The Market Structure Crisis, HFT Practices, and Securities Fraud

The phenomenon of high-frequency trading (‘HFT’), one of the pivotal ingredients of the current market structure crisis in the United States, has captivated the public eye, while becoming a key regulatory and legal issue. However, high-frequency traders (‘HFTs’) have been largely absent from the ranks of parties held liable for securities fraud, despite being referenced under such monikers as ‘Trading Firm A’ and ‘Trading Firm B’ in some prominent enforcement actions against other parties.

A starting point is that many forms of HFT are in no way illegal, and they represent, in addition to specialization and expertise of these market participants, the modern iteration of time, place, and information advantages in a fragmented architecture of securities markets. However, such ‘traditional’ advantages, which may be called unavoidable, are only one part of the real story relevant for the purposes of identifying securities fraud. The phenomenon of ‘plumbing’ embodied by market structure shortcuts and their selective disclosure by trading venues to preferred traders should be considered as well. For instance, the so-called ‘order type controversy’ is symptomatic of many advantages occurring in the modern market structure in connection with informational asymmetries in advanced functionalities, which may range from merely undocumented gray areas to discrepancies with formal documentation that constitute direct contradictions. Moreover, while the doctrine of market manipulation as a form of securities fraud has a broad reach, this charge is essentially missing, at least in securities markets, for larger players in the HFT segment, as opposed to the typical scenario of a ‘point-and-click’ trader often aided by some automated tool.

Perhaps it should not be surprising that bad actors in the HFT segment are hard to catch—at least through the means of private lawsuits. In light of trading venues’ inadequate disclosure and concomitant questionable trading practices, the role played by HFTs may appear to be secondary from a doctrinal viewpoint. More generally, HFTs may look like—and, in many instances, objectively are—just skillful beneficiaries courted by trading venues in a cutthroat environment created by the modern electronic marketplace. Moreover, another important scenario of frictions and imperfections in trading venues’ protocols does not involve collusion, but is rather based on the use of ‘glitches’, which makes such HFTs look even less culpable. But this paradigm should not result in blanket immunity, and a fresh perspective and an objective reevaluation of existing HFT practices from the standpoint of securities fraud are very much needed in order to identify, penalize, and deter wrongful conduct.

Accordingly, my forthcoming article analyzes different approaches to attaching liability for securities fraud to high-frequency traders as primary violators in connection with the current market structure crisis. One of the manifestations of this crisis pertains to inadequate disclosure of advanced functionalities offered by trading venues, as exemplified by the order type controversy. The article’s analysis is applied to secret arrangements between trading venues and preferred traders, glitches and gaming, and the reach of the doctrine of market manipulation, and several relevant issues are also viewed from the standpoint of the integrity of the trading process. While the focus of the article is on the US regulatory framework, with its doctrinal idiosyncrasies, this analysis should be useful for addressing similar practices, as well as for conceptualizing the nature of HFT-related harm, in other jurisdictions.

Stanislav Dolgopolov is a regulatory consultant with Decimus Capital Markets, LLC.