Refining the Doctrine of Market Manipulation for the Modern Electronic Marketplace
Rarely out of the headline news, market manipulation has always been a permanent fixture of securities markets. Even the earliest experiences of a modern-style stock exchange in the 17th century provide evidence of manipulative practices listed by a contemporaneous commentator among ‘the craftiest and most complicated machinations which exist in the maze of the Exchange and which require the greatest possible cunning’ (at para ). Among recent examples under US law one might mention the mounting concerns about manipulation in volatility-based products, the overlap of the manipulation-prone cryptospace with the regulatory regime governing securities markets, and increasingly complex methods to detect market manipulation, whether broadly or narrowly defined. Moreover, the modern electronic marketplace presents a host of issues relating to potentially manipulative practices, such as ‘electronic front-running’, new iterations of ‘spoofing’ and ‘layering’, and symbiotic relationships between trading venues and high-frequency traders based on inadequate disclosure, as exemplified by the monumental City of Providence v BATS Global Markets, Inc, 878 F3d 36 (2d Cir 2017).
Like many other legal doctrines, the one of market manipulation cannot be defined with absolute precision, instead being fact-intensive and guided by the evolution of the marketplace, but this doctrine needs to remain consistent with its goals and the very nature of the trading process. Overarchingly, an analytical framework for crafting a definition of market manipulation should consider the process of price discovery and liquidity provision as key market mechanisms. Price discovery points in the direction opposite to market manipulation, and providing liquidity—or engaging in arbitrage or speculation more generally—need not be coupled with manipulative activities. That is not to say that market manipulation does not occur in tandem with any of these activities. More generally, a holistic evaluation of trading strategies is necessary to identify a manipulative intent and isolate manipulative and otherwise non-manipulative components of such strategies.
A proper goal is to approach the very scope of market manipulation cautiously. For instance, any non-price ‘manipulation’ presents a very different kind of underlying harm, and some recent attempts to expand the doctrinal reach to mere market activity is quite problematic. While ‘artificial market activity’ is a necessary element for creating ‘artificial pricing’, the former does not function independently. Even recognizing the fact that several key non-US jurisdictions have a formalized multidimensional definition of market manipulation, other relevant factors could be logically interpreted as proxies for the intent to create artificial pricing. Similarly, focusing on granularities of price changes in the modern electronic marketplace does not transform a wide variety of practices to market manipulation, which, after all, requires certain price patterns to capitalize on deliberate deviations from the equilibrium price. Moreover, the scope of analysis should include an interaction of different types of trading strategies in an essentially zero-sum game in the short run. The process of price discovery inevitably involves various market participants’ trading strategies, risk tolerance, capital commitments, and conditional or even erroneous pricing assumptions. All of these factors impact the path of price fluctuations to some equilibrium, without necessarily producing any deliberate artificial pricing. Likewise, mere additional trading activity and price volatility, even including market disruptions, should not be equated to market manipulation. That is not to say that all of these practices are harmless, but they need to be defined and addressed through other legal tools. Similarly, some degree of discretion, if not control, over prices in terms of orders and transactions is inevitable in connection with the process of price discovery and liquidity provision, but that does not necessarily cross the line separating artificial from non-artificial pricing.
The doctrine of market manipulation is an evolving organism, and the identification of wrongful practices and analytical approaches, such as the phenomenon of quote stuffing or the concept of open market manipulation, is an ongoing process. Gray areas and blind spots are inevitable, and some degree of discretion exercised by the courts and regulators to reframe certain issues is also a critical factor. Shifting perceptions about the boundaries of the doctrine of market manipulation and its elements require attention, as illustrated by such key issues as the definition of ‘market activity’, the concept of non-bona fide orders, the extent of the legitimacy of price impact-based trading strategies, and the distinction between primary and secondary violators in complex manipulative schemes.
Accordingly, my article (forthcoming in the Journal of Corporation Law) sketches a frame of analysis for the doctrinal quandary of manipulative practices in securities markets under US law, drawing on the historical origins of the concept of market manipulation and the realities of the modern electronic marketplace. The essence of market manipulation is maintained to be in artificial pricing based on market activity, as opposed to other indicia of ‘artificiality’, and this definitional approach is compared and contrasted to the process of price discovery and liquidity provision. The article addresses several key themes relevant for today’s securities markets, such as the phenomenon of exploratory trading, market making and the role played by market makers, the doctrine of open market manipulation, spoofing / layering and disruptive trading, and the implications of the market structure crisis.
Stanislav Dolgopolov is the Chief Regulatory Officer at Decimus Capital Markets, LLC.
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