert A. Schwartz, Life after the Big Board Goes Electronic, Financial Analysts Journal, Vol. 62, No. 5, at 14 (2006). See also NYSE Euronext: Who We Are, available at 20 Only 1,200 traders remain on the floor, which is less than half the amount present around 15 years ago. Even on the floor of the exchange itself, most trading is conducted electronically See Graham Bowley, Preserving a Market Symbol, N.Y. Times (April 25, 2011), available at ( 21 NYSE listed stocks were traded primarily on the floor of the NYSE in manual fashion until October 2006. See Concept Release on Equity Market Structure, 75 Fed. Reg. 3594 (Jan. 21, 2010). 22 Id. 23 Id. 24 See Clark, supra note 1 (describing the explosion in order volume after the decimalization of US Capital Markets and processing such volumes exceeded the abilities of human traders); Emily Lambert, Flash Crash: The Regulators Did It, Forbes (Sep. 29, 2010), available at; Tom Lauricella, et al., Investors, Regulators Laid Path to Flash Crash, The Wall Street Journal (Sep. 29, 2010) (describing the various SEC regulations that have pushed markets into electronic markets including requiring stocks be priced in pennies instead of 1/8 fractions). See also, Concept Release on Equity Market Structure at 3594 n.12 (listing regulations that have helped push markets towards an electronic environment) citing Securities Exchange Act Release No. 51808 (June 9, 2005), 70 FR 37496 (June 29, 2005) (Regulation NMS Release); Securities Exchange Act Release No. 37619A (September 12, 1996) (Order Handling Rules Release). 25 However, a list of all the technological developments is outside of the scope of this paper. This paper includes only a condensed account of the development of electronic trading on

The development of the modern marketplace is a result of many interactions between its market participants and those seeking to regulate it. The first major signs of technology entering the trading arena stretches back to the late 1960s. Around that time, the SEC concluded that a computer could be used to report inter-dealer quotations in the over-the-counter (OTC) market.26 The National Association of Securities Dealers (NASD)27 turned this proposal into a reality in 1971 when they opened the National Association of Securities Dealers Automated Quotations (NASDAQ), an electronic quotation system that allowed broker-dealers to enter market quotations that could be retrieved from computers located at the brokers desks. 28 At first, the NASDAQ served only as a computerized bulletin system. Despite the fact that it did not actually connect buyers and sellers, it increased market efficiency because its quotations could be updated electronically. 29 The NASDAQs computerized bulletin system, however, represented only the regulators attempt to streamline trading. In fact, Instinet, the first electronic communications network (ECN) developed in 1969, actually preceded the NASDAQ.30 An ECN is an electronic system that collects buy and sell orders for

the equity market. Certain advancements may be mentioned but only as deemed relevant. For a more complete discussion of how computer and communication technologies have changed the equities and futures markets, see generally, 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 (2008). 26 2 JERRY W. MARKHAM, A FINANCIAL HISTORY OF THE UNITED STATES, FROM J.P. MORGAN TO THE INSTITUTIONAL INVESTORS (1900-1970) 347 (2002) (Explaining that an SEC Special Study was conducted in response to manipulative behavior regarding the distribution of pink sheets, which contained the daily, hard-print quotations of dealers. The SEC determined that a computer could be a substitute for the pink sheets.). 27 NASD was a non-governmental, self-regulatory organization responsible for certain aspects of financial market regulation. See United States v. Natl Assn of Sec. Dealers, Inc., 422 U.S. 694, 700 n.6 (1975). NASD has since been succeeded by the Financial Industry Regulatory Authority (FINRA) in 2007. 28 See Markham, supra note 26, at 347. 29 Id. 30 See Mark Borrelli, Market Making in the Electronic Age, 32 Loy. U. Chi. L.J. 815, 826 (2000).

securities and allows the orders to be executed against each other.31 ECNs serve as a means of bringing buyers and sellers together, rather than conducting market making as a principal.32 Similar to the NASDAQ display of market maker quotes, ECNs also displayed orders from its subscribers. 33 Instinets subscribers consisted of institutional investors and money managers who traded directly with each other.34 Essentially, ECNs gave institutional traders access to one another without having to go through an exchange. These developments greatly enhanced efficiency, except that the SEC became increasingly worried that the growth of institutional trading would create a tiered market system, placing retail investors at a disadvantage. 35 The SEC was also concerned with market fragmentation, which may result in incongruent pricing for the same securities sold on different exchanges.36 In 1975, the SEC sought to counter these concerns by amending the 1934 Act to create a national market system (NMS). 37 These amendments solidified the facilitation of an NMS as a major concern of the SEC going forward.
Id. at n.76 (The technical definition of ECN is contained in SEC Rule 11Ac1-1 as any electronic system that widely disseminates to third parties orders entered therein by an exchange market maker or ORC market maker, and permits such orders to be executed against in whole or in part. 17 C.F.R. 240.11Ac1-1(a)(8) (2000) (SEC Rule 11Ac11(a)(8)). Under Rule 11Ac1-1, the term ECN does not include: (1) a system that crosses multiple orders at specified times only at a price determined by the system; and (2) a system operated by or on behalf of a market maker that executes orders primarily against the account of the market maker as a principal, other than a riskless principal. Id. A riskless principal transaction is a transaction in which the broker-dealer technically acts as a principal but has arranged for another party to buy or sell from it, which eliminates the risk normally associated with a principal transaction. Confirmation of Transactions, Exchange Act Release No. 33,743, 56 S.E.C. docket (CCH) 558 (Mar. 9, 1994), available at 1994 WL 73633, at *2 n.11 (S.E.C.).) 32 See Borelli, supra note 30, at 826. 33 Id. 34 ECNs, including Instinet, limited the parties that who may subscribe to their system and charged an access fee. Id. 35 See Markham & Harty, supra note 25, at 878-879. (The concern was that a three-tiered market was developing that was composed of (1) large institutions, (2) medium sized institutions and wealthy individuals, and (3) small retail customers.); See also, 1-4 Sec. & Exchange Comm., Institutional Study Report 9 (1971). 36 See Id. 37 Id.

The 1980s were marked by continued innovation in the trading markets, including new portfolio strategies 38 and the rise of algorithmic trading (AT) or program trading.39 As AT became popular, individuals expressed concerns, not unlike those today, of its potential effects on the market. It was feared that AT could produce a sell signal that would generate overselling, causing prices to sharply drop and tumbling the overall market.40 Unfortunately, these fears nearly became a reality on October 19, 1987.41 Nearly is used in the sense that, ultimately, the events of Black Monday, as it became known, were attributed to market malfunction: the NYSE was unable to handle the level of trading volume.42 In 1987, the NYSE had the capacity to handle 95 trades per second.43 Despite the severity of this event, the only measure taken was to install circuit breakers, which would kick in and suspend trading activity during periods of high volatility.44 However, advancing technology rendered the circuit breakers obsolete, and they were discontinued in 2007at that time the NYSEs capacity was up to 38,000 trades per second.45 By 2010, that number was up to nearly 50,000 trades per

Such strategies include dynamic hedging and portfolio insurance. See Id. at 881. Id. See also, Terrence Hendershott, Charles M. Jones, & Albert J. Menkveld, Does Algorithmic Trading Improve Liquidity? 66, Journal of Finance, 1 (August 2010). See also, infra Part II.C. 40 Id. 41 This day marked the largest single day decline in the market in history. It dwarfed the Stock Market Crash of 1929, which led to the Great Depression, in both absolute and relative terms. See Id. See also, Andrea M. Cocoran, The Lessons of 1987: Thinking Back After a Decade of Response, 17 No. 7 Futures & Derivatives L. Rep. 14 (Oct. 1997), available at 42 See Markham & Harty, supra note 25, at 881. 43 Id. at 882. 44 Id. 45 Although they were discarded in 2007, the increased capacity of the NYSE rendered them unnecessary prior to this time. Id. However, the SEC subsequently reinstated a stockby-stock circuit breaker program following the Flash Crash. The new circuit breakers will apply to individual. i.e., stocks included in the Russell 1000 Index, as opposed to the prior market-wide circuit programs. The circuit breakers issue a trading pause in a stock if its price moves up or down by 10% or more in a five minute period. See S.E.C. Investor Bulletin: New Stock-by-Stock Circuit Breakers, available at



second.46 It was during this 20 year time period that the market experienced substantial change and set the stage for the entrance of HFTs. This dramatic change was set in motion during the 1990s47 and was characterized by the expansion of ECNs in the marketplace. As mentioned above, ECNs are systems that facilitate transactions between traders, typically institutional traders, outside of the traditional stock exchange. Despite their largely unregulated nature, ECNs were not widely used and had difficulties attracting institutional traders.48 This, however, changed when the SEC finally took notice of them, viewing ECNs as a threat to the national market system they endeavored to create in 1975.49 ECNs enjoyed pricing advantages over the major exchanges, lacked fraud surveillance and self-regulatory components, and were not required to report volume capacities.50 As such, the SEC implemented Regulation Alternative Trading Systems (ATS) in 1999 to integrate ECNs into the NMS.51 Reg. ATS effectively sanctioned the existence of ECNs and allowed them to register as either an exchange or broker-dealer.52 In
See Colin Clark, Improving Speed and Transparency of Market Data, (Jan. 19, 2011), available at 47 See James McAndrews & Chris Stefanadis, The Emergence of Electronic Communications Networks in the U.S. Equity Markets, 6 Current Issues in Economics and Finance 12 (2011), Federal Reserve Bank of New York, available at: (describing how Electronic Communication Networks, innovative stock-trading systems that rely on computer software to match buy and sell orders, first entered the equity markets in the mid-1990s to display and communicate customer buy and sell orders publicly). 48 See Brian R. Brown, How Black-Box Trading influences stock markets from Wall Street to Shanghai at 30, John Wiley & Sons (2010). 49 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, 67273. 50 Id. at 674-76. 51 17 C.F.R. 242.300 (1999). 52 However, few ECNs, if any, will actually ever qualify as exchanges. 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 broker-dealer. Further, clarifying that while criteria are available for ATSs to choose to register as exchanges, the SEC does not plan on having many, if any operate as exchanges).


combination with other SEC Rule amendments,53 the playing field between ECNs and traditional exchange market markers was leveled.54 This marked the beginning of a huge growth in ECNs. Doors continued to open for ECNs and advancing technology. In December 1999, the NYSE (after much pressure from the SEC) dropped an exchange rule that had prevented ECNs from trading NYSE stocks that had been listed before 1979. 55 This rule had severely restricted the range of business for ECNs, as the list of securities under Rule 390 encompassed about half of the exchanges trading volume. Further, in 2000, the SEC unwittingly spurred a huge growth in algorithmic trading activity on ECNs by mandating the decimalization of exchanges. 56 Prior to this mandate, the minimum tick stock tick size was 1/16th of a dollar.57 The smaller tick sizes shrunk the bid-ask spread and caused an explosion in trading volume and liquidity,58 which led to a boom in algorithmic trading in two ways. First, [p]rocessing such high volumes began to exceed data assimilation capabilities of human traders, whereas machines were ideally suited to handling thousands of data points per second. 59 Second, institutional traders began using their algorithms to break up large orders, executing them quicker and at a better average price.60 Automated trading was on the rise.
The rule amendments include: (1) limit order display rule, which mandated specialists and market making firms to display publicly the better quotes available on alternative trading systems; and (2) quote rule stated that specialists and market makers should provide their clients with the most competitive quotes. See Brown, supra note 48, at 30. 54 See Markham & Harty, supra note 25, at 912 (explaining that market makers and specialists were required to make publicly available superior prices that it privately offered through ECNs). 55 Id. at 879-80 (explaining that NYSE Rule 390 required that securities listed on the NYSE prior to April 26, 1979 could only be traded on the NYSE). 56 See Order Directing the Exchanges and the National Association of Securities Dealers, Inc. to submitted a Decimalization Implementation Plan Pursuant to Section 11A(a)(3)(B) of the Securities Exchange Act of 1934, Exchange Act Release No. 42,360, 71 S.E.C. Docket (CCH) 1274 (Jan. 28, 2000). 57 See Michael J. McGowan, The Rise of Computerized High Frequency Trading: Use and Controversy, 2010 Duke L. & Tech. Rev. 16 at 12. 58 See Clark, supra note 1. 59 Id. 60 See McGowan, supra note 57, at 12.


Enter the high-frequency trader. HFTs entered the market to leverage their technological edge to take advantage of the favorable regulatory developments in the early 2000s. 61 Still, they only accounted for a relatively modest amount of the trading volumeat least until 2005. The year 2005 featured the latest regulatory development which ignited the expansion of HFTs: Regulation National Market System (NMS). Reg. NMS is a series of initiatives designed to modernize and strengthen the national market system for equity securities 62 through fostering competition among individual markets and competition among individual orders.63 Reg. NMS effectively institutionalized the legitimacy of electronic trading. Prior to NMS, brokerages were accorded ample discretion to determine the best possible execution of stock orders. 64 Sometimes best meant fastest; other times, it meant most favorable price.65 But at all times this discretion left brokerages plenty of wiggle room to match buy and sell orders internally and pocket the spread, or send them to exchanges that paid kickbacks for order flow.66 However, Reg. NMS changed this practice through its Order Protection or Trade Through Rule.67 This rule prohibits any ECN, exchange, broker-dealer, etc. from executing a trade at an inferior price to one quoted at another trading venue. 68 More
See IOSCO Technical Committee, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency at 19 (July 2011), available at 62 See S.E.C. 70 FR 37496, Exchange Act Release No. 34-51808 at 37496, (June 29, 2005) [hereinafter, Release No. 34-51808], available at 63 Id. at 12 (explaining that competition among both markets and individuals promotes efficient and fair price formation and markets). 64 See Liz Moyer & Emily Lambert, Wall Streets New Masters, Forbes, (Sept. 21, 2009), available at: 65 Id. 66 Id. 67 17 C.F.R. 242.611 (2010). See also, Release No. 34-51808, supra note 62, at 37497 n.2 (explaining that Order Protection was the final name of Rule 611). 68 See Id. at 37496. See also, Responses to Frequently Asked Questions Concerning Rule 611 and Rule 610 of Regulation NMS, available at: (explaining that the definition


specifically, this price was called the national best bid or offer (NBBO) price.69 Essentially, exchanges (or other order recipients) must handle an order immediately at the NBBO or redirect it to another venue with that best price. In order to take advantage of the market share for routed orders, exchanges were forced to offer an electronic platform, which helps explain the timing of the launch NYSEs hybrid market shortly after in 2006.70 More generally, the nature of the linkages between trading venues promoted the use of electronic, automated trading. These strings of regulatory and technological developments have paved the way for new opportunities for gain in the marketplace. With increased speed, capacity, and efficiency, targeting tiny gains is now a very profitable business plan. Different trading firms have shifted their efforts toward developing strategies to capture these seemingly miniscule gains, many times over. Many of these strategies fall under the umbrella of HFT, which is characterized by two major components: lightning speed and high volume. The competition between firms to develop strategies taking advantage of todays technology has been dubbed a micro-arms race. 71 Firms are fiercely competing to have the quickest and smartest strategies. Further, as computer technologies have advanced, the time frame to compete and capture gain has become razor thin.72 Even the time it takes to blink is too longthankfully for HFT firms, supercomputers do not rely on eyesight to function.
of Trading Center includes OTC Market Makers, ATSs, and any other broker-dealers that execute orders internally as principal or agent). 69 17 C.F.R. 242.602 (2010); 17 C.F.R. 242.301(b) (2010); Release No. 34-51808 (explaining that NBBO, a new term, refers to the best quotations that are calculated and disseminated by a plan processer pursuant to an effective national market system). However, flash orders were excepted from this regulation. See infra Part V.B. 70 See supra note 19. 71 See Letter from U.S. Sen. Edward E. Ted Kaufman to Mary L. Shapiro, Chairman, U.S. Sec. & Exch. Commn, at 2 [hereinafter Letter from Sen. Kaufman] (Aug. 5, 2010), available at ([W]hile speed and efficiency can produce certain benefits, they have also created a micro-arms race that is being waged in our public marketplace by high frequency traders and others.). 72 See High-Frequency Traders: Spread Betting, The Economist (Aug. 14, 2010) (Explaining that as a result of electronic, and in particular automated trading, bid-ask spreads have narrowed and arbitrage opportunities exist for ever-briefer periods.).


The computers used by many firms today, including those that do not engage in HFT, automate trades by processing information, making decisions, and executing tradesaccomplishing each step without humans. This computer automation is AT. Here it is important to clarify that HFT is a type of AT. Not all AT is HFT. Both strategies utilize computer generated trade decision-making technology. AT may utilize technology to hold a position for days, weeks, months, or longer. HFT, by definition, consists of positions held for a very short period of time and closing the day in a neutral position. As HFT is a subset of AT, a more full description of AT is helpful. C. Algorithmic Trading At its most basic level AT can be described as follows: utilizing advanced computers and software to process information, make trading decisions based on that information, and place the appropriate order all without human intervention.73 Essentially, it is a generic term used to describe any style of trading that employs computers and algorithms rather than humans. The advantages of utilizing advanced algorithms and programs are clear: speed and accuracy. The machines can process a larger amount of information in less time and with less errors, make quicker decisions, and place orders all quicker than any human can even imagine. These efficiencies are encompassed in the different AT strategies. AT firms may quickly analyze enormous amounts of information to solely take advantage of arbitrage opportunities.74 Firms also use AT to break up large orders into several smaller parts traded over time, reducing market impact of the order.75 Finally, and
73 See Alain Chaboud, Benjamin Chiquoine, Erik Hjalmarsson & Clara Vega, Rise of the machines: Algorithmic trading in the foreign exchange market (2009), FRB International Finance Discussion Paper No. 980 at 1, available at 74 See Hendershott, supra note 39, at 2. 75 Id. This reduces their transaction costs by minimizing the price movements that occur when a large buy order is placed or having to search for a counterparty large enough to take the opposite position.


most relevant to this paper, AT firms use the speed of their computers to take advantage of opportunities that exist for fractions of a secondopportunities that are not available to slower participants, such as human traders. D. High Frequency Trading HFT falls under the broader class of algorithmic trading. The two defining characteristics of HFT are speed and volume.76 By investing heavily in technology to leverage the nexus of high-speed communications, mathematical advances, trading, and high-speed computing,77 these HFT firms are able to achieve the volume of trades at blazing fast speeds. Still, there is a significant amount of confusion as to what constitutes HFT. Some may errantly believe that all automated trading is HFT.78 Further, many may mistake a particular strategy79 of HFT firms as representative of the whole HFT universe. This confusion is not without good reason. First, HFT firms typically keep their strategies secret. 80 Second, and compounding the former, HFT is everchanging as firms are constantly tweaking their strategies in order to capture gain from the market. It presents quite the game of cat and mouse for those trying to keep up with HFT. Generally speaking, for the purposes of this paper, HFT is defined as an advanced computerized strategy that utilizes high speed and high volume to capture gain from opportunities in the market that are short-lived and of low-value. 81 Specific HFT
76 See IOSCO Technical Committee Report, supra note 61, at 21 (explaining that HFT has several defining characteristics, including the high daily portfolio turnover and its sensitivity to latency: The implementation of successful HFT strategies depend crucially on the ability to be faster than competitors and to take advantage of services such as direct electronic access and co-location.). For further discussion on cancelled trades, see infra, Part III.C. 77 See Clark, supra note 1. 78 Hopefully, I have made this distinction clear. See supra Part II.C. 79 See infra Part III. 80 See McGowan, supra note 57, at 44. 81 See Dark Pools, Flash Orders, High-Frequency Trading, and Other Market Structure Issues: Hearing Before the Subcomm. on the Securities, Insurance, and Investment of the


strategies are delineated below. However, each strategy falls under this general definition, characterized by high speed, high volume, and sophisticated computer technology. Speed is important to HFT in both absolute and relative terms.82 In the absolute sense, firms aim to reduce latency as much as possible.83 Latency is the delay in placing, filling, and confirming or cancelling orders.84 To the extent that HFT can reduce latency, they increase the absolute speed at which they can operate. In the
Comm. on Banking, Housing, and Urban Affairs, 111th Cong. (Oct. 28, 2009) [hereinafter Hearings] (statement of Sen. Reed) (Explaining that basically, HFT is the buying and selling of stock at extremely fast speeds with the help of powerful computers.); Concept Release on Equity Market Structure, supra note 21, at 3606 (Explaining that the term HFT typically is used to refer to professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis.) Staffs of the Commodity Futures Trading Commn and Securities and Exchange Commn, Rep. to the Join Advisory Comm. On Emerging Regulatory Issues, Preliminary Findings Regarding the Market Events of May 6, 2010, Appendix A.11 (May 18, 2010) [hereinafter Preliminary Flash Crash Report] (Explaining that in general, HFT strategies typically employ the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders.); Staffs of the Commodity Futures Trading Commn and Securities Exchange Commn, Rep. to the Join Advisory Comm. On Emerging Regulatory Issues, Findings Regarding the Market Events of May, 2010 (Sep. 30, 2010), at 45 [hereinafter Final Flash Crash Report] (HFTs are proprietary trading firms that use high speed systems to monitor market data and submit large numbers of orders to the markets. HFTs utilize quantitative and algorithmic methodologies to maximize the speed of their market access and trading strategies.); Jonathan A. Brogaard, High Frequency Trading and its Impact on the Market Quality at 3, Kellogg School of Management (Nov. 22, 2010) (HFT is the execution of trading strategies based on computer programmes or algorithms to capture opportunities that may be small or exist for a very short period of time.), available at df. 82 See Concept Release on Equity Market Structure, supra note 21, at 3610 (Many proprietary firm strategies are highly dependent upon speedspeed of market data delivery from trading center servers to servers of the proprietary firm; speed of decision processing of trading engines of the proprietary firm; speed of access to trading center servers; and speed of order execution and response by trading centers.). 83 See Clark, supra note 1, at n.2 (Explaining the importance of reducing latency because price takersthose who place orders to buy or sellare exposed to market risk prior to receiving confirmation that their orders have been filled. Price makersthose who provide resting bids (buy orders) and offers (sell orders) or respond to buy and sell ordersare exposed to the risk that their prices will remain in the market at the time when the market has moved in the opposite direction of their strategy.). 84 Id. See also Brogaard, supra note 81, at 68.


relative sense, speed is important for being faster than market competitors, even if only by a microsecond.85 As such, HFT firms are always seeking to decrease latency in their market operations and be faster than their other HFT competitors. One significant development in response to this need for speed is co-location. Colocation refers to the practice of market participants (HFTs) renting rack space for its software right next to the matching engine of an exchange or other trading center.86 It seems to be that the only acceptable latency increase, albeit minute, is one to ensure that the co-located servers at the back of the room can send data to the matching engines at the same speed as those in the front. Volume is particularly important because HFTs earn only razor-thin margins for each executed transaction.87 In fact, the F for frequency in HFT refers to the high rate of turnover for an HFT firms portfolio. Considering each (winning) trade yields a profit of only fractions of a cent, it is not difficult to understand why HFTs must engage in large volumes of trading. Still, the high speed and large volumes necessary for HFTs are made possible through the utilization of advanced computer technology. HFT traders rely on extraordinarily sophisticated computer programs for generating, routing, and executing orders.88 This advanced computerized trading allows the HFTs to move at speeds that humans could only imagine. In turn, the increased speed at which they are able to operate supports their ability to achieve the enormous volumes necessary to make strong profits. How fast and how prevalent is HFT? Well, as mentioned above,89 HFT has been around since the early 2000s. At that time, the execution interval for HFTs was measured in seconds.90 At least
See Concept Release on Equity Market Structure, supra note 21, at 3610. Id. 87 See Comment Letter on Equity Market Structure from Manoj Narang, CEO, Tradeworx, Inc. (April 21, 2010), [hereinafter, Letter from Manoj Narang] at 7, available at 88 See Concept Release on Equity Market Structure, supra note 21, at 3606. 89 See supra note 61 and accompanying text. 90 See Andrew G. Haldane, Patience and Finance, Speech at Oxford China Business Forum (Sept. 2, 2010), at 17, available at
86 85


one commentator has stated that their speed of execution has undergone a quantum leap,91 and, today, trading a stock is now far faster than the blink of an eye or the speed of a lightning strike.92 HFTs operate in terms of microseconds (millionths of a second),93 and some believe that nanosecond (billionths of a second) and picoseconds (trillionths of a second) are not far off.94 HFT firms only represent approximately 2% of the 20,000 or so trading firms operating in the U.S. Markets. 95 Despite the comparatively small number of firms engaged in HFT, the trading volume that is attributed to HFT is quite impressive. Some estimates attribute as much as 70% of the equity trading volume to HFTs.96 Another estimate places the number at closer to 40% of equity trading volume. 97 Of course, much of the variance between estimates is due to the confusion over the definition of HFT. 98 Nevertheless, HFT is a dominant component of the current market structure by any measure and is likely to affect nearly all aspects of its performance.99

Id. See Jennifer Kwan, A modern traders clock: micro, nano, and picoseconds, Reuters News (Nov. 23, 2009), available at 93 See Id. See also Clark, supra note 1 (Explaining that latency is measured in microseconds and has various components, including speed at which market data and signals are processed and geographical distance and response time from the exchange matching engine.). 94 See Kwan, supra note 92. 95 See Clark, supra note 1. 96 Id. 97 See Letter from Manoj Narang, supra note 87, at 5. 98 See Concept Release on Equity Market Structure, supra note 21, at 3607 (The lack of clarity may, for example, contribute to the widely varying estimates of HFT volume in todays equity markets.); Hearings, supra note 81 (statement of Daniel Mathisson, Managing Director, Credit Suisse) ([T]here is no clear definition of the term, making it very difficult to analyze its effects or estimate what percent of the market it is, resulting in what appear to be wide overestimates of what percent of the market [HFT] makes up.). 99 See Preliminary Flash Crash Report, supra note 81, at Appendix A.11.





HFT itself is not a single strategy. Rather, it is a set of technological arrangements and tools employed in a wide number of strategies.100 Each strategy has a different market impact; thus, each raises different regulatory issues. The common thread between the different strategies, however, is they aim to profit from small changes in price and quick turnover of capital. Of course, it would be nearly impossible to create an exhaustive list of strategies.101 The more expedient approach is to group the most common strategies into broad categories: market making, statistical arbitrage, and directional strategies. A. Market Making A market maker, as defined by the SEC, is a firm that stands ready to buy and sell a particular stock on a regular and continuous basis at a publicly quoted price. 102 Essentially, this strategy involves posting limit orders103 on both sides of the order book, and acting as market intermediaries to fill buy and sell orders entered by investors.104 This provides liquidity to the market.105 Market making is conducted by placing resting orders. 106 Resting orders are a type of limit order,107 which means that the order may only be executed if another party meets its specified price.
See IOSCO Technical Committee Report, supra note 61, at 23. In part due to the secret and proprietary nature of HFT software. See supra Part II.D. 102 See S.E.C. Market Maker, available at 103 A limit order is [a]n order [that specifies] a minimum sale price or maximum purchase price, as contrasted with a market order, which implies that the order should be filled as soon as possible at the market price. CFTC Glossary, available at 104 See, e.g., Perrie M. Weiner et al., Catch Me if You Can: Speed Traders Under Scrutiny, 1843 PLI/Corp 341, 343 (July 20, 2010) (When a mutual fund wants to buy 10,000 shares of Tesla, Inc., odds are a high-frequency trader will be ready to provide the shares.). 105 See Concept Release on Equity Market Structure, supra note 21, at 3607. 106 Id. 107 A resting order is a limit order to buy at a price below or to sell at a price above the prevailing market that is being held by a floor broker. CFTC Glossary, supra note 103.
101 100


Put simply, a market maker places limit orders to buy at the bid price and sell at the ask price. Market making is a commonly employed HFT strategy. In fact, the SEC has noted that [t]he use of certain [HFT] strategies by some proprietary firms has, in some trading centers, largely replaced the role of specialists and market makers.108 HFT firms use the market making strategy to earn profit in two important ways: earning the bid-ask spread and collecting liquidity rebates.109 As described above, market makers earn the spread by buying at the bid price and selling at the ask price. This is equivalent to buying low and selling high, although these transactions typically take place simultaneously.110 Second, market makers earn profit by collecting minute rebates (typically 1/3 or of a cent per trade) 111 for

See Concept Release on Equity Market Structure, supra note 21, at 3607. See also Marco Avellaneda and Sasha Stoikov, High-frequency trading in a limit order book, available at (Traditionally, this role has been filled by market maker or specialist firms. In recent years, with the growth of electronic exchangesanyone willing to submit limit orders in the system can effectively play the role of a dealer.). 109 See Concept Release on Equity market Structure, supra note 21, at 3607 ([T]he primary sources of profits are from earning the spread by buying at the bid and selling at the offer and capturing any liquidity rebates offered by trading centers to liquiditysupplying orders.). 110 See McGowan, supra note 57, at 23 (To make money off the spread, market makers will buy and sell securities on both sides of the trade by placing a limit order to sell (or offer) above the current market price or a buy limit order (or bid) below the current market price in order to benefit from the bid-ask spread,); See also Example: XYZ May30Call option has a bid price of $1.10 and an ask price of $1.30. Market Maker John receives simultaneously and order to buy and an order to sell. Market Maker John buys that May30Call option from the seller for $1.10 and then sells that same May30Call option to the buyer for $1.30, thus making $0.20 in profit [virtually] risk-free. See also Letter from Manoj Narang at 8 (describing how the bid-ask spread is used to compensate a market maker for risk of adverse selection, which is the risk that the market maker is exposed to adverse price movements. For example, if many investors are seeking to buy, the market will tend to go up, but market markers will tend to be short, since they have taken the other side of investors trades.). 111 See McGowan, supra note 57, at 26 (citing Mark Hutchinson, High Frequency Trading: Wall Streets New Rent-Seeking Trick, Money Morning, Aug. 14, 2009).



providing market liquidity. 112 Exchanges offer these liquidity rebates because in some cases, merely capturing the bid-ask spread does not adequately compensate the market maker. 113 These liquidity rebates incentivize traders to post orders where the bid-ask spread is not enough. 114 However, for extremely liquid stocks, market makers are sometimes willing to buy and sell at the same price. 115 Such market-makers are said to be operating rebatecapture strategies because their only compensation is the rebate offered by exchanges for posting orders.116 While many praise the liquidity that market making HFTs bring to the market,117 it is not without controversy. First, market making does not always bring liquidity. In the event that a rebate-capture market maker is able to buy and sell at the same price, earning 2 rebates, no actual liquidity is added to the market.118 In fact, this represents an increase in trading costs, as there was no need for both investors to have their trades intermediated by a market maker. Thus, the exchange unnecessarily pays a fee, twice. Second, liquidity rebates incentivize broker dealers to send retail order flow to the highest bidder and not to the trading center that is necessarily the best for the buyer or seller.119 Third, the market making strategy includes a very high percentage of order cancellations.120 HFT firms must manage market risk by constantly adjusting posted quotes to
112 See Letter from Sen. Kaufman, supra note 71, at 5 (Explaining that, in essence, market making generate[s] profits by capturing spreads and earning liquidity rebates under the current maker-taker pricing models used by many market centers to attract order flow.). 113 See Letter from Manoj Narang, supra note 87, at 8. 114 Id. 115 Id. 116 Id. 117 See Id. See also Reuters News, CMEs Melamed takes on CFTCs Chilton, defends speed traders, available at (quoting Leo Melamed, CME Groups Chairma Emeritus, The liquidity [high-frequency traders] create is not fictitious.). 118 See Letter from Manoj Narang, supra note 87, at 8. However, Narang suggests that, in the aggregate, rebate capture strategies still add value to the market because they do not succeed in rapidly buying and selling at the same price 100% of the time 119 See Hearings, supra note 81 (statement of Sen. Kaufman). 120 See Concept Release on Equity Market Structure, supra note 21, at 3607 (stating that cancellation rates may reach 90%).


reflect new information or adjust inventory.121 As a result, the rate of order cancellations is very high. Finally, the term market making is itself a bit of a misnomer. Market makers play an important role in the market, and, as important players, they are typically subject to affirmative and negative obligations.122 However, the majority of HFT firms do not register as market makers, acting only as unofficial liquidity providers. 123 In this way, they are able to sidestep the prescribed market maker obligations and do not necessarily always provide their liquidity through limit orders.124 As mentioned above, however, some HFT firms have actually replaced official market makers. B. Statistical Arbitrage Statistical arbitrage strategies are strategies that take advantage of temporary deviations from stable statistical relationships among securities or instruments. This creates opportunity to capture value from pricing discrepancies, which can involve pure arbitrage between the same instruments traded across different trading venues (e.g., the same stock traded at an exchange and an ATS/MTF), between an index and the underlying basket of securities, or between related instruments (e.g., a security and an associated derivative).125 These opportunities are discovered by identifying the relevant relationships, determining historical patterns and correlations, and taking certain positions as informed by the analysis.126 Put simply, statistical arbitrage is based on mispricing in the markets or a temporary deviation from historical trends.127
See IOSCO Technical Committee Report, supra note 61. See Concept Release on Equity Market Structure, supra note 21, at 3607. 123 See IOSCO Technical Committee Report, supra note 61, at 23. 124 See infra Part IV. 125 See Joe Flood, Adventures in Algorithmic Trading, (Aug. 5, 2010), available at (Explaining that depending on the statistical analysis, firms will buy and short the affected securities to help push them back to their traditional correlations, collecting the spread along the way.). 126 Id. 127 See Concept Release on Equity Market Structure, supra note 21, at 3608 (An arbitrage strategy seeks to capture pricing inefficiencies between related products or markets.). For
122 121


Because statistical arbitrage is a very quantitative and computational trading strategy, it benefits greatly from the advanced technology used by HFT firms.128 First, this strategy requires robust computing power to analyze data and quickly identify mispricing opportunities. Further, the short-lived nature of these opportunities cause quick execution to be a critical component of this strategy. Finally, the gain associated with any single trade is typically very low. As such, to be profitable HFTs rely on the reduced trading costs made possible through computer trading and automation.129 Both the SEC and IOSCO believe that statistical arbitrage strategies consume liquidity, rather than providing it as in market making.130 However, Manoj Narang has suggested that there is at least one type of executing a statistical arbitrage strategy that actually provides liquidity to the market. 131 Despite it being a liquidity taking strategy, statistical arbitrage is attributed with improving price discovery and market efficiency.132

a plain-language explanation of statistical arbitrage, see generally, Jon Stokes, The Matrix, But With Money: The World of High-Speed Trading, (2009), available at (Stat arbs make their money by vacuuming up mountains of historical data and looking for correlations between various data points and asset prices. The stat arbs trading platform, which is basically a large computer system manned by programmers and financial engineers, uses those correlations to build predictive models that take in a stream of information inputs like new reports and stock prices, and output a rapid-fire stream of buy and sell orders for different assets.). 128 Hedge Funds Consistency Index, Statistical Arbitrage, available at 129 See Flood, supra note 125 (The profits on any one trade tend to be small but, with enough speed and volume, they can create enormous profits.). 130 See Concept Release on Equity Market Structure, supra note 21, at 3608; see also, IOSCO Technical Committee Report, supra note 61, at 24. 131 See Letter from Manoj Narang, supra note 87, at 9 (Explaining that an Active/Passive execution style of statistical arbitrage enhance[s] liquidity by transferring it from stocks where there is abundance of liquidity to stock where is a shortfall of liquidity.). 132 See Gomber, supra note 11.


C. Directional Strategies Another important way HFTs transact in the market is through directional strategies. 133 Directional strategies are based on entering positions in anticipation of price movements or to speculate on the direction of the underlying market.134 While a directional strategy may be as straightforward as concluding that a stock price temporarily has moved away from its fundamental value and establishing a position in anticipation that the price will return to such value,135 the SEC has identified types of directional strategies that could present serious problems in todays market: order anticipation, momentum ignition, and quote stuffing.136 1. Order Anticipation Order anticipation reflects a dynamic in the market that has been present for some time: [e]very market participant attempts to guess what other market participants are doing and respond in the best way.137 Large orders to buy and sell, particularly those made by large institutional investors/traders, cause prices to move.138 Order anticipation strategies attempt to foresee these price movements so that HFTs can buy a security before the price rises or sell (short) before the price drops.139 In an effort to keep transaction costs low by minimizing the effect that a large trade can have on price and avoiding other traders from taking advantage of that price movement,
See Concept Release on Equity Market Structure, supra note 21, at 3608. CFTC Glossary, Directional Trading, supra note 103. 135 See Terrence Hendershott, High frequency trading and price efficiency, (Aug. 3, 2011), available at 136 Id. 137 Id. 138 See Kirilenko, supra note 12, at 17-18. 139 See Concept Release on Equity Market Structure, supra note 21, at 3608. See also Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners at 222, 245 (2003) (Order anticipators are speculators who profit by trading before others trade. They make money when they correctly anticipate how other traders will affect prices or when they can extract option values from the orders that other traders offer to the market.) (emphasis in original).
134 133


institutional investors typically break up large orders into several small ones.140 HFTs seek to overcome this practice by using order anticipation strategies in two stages. First, HFTs use advanced programs to discover a large trade masked as several small orders. 141 This includes the use of sophisticated pattern recognition software to ascertain from publicly available information the existence of a large buyer [or seller]142 After ascertaining the existence of a large order, HFT firms use their speed to earn profit. Their speed allows HFTs to trade in front of the investors placing the large order where they buy before a price rise or sell before a price drop.143 Further, HFTs employing an order anticipation strategy are typically indifferent as to whether a large investor is a buyer or a seller.144 This trading in front of technique employed by HFTs bears a resemblance to front running, which is an illegal trade practice. However, an order anticipation strategy used to trade in front of does not necessarily equate to illegal trade behavior. The difference lies in the type of information used in each strategy. Front running requires some misappropriation of information or other misconduct.145 The SEC has excluded this from their definition of order anticipation, which combines the use of speed and sophisticated analysis of public information. 146 Here, the phrase
See supra note 75 and accompanying text. See High-Frequency Trading: Rise of the Machines, The Economist (Aug. 1, 2009). 142 See Concept Release on Equity Market Structure, supra note 21, at 3609. 143 Id. See also, supra note 139. 144 As mentioned above, HFT firms do not usually establish long-term positions and end the trading day in a flat position. As such, their strategy is profit on any swing of the price, rather than one direction in particular. 145 Further, front running can be engaged in outside of the HFT context. See Carpenter v. United States, 484 U.S. 19 (1987). 146 See Concept Release on Equity Market Structure, supra note 21, at 3609 (Explaining that their discussion of order anticipation strategies excludes those that would be illegal: The type of order anticipation strategy referred to in this release involves any means to ascertain the existence of a large buyer (seller) that does not involve violation of a duty, misappropriation of information, or other misconduct.); see also, Letter from Manoj Narang, supra note 87, at 15 (Should the anticipation of the behavior of other market participants by HFTs be prohibited? No! We submit that any trading signal is perfectly fair so long as publicly available data is being used in its construction. If somebody is able to build a better signal using the same data, should that be discouraged? No matter what
141 140


trade in front of merely means the use of high speed computing to capture bid-ask spreads. 2. Momentum Ignition The second type of directional strategy engaged by HFT firms is momentum ignition. This strategy, essentially a form of market manipulation, consists of igniting rapid price movements in either direction,147 and is illegal.148 HFTs seem to use momentum ignition to target other algorithmic traders.149 To implement this strategy, a HFT may transmit a large number of orders and cancellations in rapid succession in hopes to spoof the algorithms of other traders into buying or selling more aggressively.150 By establishing a position early, the [HFT] will attempt to profit by subsequently liquidating the position if successful in igniting a price movement.151 HFTs utilize their quick speed to ignite the dramatic movements in price and profit from the resulting short-term volatility. 3. Quote Stuffing HFTs may also engage in quote stuffing, another form of market manipulation that involves sending a high volume of orders and cancellations to an exchange.152 Rather than create a price swing,
restrictions regulators impose, some players will always be superior in terms of their ability to analyze data.). 147 See Concept Release on Equity Market Structure, supra note 21, at 3609. 148 Id. See also, 15 U.S.C. 78i. See also, Janice Fioravante, SEC and Finra Zero in on High Frequency Trading, Institutional Investor (Sep. 16, 2011), available at (Quoting Carlo di Florio, Director of Compliance and Examinations, SEC, Of course, trading firms that are engaged in market manipulationsuch as momentum ignition, where the trader would be driving interest in a lightly traded stock from which he or she would profit through market manipulation.). 149 See Concept Release on Equity Market Structure, supra note 21, at 3609. 150 Id. 151 Id. 152 Quote Stuffing, Investopedia Dictionary (Defined as [a] tactic of quickly entering and withdrawing large orders in an attempt to flood the market with quotes that competitors


HFTs sends a high volume of quotes with the specific purpose of [creating] data delays that would afford the firm sending these quotes a trading advantage.153 The enormous number of bids and offers, significantly outside the current bid-offer spread, [introduce] a vast amount of noise into the quote feed.154 This presents an advantage for the sending firm in two ways. First, the high volume of orders would not have to be processed by the quote generating firm but would have to be processed by other HFT firms, thus slowing the competing firms. 155 Second, the volume of orders may actually be high enough [to] cause the data generating process from the exchange receiving the high quote volume to lag other exchanges. 156 In other words, a firm may manipulate the market by overloading the quotation system, purposefully slowing down the engines of another HFT firm or an exchange as a whole. Both momentum ignition and quote stuffing strategies manipulate the market through transmitting large amounts of orders and cancellations.157 While both are forms of market manipulation, however, the distinction between them is an important one. Momentum ignition may send the price of a single security in motion. On the other hand, quote stuffing is a destructive attack on the market as a whole.158 Interrupting the exchange engines could
have to process, thus causing them to lose their competitive edge in high-frequency trading. This tactic is made possible by high-frequency trading programs that can execute market actions with incredible speed. Only market makers and other large players in the market are capable of executing these tactics, since they require a direct link to the exchange in order to be effective.), available at 153 See Final Flash Crash Report, supra note 81, at 79. 154 See Brogaard, supra note 81, at 68. See also Felix Salmon, Trillium Wasnt Quote Stuffing (Sept. 14, 2010), available at 155 See Brogaard, supra note 81, at 68. 156 Id. 157 Momentum ignition employs a high volume of orders and cancellations to incite sharp buy-side or sell-side activity, while quote stuffing uses them to create just enough noise to temporarily, albeit for an instant, paralyze its rival firms or an exchange while they process the overloaded quote traffic. 158 See Salmon, supra note 154.


have very perverse effects in the interconnected, National Market System.159 IV. REGULATORY RESPONSE

At this point, the reader should have an understanding, albeit a basic one, of the core principles, mechanics, and strategies of HFT. It should also be clear that despite some calls for its cessation, market participants have largely welcomed and benefitted from advancing technologies. As a result, HFT is here to stay. Still, one looming question remains to be answered: how do we regulate it? Of course, one response is not to regulate at all, which is sure to be welcomed by the HFT firms. However, for several reasons this is neither politically possible nor even socially desirable.160 I propose a pragmatic approach to regulation, preserving the positive aspects of HFT while mitigating the risks of HFT activity: condition access to flash trading on the acceptance of market making obligations. Regulatory responses should be evaluated in light of the overarching goals of securities litigation: ensuring investor protection, promoting market integrity and efficiency, and preventing systemic risk. 161 These goals do not point to any specific regulatory rule or measure. Rather, they serve as normative guidelines for regulators to use in evaluating positive and negative effects of proposed regulation.162

See supra Part II.B. Mary L. Shapiro, Chairman, Securities and Exchange Commn, Remarks Before the Security Traders Assn (Sept. 22, 20120) (stating that HFT exerts tremendous influence over trading and warrants regulation). 161 See Pub. L. 111-203, Dodd-Frank Wall Street Reform and Consumer Protection Act (the purpose of Dodd-Frank is specifically states: To promote the financial stability of the United States by improving accountability and transparency in the financial system [market integrity], to end too big to fail [systemic risk], to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices [investor protection], and for other purposes.); see also About the SEC: What We Do, available at (The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.). 162 J. William Hicks, Securities Regulation: Challenges in the Decades Ahead, 68 Indiana L. J. 791 (1993).



These goals are rarely considered in isolation of one another, but instead are viewed in the aggregate.163 First, I will quickly discuss some of the current regulatory framework. Second, I argue that Congress should finally implement its ban on flash trading. Finally, I demonstrate how this general ban on flash trading can be used to charge market making HFT firms with market making obligations similar to those previously observed by human traders. A. Current Regulation As a general matter, regulators are not currently powerless against HFT firms. In fact, specific laws that have been a part of the regulatory structure for decades apply to HFTs. Further, the SEC has made significant regulatory strides that will assist in curtailing undesirable HFT activity. 1. Market Manipulation Many concerns of the public regarding HFT revolve around the idea that HFTs can and in fact do manipulate the market.164 This activity represents some of the most egregious actions on the market. Quite frankly, these concerns are not without meritstrategies such as order anticipation, momentum ignition, and quote stuffing are all within the power of HFT firms and are all likely forms of market

163 Id. (Two of these goalsefficiency and protection of investors and securities marketsare likely to be at the core of future solutions. However, these goals are inherently bipolar. For example, an efficient system of regulation relies heavily on competition and free-market forces, while the protection of investors and securities markets hinges on legislative, administrative, judicial, and private restraints on free enterprise.). 164 See Tyler Durden, HFT Quote Stuffing Market Manipulation Caught in the Act (Aug. 25, 2011) available at:; Mike Whitney, High Frequency Trading: High-tech Highway Robbery (Apr. 18, 2010) available at:; Mike Williams, Is HFT Manipulating the Markets? (Aug. 18, 2011) available at:


manipulation.165 Fortunately, market manipulation is prohibited, and the SEC, CFTC, FINRA, and NFA are able to initiate enforcement actions against those who violate this prohibition.166 In September 2010, the Financial Industry Regulatory Authority (FINRA) took enforcement action against Trillium Brokerage Services, LLC, resulting in a $2.3 million fine for using an illicit high frequency trading strategy. 167 Although this case did not actually involve a high frequency trader,168 it did involve the use of a type of momentum ignition strategy. FINRA was able to levy a significant fine on those trying to improperly incite a price movement. As such, regulators should be encouraged that similar victories can be won against any perpetrating HFT firm employing manipulative strategies. With a new reporting system, the SEC shall be able to better monitor HFT firms and identify market abuse. 2. Large Trader Reporting System/Consolidated Audit Trail The SEC has finalized the rule for its large trader reporting system, which is designed to both identify and collect trading information on market participants that conduct a substantial
165 Of course, not all forms of order anticipation represent manipulative practices. See supra Part III.C. 166 Securities and Exchange Act of 1934 9; Commodity Exchange Act 13b; FINRA Rule 5210; NFA Compliance Rule 2-2(e). 167 See Press Release, Financial Industry Regulatory Authority, FINRA Sanctions Trillium Brokerage Services, LLC, Director of Trading, Chief Compliance Officer, and Nine Traders $2.26 Million for Illicit Equities Trading Strategy, (Sept. 13, 2010) available at: (Trillium, through nine proprietary traders, entered numerous layered, non-bona fide market moving orders to generate selling or buying interest in the specific stocks. By entering the non-bona fide orders, often in substantial size relative to a stocks overall legitimate pending order volume, Trillium traders create a false appearance of buy- or sell-side pressure. This trading strategy induced other market participants to enter orders to execute against limit orders previously entered by the Trillium traders. Once their orders were filled, the Trillium traders would then immediately cancel orders that had only been designed to create false appearance of market activity. As a result of this improper high frequency trading strategy, Trilliums traders obtained advantageous prices that otherwise would not have been available to them on 46,000 occasions.). 168 The trades were executed by proprietary, human tradersnot advanced software algorithms, which does not meet the definition of HFT.


amount of trading activity, as measured by volume or market value. 169 The large trader reporting system will function in conjunction with the consolidated audit trail system (CAT).170 The CAT will give the SEC access to detailed information about orders from origination, through modification, cancellation, routing and execution of an order. 171 Together, these systems will increase the ability for the SEC and other regulators to detect and deter manipulative acts and practices, including those feared employed by HFT firms. With the tools to identify manipulation and the authority to prosecute it, investors should be confident in the ability of regulators to handle manipulative HFT strategies. 3. Naked Access In November 2010, the SEC adopted Rule 15c3-5, effectively eliminating HFTs naked access to the market.172 Naked access refers to a form of sponsored access in which broker-dealers allowed HFTs to directly access markets, bypassing pre-trade risk controls to send trades directly to the exchange matching engine.173 Rule 15c35 eliminates this bypass of pre-trade risk controls and impacts HFTs in two important ways. First, it slows down trades and increases latency for HFTs.174 Second, subjecting HFT firms to pre-trade risk
169 Market participants will be required to identify themselves as large traders if their transactions in NMS securities equal or exceed (1) 2 million shares or shares equivalent to $20 million during one day; or (2) 20 million shares or shares equivalent to $200 million in one month. See SEC Release No. 34-64976 (17 CFR Parts 240 and 249), available at 170 See Consolidated Audit Trail, 75 Fed. Reg. 32556 (June 8, 2010), available at 171 See Mary Schapiro, Securities and Exchange Commission, Speech by SEC Chairman: Opening Statement at the SEC Open Meeting Consolidated Audit Trail (May 26, 2010), available at 172 Naked access is formally known as unfiltered access. See SEC Rule 15c3-5. Risk Management Controls for Brokers or Dealers with Market Access, 17 C.F.R. 240 (2010). 173 A discussion of sponsored access and risk controls is outside of the scope of this paper. For a more complete discussion, see, e.g., Clark, supra note 1. 174 Pre-trade risk controls slow trades down and increase latency. See Id. Still, brokerdealers will compete to upgrade their systems to perform pre-trade risk check with the lowest latency possible. See Melanie Rodier, Broker-Dealers Modifying Trading Systems to


controls decreases the likelihood that HFT firms will be able to engage in manipulative strategies. Sponsoring broker-dealers can be held liable for fines or subject to enforcement actions for client (HFT firms) violations.175 As it is not explicitly addressed in the rule, it is unclear whether the SEC may also be able to pursue direct enforcement action against sponsoring broker-dealers if one of their HFT clients were to employ a manipulative strategy. The SEC should amend the market access rules to unambiguously state their ability to seek enforcement action for such violations. Doing so incentivizes broker-dealers to monitor their clients for these specific strategies, effectively enlisting them to assist in regulating market manipulation. Another effect of this regulation is that it may entice large HFT firms to register as broker-dealers themselves. 176 While this will allow them to retain their naked access, this also opens them up for greater reporting requirements and inspections from FINRA. B. General Ban on Flash Orders Recall the requirement under Reg. NMS for exchanges to execute orders at the NBBO or route them to an exchange that will.177 Rule 602 of Reg. NMS, however, provides an exception for flash orders or flash trades from this requirement to execute at the NBBO or be re-routed.178 I argue that the current high speed,
Offer Ultra Low-Latency, (Oct. 26, 2011), available at 175 See James Armstrong, Brokers Scramble as Naked Access Ban Nears, Traders Magazine Online News (June 16, 2011), available at (explaining that sponsoring broker-dealers must ensure that clients follow certain procedures to prevent accidental or improper trades. Additionally, a clients violation of an exchange rule opens up the sponsoring broker-dealer to fine from the exchange as well as enforcement action from the SEC). 176 See Justin Grant, HFTs Fear SECs Naked Access Ban May Squeeze Profits, (Nov. 11, 2010), available at 177 See supra notes 69-70 and accompanying text. 178 Paragraph (a)(1)(i)(A) of Rule 602 excepts any bid or offer executed immediately after communication and any bid or offer communicated by a responsible broker or dealer other than an exchange market maker which is cancelled or withdrawn if not executed


electronic market structure does not support the enduring viability of the flash order exemption. As such, the SEC should amend Rule 602, eliminating the exception for flash orders. A basic understanding of flash orders will be sufficient in understanding why the SEC should ban flash trades.179 When an exchange or ATS/ECN cannot identify a seller or buyer at the NBBO (best publicly quoted price), instead of immediately routing the order away they will flash the order to a group of traders: HFTs, as they possess the requisite high-speed technology. 180 The exchanges seek out traders who have not publicly displayed the NBBO price through a limit order.181 Since flash orders last only for milliseconds, only HFTs are able to respond with a market order against flashed one, executing at the same price as a limit order at the NBBO. Effectively, flash orders convert market orders into limit orders executed at the NBBO. It is also important to note that flash orders are sometimes displayed at a marketable price that is actually better than the NBBO.182
immediately after communication from being mandatorily included in the consolidated quotation data. In effect, exchanges do not have to display quotes for flash orders. 17 C.F.R. 242.602 (2010). The SEC further extended this exception to ATSs. See Elimination of Flash Order Exception from Rule 602 of Regulation NMS, 74 Fed. Reg. 48632, 48634 (proposed Sept. 18, 2009) (to be codified at 17 C.F.R. pt. 242), available at [hereinafter Proposed Ban] (consistent with the language in Rule 602 excepting exchanges from including flash orders in the consolidated quotation data, the Commission has not applied Rule 301 to include flash orders in the consolidated quotation data.). 179 For a more detailed description of flash orders, see Proposed Ban, supra note 178, at 48633-34. 180 As the name flash trade connotes, these orders are available for only short times milliseconds. 181 Fact Sheet, Sec & Exch. Commn, Banning Marketable Flash Orders: Open Meeting of the Securities and Exchange Commission (Sept. 17, 2009), available at These market participants ATSs that do not display quotations to the investing publicare known as dark pools of liquidity, and in 2009, the SEC estimated that roughly thirty dark pools exist, and that dark pool trading accounted for 7.2% of the total share volume in stocks trading in those pools. Fact Sheet, Sec. & Exch. Commn, Strengthening the Regulation of Dark Pools (Oct. 21, 2009), 182 For example, a flash order to buy would be displayed at a higher price than the national best bid, and a flash order to sell would be displayed at a lower price than the national best offer. See Proposed Ban, supra note 178, at 48636.


The roots of the flash order exemption run deep in the Exchange Act. In fact, the specific language was included in the original adoption of Rule 602s predecessor in 1978 and has been around ever since.183 At that time, the SECs goal was to accommodate ephemeral quotations of non-specialist participants in exchange trading pits.184 Essentially, the SEC believed that since the face-toface quotes were so short-lived, either immediately executed or withdrawn, it would be impractical to require their inclusion in the consolidated quotation data. Of course, the ephemeral orders of 1978 were made manually, face-to-face on the exchange floorsa stark difference from the flash orders routed by high-speed computers through ECNs in 2012. Because of the transformation and technological advances in the financial markets, the SEC has decided to revisit this flash order exception, formally proposing to repeal the exception and ban flash orders in September 2009.185 There are several reasons in support of the SECs formal amendment of Rule 602 banning flash orders. First, the original justification for the exception is not supported by todays market structure. Some may argue that todays flash orders are even more ephemeral and deserving of this exceptionflash trades in 1978 may have lasted a several full seconds, where now they are for less than a second. But to argue in terms of absolute speed would completely ignore the markets technological transformation. Today, the vast majority of trading activity is placed by automated trading systems, HFTs and generally ATs, and is funneled through ECNs, electronic exchange mediums, etc. HFTs are able to respond within a fraction of a second,with their own order to execute against [a] flashed order.186 Traders are simply no longer engaging in these
183 See Proposed Ban, supra note 178, at 48634 (explaining that Rule 602 was originally Rule 11Ac1-1 under the Exchange Act until it was changed to Rule 602 in 2005). 184 Id. (quoting Exchange Act Release No. 14415 in n.19 that [t]his determination is consistent with the Commissions intent in providing this exception for ephemeral quotations in the 1977 Proposal; that is, that the Rule as adopted reflects the fact that certain non-specialist participants in exchange crowds have bids and offers which, while narrowing the exchange quotation for an instant in time, never in fact become a part of the quoted market on the exchange because they are withdrawn immediately if not accepted.). 185 Id. at 48632. 186 See Fact Sheet on Banning Marketable Flash Orders, supra note 181.


ephemeral face-to-face discussions whose inclusion in the quoted market was impractical. In fact, NYSE Euronext has stated its belief that orders held for a mere 500 milliseconds in todays environment do not receive immediate execution.187 Further, flash orders are routed through the same electronic mediums as other market orders. They are not communicated on the floors of exchanges and can very easily be included in the consolidated quotation data. However, the speed of todays market does not merely destroy the previous justifications of the exception. Todays HFT speed can also lead to very perverse market effects when combined with this flash order exception, such as creating a two-tiered market and decreasing the quality of market liquidity. HFTs are able to view and respond188 to flash orders in a matter of milliseconds. As such, flash trading allows HFTs to view other traders orders and activity for a brief moment before the orders go through. Access to this information gives HFTs an advantage in several ways, including executing the order before it is routed away without having to post a limit pricethereby escaping the risk of adverse selection189 and revealing their trading interest or strategy. Further, an HFT may also choose not to trade, instead utilizing the order information to capitalize on an available arbitrage opportunity or to trade ahead of others on the market.190 This preferred access to
Under NYSE Euronexts stance, any trade flashed for 500 milliseconds or longer would not qualify for the Rule 602 exception. See Letter from Janet M. Kissane, Senior Vice PresidentLegal & Corporate Secretary, Office of the General Counsel, NYSE Euronext to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn, at 3 (May 28, 2009) ([W]here trading and reaction time are discussed in micro seconds, an order that is held for even 500 milliseconds cannot be deemed an immediate execution.). 188 They can execute the order or pass. If every member of the flashed group passes then the order is withdrawn. 189 While a discussion of adverse selection is outside the scope of this paper, it can be defined as: the risk of adverse price movements while a security is held in inventory. See Letter from NASDAQ OMX regarding the Elimination of Flash Order Exception from Rule 602 of Regulation NMS (stating its position as the worlds largest exchange company in support of banning flash orders as they degrade the transparency and price discovery functions that are at the heart of a true national market system by diminishing the incentive to quote. By flashing orders rather than posting liquidity, firms avoid adverse selection risk and also widen the bid/ask spread resulting in greater compensation for market making.). 190 At least one commentator, Mi Hyun Yoon, has focused on ability for flash traders to


information leads to financial benefits otherwise not available to market participants and, in effect, a two-tiered market. Aside from the potential for arbitrage opportunities mentioned above, HFTs may receive more direct financial and strategic benefits from flash trading. First, flash orders that are displayed with a better price than the NBBO translate to a direct price advantage for HFTs. 191 Some commentators have disclaimed this price advantage, stating that investors are not deprived of a fair price, since a flash trade cannot, by SEC rules, trade through pre-existing orders.192 However, that statement is patently false. The SEC has stated that flash orders are often displayed with a direct price advantage.193 And, to the extent that this happens, there is no leading up to a two-tiered marketit is already here. Further, HFTs can take advantage of rebates or lower fees offered by the different exchanges and ECNs for executing flash orders.194 From a strategic
front-running as the biggest issue concerning flash trading. However, Yoon ultimately argues against the SECs ban on flash trading. See Mi Hyun Yoon, Trading in a Flash: Implications of High-Frequency Regulators For Securities Regulators Worldwide, 24 Emory Intl L. Rev. 913, 934 (2010) (The real problem of flashing an order is that it gives the recipient the ability to front-run the customer whose order has been flashed.). See also Scott Patterson, Kara Scannell, & Geoffrey Rogow, Ban on Flash Order Is Considered by SEC: Shapiro Sees Inequity While Exchanges Wrestle for Market Share in High-Speed Trading, Wall Street Journal (Aug. 5, 2009), available at (In a flash order, a firm wishing to buy or sell a stock can elect to freeze the order on an exchange for as long as half a second. This move can have several effects, one of which concerns a system of rebates and fees on trading orders.). 191 For a discussion of the importance of reported prices as a product of the financial markets, see generally, J. Harold Mulherin et al., Prices are Property: The Organization of Financial Exchanges From a Transaction Cost Perspective, 34 J.L. & Econ 591 (1991) (discussing the theory that the products of financial exchanges are prices and the exchanges function is to establish property rights in price quotations); see also David E. Van Zandt, The Market as a Property Institution: Rules for Trading Financial Assets, 32 B.C.L. Rev. 967 (1991) (discussing the market as a property-based system). 192 [T]hat is, [flash trades] cannot be executed below the best bid or above the best offer. See Yoon, supra note 190, at 934 (quoting Chris Hynes & Donald Luskin, In Defense of Flash Trading, Wall St. J., Aug. 27, 2009, at A13). 193 See supra note 180 and accompanying text. 194 See Proposed Ban, supra note 178, at 48637 ([M]any markets that display quotations charge feesFlash orders may be executed through the flash process for lower feesIndeed, some markets have offered rebates on orders that are executed during a flash, so that the order, rather than paying a fee, will earn a rebate.); see also Fact Sheet on


point of view, HFTs benefit from the anonymity of executing flash orders. Often, they will be reluctant to display their quotations in order to avoid revealing full trading interests and strategies.195 To what does this all amount? For HFTs, to a pretty good deal. The benefits consist of preferred access to information, lower transaction costs, potential for direct prices benefits, and even cover from other HFT anticipatory strategies. Of course, some commentators make blanket statements dismissing the preferred status of HFTs in flash trading. The truth is that theres no particular privilege involved. Any broker can enter flash orders or respond to them[.]196 They further assert that todays practices are no different from those in the pre-computer era.197 Sure, any trader can enter and respond to flash ordersafter obtaining extremely expensive equipment. In addition, such cut-and-dry comparisons between market participants of the pre-computer era and today are too simplistic in nature. As such, the failure to address the significant barriers to entry in the form of extremely high technology costs and dramatic changes in the marketplace in conjunction with these statements amount to a rather superficial discussion of the issues. The SEC has stated that when the interests of long-term investors and short-term traders conflict in this context, the
Banning Marketable Flash Orders, supra note 181. For an example of liquidity rebates, see also, supra Part III.A. 195 See Proposed Ban, supra note 178, at 48638. 196 The authors continue that any broker can enter and respond to flash orders even when executing on behalf of ordinary individual investors. They also analogize the practice of flash trading to selling your house without a real estate listing. See Chris Hynes & Donald Luskin, In Defense of Flash Trading, (Aug. 27, 2009), available at See also Yoon, supra note 190, at 934. 197 See Hynes & Luskin, supra note 196 (its just like what upstairs traders did in the pre-computer era: shopping an order before sending it to the exchange floor. We had no problem with this process, so why would be ban flash trading[?]); see also Yoon, supra note 190, at 934 ([I]n determining whether flash orders should be banned, one may look to a historical account of any similar emergence of a select group of market participants who had access to certain non-public quote information. There were a number of historical instances where certain exchange members, such as specialists, had access to quote information before it was publicly displayed.).


Commission believes that its clear responsibility is to uphold the interests of long-term investors. 198 It is clear that flash trading certainly produces benefits for at least one select group. However, with such a skewed accruement of benefits in favor of short-term traders, or HFTs, it is difficult to see how flash trading might similarly benefit the long-term investor. Fairness concerns aside, there must be some broader corresponding benefits to the market.199 The SEC believes that the flash orders can attract additional liquidity from market participants who are not willing to display their trading interest publicly.200 As some sort of market heroes, these traders will step up and provide liquidity to flash orders.201 The notion that this added liquidity provides a benefit to the overall market equal to those HFT-specific benefits of flash trading is suspect. In fact, the assertion that flash trading improves liquidity at all is dubious. Flash trading likely damages market liquidity. Instead of placing resting limit orders, which may be executed against at the NBBO, HFT firms are incentivized to just wait for an order to be flashed.202 Limit orders include the risk of adverse selection.203 Market orders placed in response to flashed orders, however, do not. Since flash trading allows HFTs to buy or sell at the NBBO without posting a limit order, HFTs can avoid the risk of adverse selection. To state it differently, they can utilize market orders to achieve the same goal with less risk. This may explain to some degree the evaporation of liquidity from HFT firms on the May 6th Flash Crashit was likely
See Proposed Ban, supra note 178, at 48636. Here, I generally assume that enhancements to the broader market, such as increased efficiency and liquidity, are aligned with the interest of long-term investors. 200 See Proposed Ban, supra note 178, at 46837. 201 Id. at 46838. The SEC mentions this is its discussion on whether to ban the practice of flash trading. It has not necessarily made the determination that this added liquidity any negative effects of flash trading. 202 See Letter from Stephen Schuler & Daniel Tierney, Managing Members, Global Electronic Trading Company (GETCO) to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn (June 4, 2009) (Market participants interested in finding the best priced orders to execute against would be encouraged to join the disparate system of step-up order display systems on the various exchanges so that they could execute against better priced step-up orders without displaying limit orders on the public markets.). 203 See supra note 189 and accompanying text.
199 198


never there. Absent market making obligations, most HFT firms likely did not have resting limit orders posted. Rather, they sought to grab flashed orders as they became available. But they never did. Instead, as HFTs are able to see flashed orders, they likely quickly realized that the market was sharply declining. HFTs capitalized on this information advantage by exiting the market before others even knew what was happening. Despite the fact that most major US stock platforms use flash orders to stay competitive internationally, several have stated they would welcome the end of the flash era.204 They even go as far as to state that banning the practice will not be harmful to their profits or operations.205 Further still, some venues voluntarily shut down their flash order mechanisms in anticipation of the SECs formal adoption.206 However, unless the SEC formally bans flash trading, these firms will likely reboot their flash mechanisms in order to remain competitive with other exchanges continuing to offer it. At this point, it should be clear that flash trading cannot stand firmly on the justifications offered in support of its ancestral exception. The benefits of flash trading accrue primarily to HFTs as short-term traders able to participate in it. Finally, the flash order exception likely has adverse effects on market liquidity. As such, the SEC should amend Rule 602 with a general ban on flash orders.

204 See Jacob Bunge, US Regulators Seen Moving To Ban Dark Flash Orders Soon, Marketwatch.Com (July 28, 2009), available at See also NASDAQ Letter, supra note 189. 205 See Bunge, supra note 204 (explaining that officials from both the BATS Exchange and Direct Edge, two leading stock trading venues, were confident that a ban would not damage their overall businesses). 206 See Nandini Sukumar, NASDAQ, BATS to Stop Allowing Flash Orders for Stocks, (Aug. 6, 2009), available at


C. Market Making Obligations Another important regulatory discussion revolves around the fact that despite being de facto market makers,207 HFTs 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. 208 Requiring market making HFT firms to observe certain obligations may significantly decrease the chances of another Flash Crash as well as enhance the liquidity already provided by HFT.209 Specialists and market makers210 once played a large role in the functioning of the markets. Historically, exchanges provided market makers with certain benefits in exchange for taking on the obligations of providing liquidity and maintaining fair and orderly markets. 211 As a matter of illustration, NYSE specialists advantages consisted of time and place advantages by being on the trading floor, knowledge of all limit orders on his limit order book,212 superior ability to interpret market trends, the opportunity to trade against the book, and a central role in controlling the
See supra Part III.A. See Mary L. Schapiro, U.S. Sec. and Exchange Commn, Remarks Before the Security Traders Association, (Sept. 22, 2010). These obligations consist of affirmative and negative obligations, which are intended to promote market quality. Affirmative obligations may require market makers to consistently display high quality, two-side quotations that help dampen price moves. Negative obligations may restrict the ability to reach across the market to execute against displayed quotations and thereby cause price moves. See Concept Release on Equity Market Structure, supra note 21, at n.70. 209 As stated above, any regulation that arbitrarily applies to all HFT firms is overly broad and that holds true here. It is unnecessary for every single HFT firm to be subject to market maker obligations. For example, a firm that only engages in statistical arbitrage should not be subject to affirmative and negative obligations because they are not engaging in a market making function. 210 I will use the terms specialist and market maker interchangeably as to avoid mentioning both each time. However, there is an important distinction in their regulation will be discussed infra note 223. 211 See Janet M. Angstadt, What will be the legacy of the Flash Crash? Developments in the US equities market regulation, 6 Capital Markets L. J. 80, 85 (2010). 212 Limit Order Book, Investopedia Dictionary (A limit order book is [a] record of unexecuted limit orders maintained by the specialist.), available at
208 207


auction-based market.213 At least one commentator has stated that these benefits were rationalized as a means of compensating specialists.214 The SEC expressed its view of the situation as early as 1963: The specialists exclusive knowledge of the orders on the book and the known source of supply and demand available to him through the book give him a definite trading advantage over other market participants. This can be justified only by the benefits which the specialist confers on the market, and only if high standards of conduct in dealer and broker activities are defined and enforced.215 Essentially, the SEC believed the benefits enjoyed by a specific set of participants were offset by a corresponding benefit to the overall market. Specialists could trade at an advantage, but the market would receive continuous, high quality liquidity. Fast forward to the modern era: many of the benefits available to traditional market makers have disappeared and their once large role has followed suit. 216 Today, the majority of trading volume is
213 See George T. Simon & Kathryn M. Tirkla, The Regulation of Specialists and Implications for the Future, 61 Bus. Law. 217, 282-83 (2005) (citing the Sec. & Exch. Commn, Report on the Feasibility and Advisability of the Complete Segregation of Functions of Dealer and Broker Pursuant to Section 11(e) of the Securities Exchange Act of 1934, at 1 (1936)). 214 See Craig Pirrong, Should Affirmative Obligations Be Imposed on High Frequency Traders, (Sep. 12, 2010), available at 215 See Simon & Tirkla, supra note 213 (citing Sec. & Exchange Commn, Report of Special Study of the Securities markets of the Securities and Exchange Commission Part 5, at 86). 216 As the advantages for market makers diminished, so did the corresponding obligations. However, the market structure also created more competitive pressure between exchanges. The exchanges sought to attract additional traders by competing with each other in terms of obligations. For example, in 2007, the NASDAQ eliminated the market makers obligation that quotations must be reasonably related to the prevailing market. Their rationale for eliminating this requirement was so that the NASDAQ rules could be consistent with market maker obligations contained in the rules of other national securities exchanges. See Angstadt, supra note 211, at 85 (quoting Securities Exchange Act Release No. 56759


conducted by market making HFT firms. As de facto market makers, many post-Flash Crash proposals have called for HFT firms to take on similar obligations once held by their predecessors.217 However, as one might assume, any proposal for market making obligations cannot be discussed without resolving the issue of corresponding trading privileges. As of now, there are serious concerns as to whether the current calculus supports the imposition of market making obligations.218 I will go a step farther and agree with those who believe it does not. What about flash trading? I described above several reasons why the current market structure does not support the continuing general exception for flash trading. At first, it may make the reader uneasy to read several reasons in support of a general ban on flash trading then to see its re-exception suggested shortly following. Nevertheless, a limited exception for flash order participation for those willing to take on market making obligations has great utility here. It is important to note that the market today is not devoid of market makers and trading obligationsthe NYSE currently has

(Nov. 7, 2007)). See also Stanislav Dolgopolov, Providing Liquidity in a High-Frequency World: Trading Obligations and Privileges of Market Makers and a Private Right of Action at 51, Working Paper (2012) (Another key development is that changes in the business models of many exchanges and advancements in technology have eliminated or reduced the value of the special time and place privileges traditionally enjoyed by specialists and registered market makers.). 217 See Final Flash Crash Report, supra note 81, at 12 (The SECs review should, at a minimum, consider whether torequire firms internalizing customer order flow or executing preferenced order flow to be subject to market maker obligations that requires them to execute some material portion of their order flow during volatile market periods.); Letter from Sen. Kaufman, supra note 71, at 5 ([T]he SEC should impose some liquidity provision obligations on high frequency tradersto encourage [them] to post two-sided markets and supply investors with a consistent source of deep liquidity. In addition to affirmative liquidity provision obligations, the Commission should consider instituting negative obligations as well.); Letter from Karrie McMillan, Gen. Counsel, Inv. Co. Inst., to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn (Apr. 21, 2010), available at (We recommend that the [SEC]consider whether HFT firms should be subjected to quoting obligations similar to that of OTC market makers or any other regulations similar to the affirmative and negative obligations of specialists and market makers.). 218 See Stanislav, supra note 216, at 61-64.


designated market makers (DMMs).219 However, DMMs do not receive any advanced look at the order book, and, to date, only six firms have registered and subjected themselves to obligations as a DMM.220 Flash trading gives participants several advantages, such as the superior ability to interpret market trends, the opportunity to trade against the book, and central role in controlling the [order]-based market, much like the SEC has described in the past.221 In a sense, the SEC can manufacture a limited privilege for registered market makers by instituting a general ban on flash orders. With the ability to offer flash order privileges in a banned-flash-order environment, the NYSE and other exchanges will likely offer sufficient incentive for additional firms to take on market maker obligations. Although they did not delve into any detail, it should be noted that Goldman Sachs suggested a similar arrangement.222 I propose, at least, a basic structure for this limited exception and corresponding obligations. First, the exception will be available only to market making HFT firms. Second, the obligation will generally consist of an affirmative obligation to promote fair and orderly markets by providing market depth and continuity in prices. 223
219 DMMs manage both physical auctions as well as fully automated trading. They are subject to affirmative obligations. See NYSE Designated Market Makers: Fact Sheet, available at 220 The firms include Barclays Capital, GETCO Securities, LLC, Goldman Sachs & Co., Knight Capital Group, Inc., J. Steicher & Co., LLC, and Virtu Financial Capital Markets, LLC. See NYSE Equities Membership Types, available at 221 See supra note 215 and accompanying text. Also, the current market structure is not auction driven as in the old structure of floor trading and dominant specialists. The modern market is an order-driven market. See Angstadt, supra note 211, at 84. 222 See Letter from Greg Tusar, Managing Dir., Goldman Sachs Execution & Clearing, L.P. & Matthew Lavicka, Managing Dir., Goldman Sachs & Co., to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn, at 7 (June 25, 2010), available at (Exchanges shouldconsider expanding the classes of firms to which [market making] obligations apply, such as to firms that choose to utilize step-up order types [such as flash orders] or significant bandwidth.). 223 This presents somewhat of a harmonization of the previous NYSE specialist and NASDAQ market maker rules and is closer to the NYSEs current DMM obligations. Historically, specialists were subject to a more stringent affirmative obligation than market


Finally, the rules for eligibility and obligations should be clearly stated by the SEC and be uniformly adopted by all exchanges and trading venues.224 Of course, additional concerns and suggestions remain regarding HFT market making obligations.225 Enacting this proposal will benefit the market in several ways. With greater incentive to observe affirmative trading obligations, there will be a greater number of market makers present in the market. In order to satisfy their market making obligations, this larger number of market makers will have to compete with each other for liquidity. Further, HFTs not eligible for the limited exception will have to compete by more aggressively placing limit orders, as they will no longer be able to use market orders against
makers. Although both called for promotion of fair and orderly markets, specialists were required to provide market depth and continuity, while market makers needed only to maintain two-sided quotations that were reasonably related to the prevailing market. Specialists were also subject to a negative obligation, which limited their dealer activity to only what was reasonably necessary to maintain a fair and orderly market. This rule stems from the fact that specialists typically combined the broker-dealer functions. The negative obligation was used to resolve the inherent conflict of interest between fiduciary obligations to customers and personal trading interests. However, since HFT firms are proprietary traders, and absent the broker/agency relationship a negative obligation is not necessary. See Simon & Tirkla, supra note 212, at 222-23, 346-47. Also, market depth is defined as the markets ability to sustain relatively large market orders without impacting the price of the security. See Market Depth, Investopedia Dictionary, available at 224 Senator Charles Schumer raised this concern in his letter detailing his position on market maker obligations for HFTs. See Letter from U.S. Sen. Charles E. Schumer to Mary Shapiro, Chairman, U.S. Sec. & Exch. Commn (Aug. 11, 2010), available at 225 To be sure, this proposal only encompasses the largest issues concerning the imposition of market making obligations on HFTs. I seek to clarify the importance of these main pillars and provide a framework from which to continue further discussions. It is necessary to more fully develop the liquidity obligation and more clearly define appropriate measures of market depth and price continuity. Different classifications are likely necessary to account for differences in the most liquid, actively traded equities and those that are thinly traded. Further, any determinations will need to account for the trading pauses triggered by price movements in the SECs new circuit breaker program. See SEC Bulletin: Circuit Breakers, supra note 45. For additional concerns and suggestions regarding trading obligations related to HFT, see, e.g. Letter from John A. McCarthy, Gen. Counsel, GETCO, LLC, Christopher R. Concannon, Partner, Virtu Fin., LLC, & Leonard J. Amoruso, Gen. Counsel, Knight Cap. Grp., Inc., to Robert Cook, Dir., Div. of Trading and Mkts., U.S. Sec. & Exch. Commn, at 12 (July 9, 2010), available at See also Letter from Senator Schumer, supra note 224.


flashed trades.226 Such increased market and liquidity competition is likely to result in a deeper market and tighter bid-ask spreads. This translates into two direct benefits for market participants. First, a deeper market will dampen price volatility. Second, tighter spreads will lead to decreased transactions costs for investors. Although there are very large potential gains from enacting this proposal, it is sure to be met with opposition in at least a few days. Fearing that the exception will swallow the rule, opponents will argue that allowing for a limited exception will eliminate the gains achieved by banning flash orders. First, it is important to reiterate that this limited exception will be just that: limited. I propose that this exception be made available only to HFT firms engaging in market making strategies. As such, HFT firms will not be able to engage in arbitrage opportunities or front-run as a result of this exception because engaging in such strategies will disqualify them from the exception.227 Further, any HFT firm seeking to participate in flash trading must commit itself to market making obligations.228 Although market making HFT firms will receive a direct trading advantage, the advantage is justified by the benefit the firms confer on the market by observing market making obligations. These two requirements restrict this exceptions availability to only a fraction of the HFT community. Further still, allowing for the obligation plus flash order structure may actually enhance the gains achieved through a general ban on flash orders. By allowing a certain group of traders to capture flash order benefits while simultaneously conferring a benefit to the overall market, the SEC can realize an opportunity for mutual gain. Opponents are also likely to discount the general utility of market maker obligations. They may point to the fact that obligated market makers could not have prevented the Flash Crash, and will
See supra notes 202-203 and accompanying text. Market maker registration and the new consolidated audit trail system ensure the SECs ability to effectively monitor for this activity. 228 It is possible that a firm may wish to engage in market making strategies without subjecting itself to market making obligations. A firm may also decide to engage in market making and statistical arbitrage strategies. In either case, the HFT is ineligible to engage in flash trading through the limited exception.
227 226


similarly fail in the future.229 This presents a legitimate concern, to be sure. HFT market maker firms did not fulfill the spirit of their obligations during the sharp decline on May 6. There were very few HFT market maker firms at that time. More importantly, market makers generously relied on posting dubious stub quotes,230 which will not be an option under my proposal. Market makers utilized stub quotes to comply with their obligation of maintaining two-sided quotations when they did not wish to actively provide liquidity.231 Given the ability to so frivolously use stub quotes at the time, it is true that obligated market makers could not have prevented the Flash Crash. However, the same does not hold true in the post-Flash Crash era if a version of this proposal is adopted because the SEC banned stub quotes and market making obligations can no longer be satisfied through outrageously priced quotes. Further, there will be a greater number of market makers present in the market. As discussed above, a greater number of obligated traders competing to provide liquidity will likely smooth market volatility, not exacerbate it. Finally, other opponents may challenge this proposal on the grounds that a uniform rule for all trading venues is too restrictive. Specifically, exchanges will be unable to compete with each other by varying trading obligations. In fact, this competition is precisely what I aim to curb by proposing a uniform rule. Such competition effectively ignites a race to the bottom where exchanges are pressured to continually relax obligations in order to earn additional business. This would eviscerate the flash order-trading obligation trade off and leads to a structure in which exchanges impose no
See, e.g., Paul Amery, Could Stricter Rules for Market Makers Have Prevented the Flash Crash?, (May 20, 2010), available at 230 Stub quotes are offer[s] to buy or sell a stock at a price so far away from the prevailing market that it is not intended to be executed, such as an order to buy at a penny or an offer to sell at $100,000. See Securities and Exchange Commission, SEC Approves New Rules Prohibiting Market Maker Stub Quotes (Nov. 8, 2010), available at 231 As a result, a significant number of stub quote orders were executed at extreme prices during the Flash Crash. The SEC has since banned the posting of stub quotes. Id.


true affirmative quoting or trading requirements.232 Any increase in business amounts to little more than regulatory arbitrage. By imposing a uniform rule, the SEC can prevent this from happening. Instead, exchanges will be forced to compete in terms of service and functionality. As the market structure currently stands, it does not justify the imposition of market making obligations on HFT firms. The benefits once afforded to market makers, such as a presence on the trading floor and an advanced look at orders, have faded. However, the SEC holds the power to manipulate the equation with a general ban on flash orders. The subsequent limited exception for market making HFTs will justify the corresponding affirmative trading obligations on such firms. Further, it is necessary that the SEC implement a uniform rule on all trading venues. V. CONCLUSION

High-frequency trading is a result of decades of interplay between regulatory and technological advancements. Although its ascent to constituting the majority of market volume remained largely unnoticed, in the wake of the Flash Crash HFT has captured the attention of laypersons, academics, financial industry professionals, and most significantly regulators. HFT utilizes speed, advanced technology, and algorithms and employs several different strategies to turn a transactions seemingly insignificant gains into substantial profits. Due to its complexity and continual evolution, it is often misunderstood and misinterpreted. Unfortunately, some concepts in this article will inevitably be altered, at least slightly, before you reached this conclusion. This makes it incredibly difficult to regulate. Ultimately, my proposal to condition a flash order exception on an affirmative market making

See Letter from McCarthy, Concannon & Amoruso, supra note 225, at 1 (Over the years, as the market structure changed, market maker obligations have evolved into the current rule set, which on several exchanges impose no true affirmative quoting or trading requirements.). See also, e.g., supra note 216.



obligation seeks to capture the positive effects that HFT can bring to the market while mitigating its potentially perverse effects. My proposal comports with overarching goals of securities regulation: ensuring investor protection, promoting market integrity and efficiency, and preventing systemic risk. The general ban on flash trading improves investor protection by decreasing the chances that an HFT firm can and will front-run another less technologically equipped investor. Further, it improves market integrity in preventing an eventual wholesale transformation to a two-tiered market. However, flash trading does provide at least some tangible efficiency in the form of lower costs for those participants engaging in such practice. By allowing a limited group of HFT firms to engage in flash trading, some efficiency benefits are recouped in the form of lower costs for those participating firms. The deeper, higher quality liquidity that results from increased participation in market making activity similarly improves the market efficiency. Finally, and most importantly, the increased liquidity significantly reduces the chance that another destabilizing event such as the Flash Crash will occur, thereby reducing the systemic risk the equities market poses to the overall economy.