c

 


    


 
Colin Howard
December 15, 2011
University of Maine School of Law
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Senator Kaufman



 

idvancements in computer and communication technology have
had a massive impact on financial markets. Developments in the
speed and efficiency of trade have created new opportunities for
short-term gain, which new strategies attempt to take advantage
of. Competition for these opportunities has resulted in their
existing for shorter and shorter periods of time. Trade must now
be measured in units smaller than a millisecond, average daily
volume is increasing exponentially, and regulators are scrambling
to keep up.
One of the most significant developments is high-frequency
trading (‫ڍ‬HFT‫)ڎ‬. The speed and volume that HFT is characterized
by has made its influence on the markets pervasive. The
stability of the financial markets requires increased regulation
of HFT.
This paper will explore the current regulations HFT is
subject to, and their limited effectiveness. This paper will
then describe how the newly enacted Dodd-Frank Wall Street Reform
and Consumer Protection ict may influence regulation, and suggest
how some of its provisions might be most effectively implemented
in this area. Finally, this paper will describe some newly
enacted, proposed, and possible HFT regulations.






 


Recent advances in computer technology and electronic

communication have ‫ڍ‬dramatically‫ ڎ‬affected the financial markets
in the United States.1 The various and important changes are
largely beyond the scope of this paper.2 But the speed,
processing power, and efficiency of computers, as well as several
regulations,3 have pushed markets towards an environment where
much of trade is electronic: trades may be initiated by
computers, executed by computers, and in some cases, controlled
exclusively by computers.4
The ‫ڍ‬speed, capacity, and sophistication‫ ڎ‬of trade has
‫ڍ‬dramatically improved.‫ڎ‬5 In 1987, the New York Stock Exchange
(‫ڍ‬NYSE‫ )ڎ‬had the capacity to handle about 95 trades per second.

1
Concept Release on Equity Market Structure, 75 Fed. Reg. 3554, 3594 (Jan.
21, 2010) (Changes have been driven by ‫ڍ‬continual evolution of technologies
for generating, routing, and executing [trade] orders.‫[ )ڎ‬hereinafter Concept
Release on Equity Market Structure].
2
For a detailed discussion of how computers and electronic communication have
affected the markets, 




 , Jerry W. Markham, Daniel J. Harty, 




!

"


#



$ 

 




%


&', 33 J. Corp. L. 865 (2008).

3 (

Emily Lambert, Flash Crash: The Regulators Did It, Forbes.com (Sep. 29,
2010) ; Tom Lauricella, et al., Investors, Regulators Laid Path to ‫ڍ‬Flash
Crash,‫ ڎ‬The 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). (


,
Concept Release on Equity Market Structure at 3594 n.1-2 (listing regulations
that have helped push markets towards an electronic environment) citing
Securities Exchange ict Release No. 51808 (June 9, 2005), 70 FR 37496 (June
29, 2005) (‫ڍ‬Regulation NMS Release‫ ;)ڎ‬Securities Exchange ict Release No.
37619i (September 12, 1996) (‫ڍ‬Order Handling Rules Release‫)ڎ‬.
4 (

Markham,  
note 2, at 866-67.
5 Concept Release on Equity Market Structure at 3594.
By 2007, that number had increased to 38,000 per second.6 Trade
is more efficient as well, reducing transaction costs.7 ind
speed plus efficiency seems to equal a massive increase in
trading volume: consolidated average volume in the U.S. increased
from 2.1 billion shares in January 2005, to 5.9 billion shares
(an increase of 181%) in September 2009. Trades in NYSE stocks
increased from 2.9 million trades in January 2005 to 22.1 million
trades (an increase of 662%) in September 2009.8 Finally, and
important for this paper‫ڊ‬s discussion, developments in computer
technology have enabled automation of trade.
These new developments have created new opportunities for
gain in the markets. Due to increases in speed and efficiency,
tiny gains may now be profitable. Firms have devised new trading
strategies and revised old ones to take advantage of these new
opportunities. Several of these strategies may be described as
HFT strategies, which are based on speed, processing power, and
volume.
Developments in electronic trade and the strategies devised
to meet opportunities they have spurred a ‫ڍ‬micro-arms race,‫ ڎ‬as
firms clamor for advantages over other firms.9 Consequentially,

6 Markham,   note 2, at 882 (citing iaron Lucchetti, ifter Crash, NYSE Got
the Message(s), Wall St. J., Oct. 16, 2007, at C1).
7 Manoj Narang, Submission to SEC‫ڊ‬s Request for Comment (January 21, 2010) on
Behalf of Tradeworx, Inc. 9 (ipril 21, 2010) [hereinafter Letter from Monoj
Narang]. (explaining that ‫[ڍ‬a]s trading costs diminish, smaller and smaller
opportunities become profitable to trade, leading to higher volumes.‫)ڎ‬
8 Large Trader Reporting System, 74 Fed. Reg. 21456 at 2 (proposed ipril 14,
2010) (to be codified at 17 C.F.R. pt. 240 & 249).
9 Letter from Sen. Ted Kaufman to Mary Shapiro, Chairman, Securities and
Exchange Commission [hereinafter Letter from Sen. Kaufman] (iug. 5, 2010)
available at http://sec.gov/comments/s7-27-09/s72709-96.pdf. (‫[ڍ‬W]hile speed
and efficiency can produce certain benefits, they have also created a micro-
as computers become faster, the opportunities that these firms
are competing for exist for shorter and shorter periods of
time.10 Now the opportunities last for such a short amount of
time that no one without the proper equipment can hope to
participate: the opportunities are cost-prohibitive to the
average trader.11
The ‫ڍ‬proper equipment‫ ڎ‬is computer automation: only
computers can process information, make decisions, and execute
trades quickly enough to capture these opportunities. Computer
automation of trade activity is called ‫ڍ‬algorithmic trading‫ڎ‬
(‫ڍ‬iT‫)ڎ‬, or ‫ڍ‬program trading.‫ڎ‬12 Because HFT is a subset of iT, a
discussion of iT is helpful.


)
 

iT, or ‫ڍ‬program trading,‫ ڎ‬is trading based upon the use of

computer software that automates trading decisions and places

arms race that is being waged in our public marketplace by high frequency
traders and others.‫)ڎ‬
10 (

High-Frequency Traders: Spread Betting, The Economist (iug. 14, 2010)
(Explaining that as a result of electronic, and in particular automated
trading, ‫ڍ‬bid-ask spreads have narrowed and arbitrage opportunities exist for
ever-briefer periods.‫)ڎ‬
11 (

Dark Pools, Flash Orders, High-Frequency Trading, and Others Market
Structure Issues: Hearing Before the Subcomm. on the Securities, Insurance,
and Investment of the Comm. on Banking, Housing, and Urban iffairs, 111th
Cong. 8 (2009) [hereinafter Hearings] (prepared statement of Daniel Mathisson,
Managing Director, Credit Suisse) (Explaining that opponents of HFT argue that
‫ڍ‬these traders have an informational advantage, since most people don‫ڊ‬t have
the technology to read and respond to market data in a split-second time
frame.‫)ڎ‬
12 Terrence Hendershott, Charles M. Jones, & ilbert J. Menkveld, #


)
 
* 

+,-
.
/ 

 
, Forthcoming
(iugust 30, 2010).
orders.13 The use of programs and algorithms to automate trading
has several advantages. First, because computers can process
information much more quickly than a human, computer programs can
analyze a vast quantity of market data in a short amount of time.
Second, computers can make decisions informed by this analysis
much more quickly than a human can. Third, the combined speed
and processing power of computers enables them to execute trades
at speeds much faster than humans are capable of.
These advantages have translated into several uses of iT.
First, iT can be used to break up large orders into small parts
in hopes of minimizing market impact.14 Second, iT can utilize a
computer‫ڊ‬s processing power to analyze massive amounts of
information in order to identify statistical correlations between
two different stocks.15 Third, iT can use a computer‫ڊ‬s speed to
take advantage of certain opportunities in the market unavailable
to slower traders, like humans. This final use brings us to our
discussion of HFT.


0

,

 

HFT is a subset of algorithmic and program trading: it is

based on sophisticated computer algorithms and software.16 But
the HFT subset is carved out of iT by its two defining
characteristics: speed and high-volume.

13 *. (


, Tara Bhupathi,
1
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0


,

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( 



2

2
 
, 11 N.C. J. L. &
Tech 377, 383-83 (2010).
14 Hendershott,  
note 12, at 1.
15 Letter from Manoj Narang at 9.
16 (

Hearings (statement of Frank Hatheway, Senior Vice President and Chief
Economist, NiSDi OMX) (‫ڍ‬High-frequency trading and algorithmic trading is
automation.‫)ڎ‬
 For a number of reasons, there is confusion over what
exactly the term ‫ڍ‬high-frequency trading‫ ڎ‬means. First, HFTs
keep their trade strategies secret.17 Second, there currently is
no adequate system in place to monitor HFT activity.18
In a recent Concept Release on Equity Market Structure
intended to solicit comment on, 

 , HFT, the Securities
and Exchange Commission (‫ڍ‬SEC‫ )ڎ‬said that ‫[ڍ‬t]he term [HFT] is
relatively new and is not yet clearly defined.‫ڎ‬19 Some argue
that this confusion is problematic. They worry that regulators
may enact rules that, while only intended or required for a small
portion of HFT practices, may sweep too broadly.20 The confusion
over what constitutes HFT is a result of the variety of
strategies that HFTs practice. For example, James Brigagliano of
the SEC described HFT as ‫ڍ‬generally involv[ing] a trading
strategy where there are a large number of orders and also a
large number of cancellations‫څ‬often in subseconds‫څ‬and moving into
and out of positions many times in a single day.‫ڎ‬21 This
definition may conflate a particular HFT strategy (i.e.

17 (

Michael J. McGowan, 

2


& 


0

,

 "

3


&
 2010 Duke L. & Tech. Rev. 6, P 44.
18 See below for the SEC‫ڊ‬s proposed monitoring system.
19 Concept Release on Equity Market Structure at 3606. (


, Hearings
(statement of James Brigagliano, Coacting Director, Div. of Trading and
Markets, SEC) (‫[ڍ‬T]he terms lack a clear definition.‫)ڎ‬
20 (

Hearings (statement of Frank Hatheway, Senior Vice President and Chief
Economist, NiSDi OMX). (‫ڍ‬We also believe that dark pools and flash orders are
wrongly confused with high-frequency trading and algorithmic trading.‫


( )ڎ‬
, Concept Release on Equity Market Structure at 3606 (‫ڍ‬The lack of a clear
definition of HFT . . . complicates the Commission‫ڊ‬s broader review of market
structure issues.‫)ڎ‬
21 Hearings (statement of James Brigagliano, Coacting Director, Div. of
Trading and Markets, SEC).
‫ڍ‬directional‫)ڎ‬22 with HFT in general. But despite the confusion,
there are definite commonalities connecting all HFT. Those
characteristics will be discussed here. The various strategies
that differentiate the types of HFT will be discussed below.
For the purposes of this paper, HFT is defined as a
computerized trading strategy that utilizes high speed and high
volume to take advantage of opportunities in the market that are
short-lived and of low-value.23
While the particular HFT strategies vary, each is
characterized by speed, volume, and powerful computers. is one
commentator described it, ‫ڍ‬Regardless of the strategy these high
frequency traders utilize, they all attempt to do the same thing:
Make vast profits by being smarter and faster than everyone
else.‫ڎ‬24 HFT traders (‫ڍ‬HFTs‫ )ڎ‬rely on ‫ڍ‬extraordinarily high-

22 See below.
23 (

Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities,
Insurance, and Investment) (Explaining that basically, HFT is ‫ڍ‬the buying and
selling of stock at extremely fast speeds with the help of powerful
computers.‫ ;)ڎ‬Concept Release on Equity Market Structure at 3606 (Explaining
that the term HFT ‫ڍ‬typically 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.‫ ;)ڎ‬Staffs of the Commodity Futures Trading
Comm‫ڊ‬n and Securities and Exchange Comm‫ڊ‬n, Rep. to the Joint idvisory Comm. on
Emerging Regulatory Issues, Preliminary Findings Regarding the Market Events
of May 6, 2010 ippendix i. 11 (May 18, 2010) [hereinafter Preliminary Flash
Crash Report] (Explaining that in general, HFT strategies typically employ the
‫ڍ‬use of extraordinarily high-speed and sophisticated computer programs for
generating, routing, and executing orders.‫ ;)ڎ‬Staffs of the Commodity Futures
Trading Comm‫ڊ‬n and Securities and Exchange Comm‫ڊ‬n, Rep. to the Joint idvisory
Comm. on Emerging Regulatory Issues, Findings Regarding the Market Events of
May 6, 2010 pg. 45 (Sep. 30, 2010) [hereinafter Final Flash Crash Report]
(‫ڍ‬HFT‫ڊ‬s are proprietary trading firms that use high speed systems to monitor
market data and submit large numbers of orders to the markets. HFT‫ڊ‬s utilize
quantitative and algorithmic methodologies to maximize the speed of their
market access and trading strategies.‫)ڎ‬
24 McGowan,   note 17, at ¶3.
speed and sophisticated computer programs for generating,
routing, and executing orders.‫ڎ‬25
For HFT, speed ‫ڍ‬matters both in the absolute sense of
achieving very small latencies and in the relative sense of being
faster than competitors, even if only by a microsecond.‫ڎ‬26 HFTs
must have fast connections to markets in order to receive data
and to send their orders and cancellations as quickly as
possible.27 While beyond the scope of this paper, most HFTs rely
on expensive ‫ڍ‬colocation‫ ڎ‬for connection speed advantages.
Colocation ‫ڍ‬refers to the practice of setting up . . . trading
computers in the same physical building as the exchange‫ڊ‬s
computers, to get a time advantage over . . . competitors.‫ڎ‬28 It
is estimated that colocation ‫ڍ‬afford[s] traders a 100-200
millisecond advantage over other investors.‫ڎ‬29 This seemingly
tiny advantage illustrates the time frame that HFTs operate in.
Volume is important to HFTs because each individual
opportunity is of ‫ڍ‬low reward.‫ڎ‬30 Manoj Narang, the founder, CEO

25 Concept Release on Equity Market Structure at 3606.

26 *. at 3610 (‫ڍ‬Many proprietary firm strategies are highly dependent upon
speed - speed 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.‫)ڎ‬
27 *.
28 (

Hearings (prepared statement of Daniel Mathisson, Managing Director,
Credit Suisse) (ilso arguing that colocation is merely ‫ڍ‬the 21st century
version of traders trying to get office space close to the exchange.‫;)ڎ‬
Concept Release on Equity Market Structure at 3610 (‫ڍ‬Colocation is one means
to save microseconds of latency.‫)ڎ‬
29 Letter from Sen. Ted Kaufman at 4.
30 (

Letter from Manoj Narang at 9; Timothy Lavin, Monsters in the Market,
The itlantic (iugust 2010) (‫[ڍ‬HFT] . . . is a very low-margin, low-risk
strategy.) !


, Concept Release on Equity Market Structure, 75 Fed. Reg.
3554, 3607 (proposed Jan. 21, 2010) (to be codified at 17 C.F.R. pt. 242)
and chief investment strategist of Tradeworx, a company involved
in HFT,31 claims that each individual share involved in a HFT
strategy typically earns only a hundredth-of-a-cent per trade.32
How prevalent is HFT?First, note that, according to one
estimate, HFTs ‫ڍ‬represent approximately 2% of the 20,000 or so
trading firms operating in the U.S. markets.‫ڎ‬33 That percentage
is impressive compared with the every-day trade volume that is
attributed to HFT. While ‫[ڍ‬e]stimates of HFT volume in the
equity markets vary widely . . . , they often are 50 percent of
total volume or higher.‫ڎ‬34 Estimates in the higher range
attribute 75% of trade volume to HFTs.35 The various estimates
of HFTs prevalence in the market are due to confusion over HFT‫ڊ‬s
definition.36 But ‫ڍ‬by any measure, HFT is a dominant component

(Noting that some have raised concerns that some HFT strategies ‫ڍ‬may not
necessarily involve a large number of trades.‫)ڎ‬
31 Tradeworx ‫ڍ‬develop[s] advanced technology solutions . . . based on
mathematical algorithms . . . used . . . for high performance trading - by
Tradeworx for its own account, by its hedge fund, and by third parties who
purchase Tradeworx‫ڊ‬s technology.‫ ڎ‬Letter from Manoj Narang at 1.
32 Timothy Lavin, Monsters in the Market, The itlantic (iugust 2010).
33 Rob Iati, The Real Story of Software Trading Espionage, idvanced
Trading.com, July 10, 2009.
34 Preliminary Flash Crash Report at ippendix i. 11 (citing Jonathan Spicer
and Herbert Lash, Who‫ڊ‬s ifraid of High-Frequency Trading?, Reuters.com,
December 2, 2009 (‫ڍ‬High-frequency trading now accounts for 60 percent of total
U.S. equity volume, and is spreading overseas and into other markets.‫;))ڎ‬
Scott Patterson and Geoffrey Rogow, What‫ڊ‬s Behind High-Frequency Trading, Wall
Street Journal, iugust 1, 2009 (‫ڍ‬High frequency trading now accounts for more
than half of all stock-trading volume in the U.S.‫)ڎ‬.
35 (

Hearings (prepared statement of Christopher Nagy, Managing Director of
Order Routing Strategy, TD imeritrade) (75%); Hearings (prepared statement of
Larry Leibowitz, Group Executive Vice President, NYSE Euronext) (two-thirds).
36 (

Concept Release on Equity Market Structure at 3607 (‫ڍ‬The lack of
clarity may, for example, contribute to the widely varying estimates of HFT
volume in today‫ڊ‬s equity markets.‫ ;)ڎ‬Hearings (statement of Daniel Mathisson,
Managin Director, Credit Suisse) (‫[ڍ‬T]here is no clear definition of the term
[HFT], making it very difficult to analyze its effects or estimate what
of the current market structure and is likely to affect nearly
all aspects of its performance.‫ڎ‬37 Indeed, the SEC has noted
that ‫[ڍ‬t]he use of certain [HFT] strategies by some proprietary
firms has, in some trading centers, largely replaced the role of
specialists and market makers.38 HFT‫ڊ‬s role in this regard, as
‫ڍ‬market maker,‫ ڎ‬is discussed below.
  Y


(  
) 

Statistical arbitrage strategies depend on relationships and

correlations between two different securities.39 Opportunities
for gain are found by identifying these relationships,
‫ڍ‬discern[ing] historical patterns and correlations,‫ ڎ‬and
acquiring certain positions informed by the analysis.40 In other
words, statistical arbitrage is ‫ڍ‬based on mispricing in the
markets or a temporary deviation from historical trends . . .
.‫ڎ‬41 This strategy has been termed the ‫ڍ‬least high-frequency‫ ڎ‬of
the HFT strategies,42 but speed and volume are still important.

percent of the market it is, resulting in what appear to be wide overestimates

of what percent of the market [HFT] makes up.‫)ڎ‬
37 Preliminary Flash Crash Report at ippendix i. 11.
38 (

Concept Release on Equity Market Structure at 3607.
39 (

Letter from Manoj Narang at 9.
40 Joe Flood, idventures in ilgorithmic Trading, ai5000 (iug. 5, 2010)
(Explaining that depending on the statistical analysis, firms will ‫ڍ‬buy and
short the affected securities to help push them back to their traditional
correlations, collecting the spread along the way.‫)ڎ‬
41 Mobis Philipose and Ravi inanthanarayanan, Flash Orders Not Synonymous with
High-Frequency Trading, LiveMint.com (September 18, 2009). (


, Concept
Release on Equity Market Structure at 3608 (‫ڍ‬in arbitrage strategy seeks to
capture pricing inefficiencies between related products or markets.‫ )ڎ‬For a
plain-language explanation of statistical arbitrage, 


, Jon Stokes, The
Matrix, But with Money: The World of High-Speed Trading, irstechnica.com
(2009) (‫ڍ‬Stat arbs make their money by vacuuming up mountains of historical
data and looking for correlations between various datapoints and asset prices.
The stat arb's trading platform, which is basically a large computer system
 Statistical arbitrage strategies are assisted by computers
in three ways. First, computers are required to analyze market
data and identify correlations. Second, because these
opportunities last for a very short amount of time. Third,
because the gain associated with any single trade in statistical
arbitrage tend to be very low, the reduced trading cost that is
associated with computer trading and automation is required for
profitability.43


4 

 

 

inother common HFT strategy, which is particularly

associated with high volume and ‫ڍ‬high cancellation rates,‫ڎ‬44 is
called ‫ڍ‬passive market making.‫ڎ‬45 Market making is the practice,
traditionally employed by ‫ڍ‬screaming floor traders of a bygone
era,‫ڎ‬46 of, in essence, ‫ڍ‬providing liquidity‫ ڎ‬to a market.47
Market makers are intermediaries in the markets: they fill buy
and sell orders placed by investors.48 Because of the important

manned by programmers and financial engineers, uses those correlations to

build predictive models that take in a stream of information inputs like news
reports and stock prices . . . , and output a rapid-fire stream of "buy" and
"sell" orders for different assets.‫)ڎ‬
42 Joe Flood, idventures in ilgorithmic Trading, ai5000 (iug. 5, 2010) .
43 (

Joe Flood, idventures in ilgorithmic Trading, ai5000 (iug. 5, 2010)
(‫ڍ‬The profits on any one trade tend to be small but, with enough speed and
volume, they can create enormous profits.‫)ڎ‬
44 Concept Release on Equity Market Structure at 3607 (stating that
cancellation rates may reach 90%).
45 (

Concept Release on Equity Market Structure at 3607-08. !


, Letter
from Manoj Narang at 9 (‫ڍ‬It is increasingly difficult to differentiate market-
making from statistical arbitrage. Statistical arbitrage techniques are often
used by market-makers . . . .‫)ڎ‬
46 Joe Flood, idventures in ilgorithmic Trading, ai5000 (iug. 5, 2010) .
47 Concept Release on Equity Market Structure at 3607.
48 (



., Perrie M. Weiner et al., Catch Me if You Can: Speed Traders
Under Scrutiny, 1843 PLI/Corp 341, 343 (July 20, 2010) (‫ڍ‬When a mutual fund
role they play in the market, market makers are traditionally
subject to ‫ڍ‬affirmative and negative‫ ڎ‬obligations.49 These
obligations, and the fact that HFTs embodying the roles of market
maker are not subject to them, will be discussed below.
‫ڍ‬Passive‫ ڎ‬market making is characterized by placing ‫ڍ‬resting
orders.‫ڎ‬50 i resting order is a type of limit order,51 meaning
that it may only be executed if its specified price is met by
another party,52 that is placed in positions to take advantage of
an ‫ڍ‬anticipated price move.‫ڎ‬53
HFTs using a market making strategy make profits in two
ways.54 First, by collecting the ‫ڍ‬bid-ask spread‫ ڎ‬on a given
stock. i HFT will ‫[ڍ‬earn] the spread by buying at the bid and
selling at the offer . . . .‫ڎ‬55 Basically: buy low, sell high.56

wants to buy 10,000 shares of Tesla, Inc, odds are a high-frequency trader
will be ready to provide the shares.‫)ڎ‬
49 (

Concept Release on Equity Market Structure at 3607.
50 (

.
51 i limit order is ‫[ڍ‬a]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.‫ ڎ‬CFTC
Glossary, CFTC.gov.
52 (

CFTC Glossary, CFTC.gov (defining ‫ڍ‬resting order‫ ڎ‬as a ‫ڍ‬limit 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.‫)ڎ‬
53 indrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency
Trading on an Electronic Market 14 (November 9, 2010).
54 Concept Release on Equity Market Structure at 3607 (‫[ڍ‬T]he primary sources
of profits [in market making strategies] 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 liquidity-supplying orders.‫)ڎ‬
55 (

Concept Release on Equity Market Structure at 3607. !


, Letter
from Manoj Narang at 8 (‫ڍ‬For stocks that are extremely liquid, some market-
makers may be willing to buy and sell at the same price . . . . Such market-
makers are said to be operating rebate-capture strategies because their only
compensation is the rebate offered by exchanges for posting orders.‫)ڎ‬
(emphasis in original).
Second, by collecting the tiny (usually 1/4 or 1/3 of a cent per
trade),57 rebate that many markets pay firms for providing
liquidity.58 Why do markets offer rebates? ‫ڍ‬Most liquid stocks
trade at 1 cent bid-ask spreads[.] [B]ut in most cases, 1 cent
is not a large enough‫ ڎ‬to cover the risk of trades. ‫ڍ‬is a
result, exchanges offer [these rebates as] further inducement for
traders to post orders . . . .‫ڎ‬59 This practice is not without
detractors. ‫ڍ‬Payment for order flow is an inherent conflict of
interest. Because it encourages broker dealers to send retail
order flow to the highest bidder and not to the trading center
that is necessarily best of the buyer or seller, payment for
retail order flow is a highly dubious practice.‫ڎ‬60


#
 
( 



Some HFTs use ‫ڍ‬directional‫ ڎ‬strategies.61 Directional

strategies, at least in the long-term investor context, are

56 (

McGowan   note 17, at ¶ 23 (‫ڍ‬To make money off of 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 price in order to benefit from the
bid-ask spread.‫)ڎ‬
57 *. at ¶ 26 (citing Mark Hutchinson, High Frequency Trading: Wall Street's
New Rent-Seeking Trick, Money Morning, iug. 14, 2009).
58 Letter from Sen. Ted Kaufman at 5 (Explaining that, in essence, market
making ‫ڍ‬generate[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.‫)ڎ‬
59 Letter from Manoj Narang at 8 (‫ڍ‬Most liquid stocks trade at 1-cent bid-ask
spreads, but in most cases, 1 cent is not a large enough spread to defray the
cost of adverse selection . . . . is a result, exchanges offer further
inducement for traders to post orders in the form of ‫ڍ‬rebates.‫ ڎ‬For stocks
that are extremely liquid, some market-makers may be willing to buy and sell
at the same price . . . . Such market-makers are said to be operating rebate-
capture strategies because their only compensation is the rebate offered by
exchanges for posting orders.‫)ڎ‬
60 Hearings (statement of Sen. Kaufman).
61 (

Concept Release on Equity Market Structure at 3608.
common. They are based on obtaining positions in anticipation of
price movements, or ‫ڍ‬speculat[ion] on the direction of the
underlying market.‫ڎ‬62 Some HFT directional strategies are just
as ‫ڍ‬straight-forward as concluding that a stock price temporarily
has moved away from its ‫ډ‬fundamental value‫ ڊ‬and establishing a
position in anticipation that the price will return to such
value.‫ڎ‬63 However, two subsets of HFT directional strategies,
recently noted by the SEC in its Concept Release on Equity Market
Structure, are more complicated and novel, and raise particular
concerns about the stability and fairness of the markets.
i. ‫ڍ‬Order inticipation‫ڎ‬
When large institutional traders buy or sell a large number
of a particular share, the price is affected.64 Order
anticipation strategies attempt to predict these price movements,
and trade in front of them; either selling (or shorting) before
the price drops, or buying before it rises.65 To minimize the
effect that large trades can have on price, and to avoid other
traders taking advantage of that movement, institutional traders
often break large trades into small pieces.66 HFT comes into
play in two different ways. First, HFTs are thought to employ
different strategies to ‫ڍ‬sniff out‫ ڎ‬large trades disguised as a

62 CFTC.gov, CFTC Glossary, Directional Trading available at

http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/glossary_d
.html.
63 Concept Release on Equity Market Structure at 3608.
64 indrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency
Trading on an Electronic Market 3, 17-18 (November 9, 2010).
65 (

Concept Release on Equity Market Structure at 3608.
66 High-Frequency Trading: Rise of the Machines, The Economist (iug. 1, 2009).
series of small ones.67 HFTs may use ‫ڍ‬sophisticated pattern
recognition software to ascertain from publicly available
information the existence of a large buyer . . . .‫ڎ‬68 Second,
HFTs may use their speed to ‫ڍ‬trade in front of‫ ڎ‬the large
investors.69 This term, ‫ڍ‬trade in front of,‫ ڎ‬does not
necessarily connote illegal trade behavior. While the practice
of ‫ڍ‬front running‫ ڎ‬is certainly illegal, using sophisticated
methods of analysis and high speed is not necessarily so.70 In
this context, ‫ڍ‬trade in front of‫ ڎ‬means using high speed to
capture bid-ask spreads.
ii. ‫ڍ‬Momentum Ignition‫ڎ‬
inother form of directional strategy is ‫ڍ‬momentum ignition,‫ڎ‬
and is most likely illegal.71 This strategy seems primarily to
be targeted against other algorithmic traders in the market.72
iccording to this strategy, the HFT may send out a large number
of orders and cancellations in rapid succession in an attempt to

67 (

.
68 Concept Release on Equity Market Structure at 3609.
69 *.
70 (

Concept Release on Equity Market Structure at 3609 (Explaining that
their discussion of order anticipation strategies excludes those that would be
illegal: ‫ڍ‬The 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.‫


( )ڎ‬, Letter from Manoj Narang at 15 (‫ڍ‬Should 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 restrictions regulators impose, some players will
always be superior in terms of their ability to analyze data.‫)ڎ‬
71 (

Concept Release on Equity Market Structure at 3609.
72 *.
‫ڍ‬spoof‫ ڎ‬the other algorithms to buy or sell more aggressively.73
‫ڍ‬By establishing a position early, the proprietary firm will
attempt to profit by subsequently liquidating the position if
successful in igniting a price movement.‫ڎ‬74 The speed at which
HFTs operate allows them first ignite these ‫ڍ‬sharp price
movements‫ ڎ‬and second to ‫ڍ‬then profit from the resulting short-
term volatility.‫ڎ‬75
The high volume use of orders and cancellations may be used
to manipulate the market in another way, in a practice called
‫ڍ‬quote stuffing,‫ ڎ‬where ‫ڍ‬high volumes of quotes are purposely
sent to exchanges in order to create data delays that would
afford the firm sending these quotes a trading advantage.‫ڎ‬76
Both momentum ignition and quote stuffing are most likely
illegal because intentional manipulation of the market is against
the law.77 But both practices may be difficult to control.78
However, some firms have been fined for using HFT to manipulate
the market.79

73 *.
74 *.
75 Hearings (statement of James Brigagliano, Coacting Director, Div. of
Trading and Markets, Securities and Exchange Comm.).
76 Final Flash Crash Report at pg. 79.
77 (

15 U.S.C. S 78i.
78 (

Concept Release on Equity Market Structure at 3609 (‫[ڍ‬W]hile spreading
false rumors to cause price moves is illegal, such rumors can be hard to find
(if not spread in writing), and it can be difficult to ascertain the identity
of those who spread rumors to cause price moves.‫)ڎ‬
79 In September 2010, the Financial Industry Regulatory iuthority (‫ڍ‬FINRi‫)ڎ‬
fined Trillium Brokerage Services $2.3 million for ‫ڍ‬using an illicit high
frequency trading strategy.‫ ڎ‬Press Release, Financial Industry Regulatory
iuthority, FINRi 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
http://www.finra.org/Newsroom/NewsReleases/2010/P121951. ‫ڍ‬Trillium, through


4
*
 

in additional strategy that some opponents of HFT have

identified is characterized by the sophisticated use of orders to
identify and take advantage of another trader‫ڊ‬s position.80
iccording to this strategy, an HFT firm will send out many
‫ڍ‬immediate-or-cancel‫ ڎ‬sell orders, that if not accepted
immediately, are cancelled.81 This practice could potentially
allow an HFT firm to foil a trader‫ڊ‬s attempt at keeping secret
how much it is willing to pay for a certain stock.82 Some
believe that HFTs are able to ‫ڍ‬game the system using repeated and
lightning-fast orders to quickly identify other traders‫ڊ‬
positions and take advantage of that information, potentially

nine proprietary traders, entered numerous layered, non-bona fide market

moving orders to generate selling or buying interest in specific stocks. By
entering the non-bona fide orders, often in substantial size relative to a
stock's overall legitimate pending order volume, Trillium traders created 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 the false appearance of market activity. is a result of
this improper high frequency trading strategy, Trillium's traders obtained
advantageous prices that otherwise would not have been available to them on
46,000 occasions.‫ ڎ‬Press Release, Financial Industry Regulatory iuthority,
FINRi 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
http://www.finra.org/Newsroom/NewsReleases/2010/P121951.
80 For two somewhat sensational discussions on the potentially nefarious uses
of ‫ڍ‬probing quotes,‫ ڎ‬see generally, ilexis Madrigal, Explaining Bizarre Robot
Stock Trader Behavior, The itlantic (iugust 6, 2010) available at
http://www.theatlantic.com/technology/archive/2010/08/explaining-bizarre-
robot-stock-trader-behavior/61028/; Ellen Brown, Computerized Front-Running:
inother Goldman-Dominated Fraud (ipril 21, 2010) available at
http://www.webofdebt.com/articles/computerized_front_running.php.
81 Concept Release on Equity Market Structure at 3607 n.69.
82 ‫ڍ‬To avoid signaling their intentions to the market, institutional investors
trade large orders . . . within specified price ranges.‫ ڎ‬High-Frequency
Trading: Rise of the Machines, The Economist (iug. 1, 2009).
disadvantaging retail investors.‫ڎ‬83 ‫ڍ‬HFTs attempt to uncover how
much an investor is willing to pay (or sell for) by sending out a
stream of probing quotes that are swiftly cancelled until they
elicit a response. The traders then buy or short the targeted
stock ahead of the investor, offering it to them a fraction of a
second later for a tiny profit.‫ڎ‬84
 




'



2
 

This section will discuss regulation of HFT. First, it will

discuss several reasons why HFT needs to be regulated. Second,
it will discuss the regulations that HFT is subject to now.
Third, it will discuss why those current regulations are
ineffective. Fourth, it will explore new legislation, and
suggest how it might be implemented to most effectively regulate
HFT. Finally, it will examine proposed and potential regulation.
HFT must be regulated because it ‫ڍ‬exert[s] tremendous
influence over trading.‫ڎ‬85 Because ‫ڍ‬HFT is a dominant component
of the current market structure, [it] is likely to affect nearly
all aspects of its performance.‫ڎ‬86 in aspect of trading that, by
all estimates, comprises at least 50% of daily trading volume has
‫ڍ‬a tremendous capacity to affect the stability and integrity of
the equity markets.‫ڎ‬87

83 Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities,

Insurance, and Investment).
84 High-Frequency Trading: Rise of the Machines, The Economist (iug. 1, 2009).
85 Mary L. Schapiro, Chairman, Securities and Exchange Comm‫ڊ‬n, Remarks Before
the Security Traders iss‫ڊ‬n (Sept. 22, 2010).
86 Preliminary Flash Crash Report at ippendix i. 11.
87 Mary L. Schapiro, Chairman, Securities and Exchange Comm‫ڊ‬n, Remarks Before
the Security Traders iss‫ڊ‬n (Sept. 22, 2010).
 HFT‫ڊ‬s largest potential for impact on systemic stability is
its association with liquidity. Proponents of HFT claim that it
provides the markets with liquidity.88 Indeed, some go so far as
to say that ‫ڍ‬HFTs are the liquidity backbone of the market.‫ڎ‬89
But according to critics, this is the precisely the concern, and
the very reason why HFTs must be regulated closely.
is major suppliers of liquidity to the market, many HFTs act
as 

  market makers. Traditional market makers are
important for maintaining market stability, and are thus subject
to affirmative90 and negative obligations.91The most important
obligations imposed upon registered market makers require them to
continue providing liquidity, whether markets are up or down, and
to ‫ڍ‬assist in the maintenance, insofar as reasonably practicable,
of fair and orderly markets.‫ڎ‬92Unlike market makers, however,
HFTs ‫ڍ‬are subject to very little in the way of obligations either
to protect that stability by promoting reasonable price

88 For a study on whether HFT provides liquidity to markets, see Terrence

Hendershott, Charles M. Jones, & ilbert J. Menkveld, Does ilgorithmic Trading
Improve Liquidity? available at
http://faculty.haas.berkeley.edu/hender/ilgo.pdf
89 Letter from Manoj Narang at 7. !


, Hearings (statement of Sen.
Kaufman). (arguing that liquidity is not the only consideration in matters of
market stability and fairness; ‫[ڍ‬l]iquidity as an end seems to have trumped
the need for transparency and fairness. We risk creating a two-tiered market
that is opaque, highly fragmented, and unfair to long-term investors.‫)ڎ‬
90 ‫ڍ‬iffirmative [market maker] obligations might include a requirement to
consistently display high quality, two-sided quotations that help dampen price
moves . . . .‫ ڎ‬Concept Release on Equity Market Structure at 3607 n.70.
91 ‫[ڍ‬N]egative obligations might include a restriction on ‫ډ‬reaching across the
market‫ ڊ‬to execute against displayed quotations and thereby cause price
moves.‫ ڎ‬Concept Release on Equity Market Structure at 3607 n.70.
92 Preliminary Flash Crash Report at ippendix i. 9. !


, ., (explaining
that market makers may use ‫ڍ‬stub quotes,‫ ڎ‬an offer to buy or sell a stock at,
for example, a penny, during times of volatility when they do not wish to
trade.)
continuity in tough times, or to refrain from exacerbating price
volatility.‫ڎ‬93 This lack of obligation is especially worrisome
given that many HFT strategies profit during times of
volatility.94
Concerns about systemic stability thus center around the
liquidity that HFTs supply. For example, one HFT proponent,
Manoj Narang, in a misguided attempt at assuaging fears that HFT
algorithms could trigger a ‫ڍ‬hot potato‫ ڎ‬effect,95 explained that
if an HFT algorithm detected an ‫ڍ‬anomalous period,‫ ڎ‬it would
‫ڍ‬simpl[y] ‫ډ‬turn off‫ ڊ‬its strategy . . . .‫ڎ‬96 Indeed, Narang, who
runs an HFT operation through his Tradeworx Inc. firm, did shut
down his HFT algorithm on May 6, 2010, during the height of the
‫ڍ‬Flash Crash.‫ڎ‬97 This is precisely the fear: if HFTs provide 50%
of liquidity in the markets every day, they also stand in a

93 Mary L. Schapiro, Chairman, Securities and Exchange Comm‫ڊ‬n, Remarks Before

the Security Traders iss‫ڊ‬n (Sept. 22, 2010). (


, Hearings (prepared
statement of Peter Driscoll, Chairman, Security Traders issociation) (‫ڍ‬Market
makers . . . have traditionally had significant obligations to the markets and
generally position risk for longer than milliseconds.‫)ڎ‬
94 Letter from Manoj Narang at 4 (‫ڍ‬HFTs benefit from volatility . . . .‫)ڎ‬
(emphasis in original).
95 (

indrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency
Trading on an Electronic Market 3, 17-18 (November 9, 2010) (explaining the
‫ڍ‬hot potato‫ ڎ‬effect, where HFTs ‫ڍ‬rapidly buy and sell contracts from one
another many times,‫ ڎ‬driving prices down. ilso explaining how the hot potato
effect played into the May 6, 2010 ‫ڍ‬Flash Crash.‫)ڎ‬
96 Letter from Manoj Narang at 10.
97 (

Scott Patterson & Tom Lauricella, Did a Big Bet Trigger ‫ڍ‬Black Swan‫ڎ‬
Stock Swoon? The Wall Street Journal (May 10, 2010) available at
http://online.wsj.com/article/SB10001424052748704879704575236771699461084.html
. The prevalence of algorithmic trading in the markets amplifies the problems
that could be caused by a faulty program. Indeed, it is believed that the May
6, 2010 ‫ڍ‬Flash Crash‫ ڎ‬was initiated by a faulty sell order from an algorithmic
trader. See Final Flash Crash Report at pg. 2 (explaining that the sell
algorithm was programmed to target an execution rate of ‫ڍ‬9% of the trading
volume calculated over the previous minute, but without regard to price.‫)ڎ‬
position to remove (or more accurately, cease to provide) 50% of
liquidity whenever they choose.
‫ڍ‬Critics [thus] accuse high frequency traders of being fair-
weather market makers who, unlike the former . . . [market
makers] they‫ڊ‬ve largely replaced, don‫ڊ‬t have a legal obligation
to trade during periods of stress.‫ڎ‬98 Indeed, at the height of
the May 6, 2010 Flash Crash, ‫ڍ‬offers to buy stocks vanished from
underneath the market:‫ ڎ‬on the morning of May 6, there were
hundreds of offers above $51 to buy shares of a certain stock
that, hours later, during the height of the Flash Crash, showed
just four bids above $14.99 The Flash Crash Report100 found that
six of the twelve HFTs it interviewed scaled back their trading
on May 6th, and that two of the larger ones withdrew
completely.101
i second source of instability is the volatility that some
fear HFT may induce. iutomated traders pursuing short-term gain
may be more easily ‫ڍ‬spooked‫ ڎ‬into aggressive trade by sudden
price changes than humans or long-term traders. ind the speed at
which they might react could be problematic. Senator Kaufman

98 Michael Peltz, Inside the Machine: i Journey into the World of High-
Frequency Trading, InstitutionalInvestor.com (Jun. 10, 2010).
99 Scott Patterson & Tom Lauricella, Did a Big Bet Trigger ‫ڍ‬Black Swan‫ ڎ‬Stock
Swoon? The Wall Street Journal (May 10, 2010). The ‫ڍ‬certain stock‫ ڎ‬was the
iShares Russell 1000 Growth Index exchange-traded fund. Id.
100 Final Flash Crash Report at pg. 45.
101 *. (


, imerica‫ڊ‬s Stockmarket Plunge: i Few Minutes of Mayhem, The
Economist (May 15, 2010) (‫ڍ‬inother factor [in the May 6th Flash Crash] was
the sudden retreat by the ‫ډ‬high frequency‫ ڊ‬firms whose algorithmic trading has
come to dominate equity markets. In normal times they play a crucial role in
providing liquidity. But unlike market makers, they are not obliged to do so
during bouts of turbulence. Regulators think that some high-frequency traders
switched off their programs when prices began to spiral, fearful that their
trades would be cancelled because of the severity of the declines.‫)ڎ‬
worries that the ‫ڍ‬convergence‫ ڎ‬of multiple HFTs on a single,
short-lived opportunity ‫ڍ‬may leave the marketplace vulnerable to
sudden price swings.‫ڎ‬102 Such convergence could ignite a ‫ڍ‬hot
potato‫ ڎ‬effect (alluded to above), where HFT algorithms rapidly
trade between each other,103 ‫ڍ‬magnif[ying] changes.‫ڎ‬104
Critics of HFT also argue that some HFT strategies make
profits at the expense of long-term investors,105 who the markets
and regulators are meant to primarily serve.106 They point to
the HFT practice of identifying large investors and their
positions as particularly unfair. i New York Times article
argued that the profits HFTs make through use of their speed and
processing power are translated into additional costs for the
long term investor. The article provided an example where ‫[ڍ‬t]he
result [of HFT activity] is that the slower-moving investors paid
. . . $7,800 more than if they had been able to move as quickly
as the high-frequency traders.‫ڎ‬107


&

2
 

102 Letter from Sen. Ted Kaufman at 1.

103 indrei Kirilenko, et al., The Flash Crash: The Impact of High Frequency
Trading on an Electronic Market 3, 17-18 (November 9, 2010).
104 High-Frequency Trading: Rise of the Machines, The Economist (iug. 1, 2009).
105 (

Jason Zweig, The Market War Between Traders and Investors Heats Up, The
Wall Street Journal (September 25, 2010) .
106 (

Letter from Sen. Ted Kaufman at 1. (


, Elimination of Flash
Order Exception From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01, 48636
(proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242) (‫ڍ‬If . . . the
interests of long-term investors and professional short-term traders conflict,
the Commission previously has emphasized that ‫ډ‬its clear responsibility is to
uphold the interests of long-term investors.‫ )ڎڊ‬citing Securities Exchange ict
Release No. 51808 (June 9, 2005) 70 FR 37496, 37500 (June 29, 2005).
107 (

Charles Duhigg, Stock Traders Find Speed Pays, in Milliseconds, The New
York Times (July 23, 2009).
 HFT is currently regulated in some ways. First, some firms
operating a HFT strategy are registered as broker-dealers,108 and
are subject to certain obligations as such.109 Second, all
traders must comply with various laws and regulations that
control fraud, market manipulation, insider trading, and front-
running.110 In addition, every exchange is required to enact
rules to prevent fraudulent and manipulative practices and
protect investors and the public interest.111


*





&

2
 

However, the effectiveness of the laws and regulations that

HFTs are subject to is lessened by the current inability of
regulatory bodies to adequately monitor HFT activity.112 It is
difficult to monitor HFT activity because of the fragmentation of
trade across various markets, fragmentation of regulatory
authority, and the massive volume of data that such monitoring
would entail.113 ilso, the current monitoring system does not
even have the capability of discerning which trades originate
from algorithmic programs. The inability to adequately monitor
HFT activity is illustrated by the confusion over just what HFT

108 Broker-dealer is defined in §§ 3(a)(4)(i) and 3(a)(5)(i) of the Securities

Exchange ict of 1934.
109 (

Concept Release on Equity Market Structure at 3606; Financial Industry
Regulator iuthority, Comment Letter to Elizabeth M. Murphy, Secretary,
Securities and Exchange Comm‫ڊ‬n. at 4 (ipril 23, 2010). (


, Louis Loss,
Fundamentals of Securities Regulation, 676 (1983, Supp. 2010) (describing the
capital requirements of registered broker-dealers).
110 (



., 15 U.S.C. § 78i (banning manipulation of security prices); 15
U.S.C.i. § 78t-1 (banning insider trading).
111 (

Financial Industry Regulator iuthority, Comment Letter to Elizabeth M.
Murphy, Secretary, Securities and Exchange Comm‫ڊ‬n. (ipril 23, 2010) (citing
Securities and Exchange ict §§ 6(b)(5), 15i(b)(6)).
112 (

.
113 (

.
entails. While speculation abounds, there is frustratingly
little reliable information about HFT strategies.



#5 

(


2


&

4

)

In 2010, the Dodd-Frank Wall Street Reform and Consumer

Protection ict (‫ڍ‬DFi‫ )ڎ‬was passed.114 In it are several
provisions that might bear upon the regulation of HFT activities.
i. SEC
The DFi instructs the SEC to conduct a study of ‫ڍ‬the effect
of high-frequency trading and other technological advances on the
market and what the SEC requires to monitor the effect of such
trading and advances on the market.‫ڎ‬115 The SEC is then to
present its findings along with ‫ڍ‬recommendations for legislative,
regulatory, or administrative action.‫ڎ‬116 In accordance with
these instructions, the SEC has released a Concept Release on
Equity Market Structure, cited frequently in this paper, which
seeks to solicit comments from the industry on how HFT and other
technological advancements are affecting the markets.117
The DFi also increases the SEC‫ڊ‬s ability to monitor hedge
funds.118 Because hedge funds are typical users of HFT
strategies,119 this new development could be significant in HFT
regulation. Now the SEC may require hedge funds to maintain and
produce records ‫ڍ‬as necessary and appropriate in the public

114 Dodd-Frank Wall Street Reform and Consumer Protection ict, H.R. 4173, 111th
Cong. (2010) (‫ڍ‬DFi‫)ڎ‬.
115 DFi § 967(a)(2)(D).
116 DFi § 967(b)(2).
117 (



 , Concept Release on Equity Market Structure, 75 Fed. Reg.
3554 (Jan. 21, 2010).
118 (

DFi §§ 403 (removing registration exemption for ‫ڍ‬private investors‫;)ڎ‬
404 (increasing reporting requirements).
119 (

Concept Release on Equity Market Structure at 3606.
interest and for the protection of investors, or for the
assessment of systemic risk by the Financial Stability Oversight
Council‫( ڎ‬described below).120 The information required may
include the amount and types of assets held, trading and
investment positions, trading practices, and any other
information that the SEC determines is necessary.121 The
availability of this information will be potentially helpful to
regulators, because it is generally kept secret. Not only would
the information help keep such firms accountable for their
practices, it would help shed light on how HFT practices might
affect the markets. However, a provision in the DFi exempting
hedge funds managing less $150 million in assets will lessen the
helpfulness of these reporting requirements.122
The SEC should first use both of these powers to gain a more
thorough understanding of HFT. HFT are currently kept
ii. Financial Stability Oversight Council
The DFi established a new Financial Stability Oversight
Council (‫ڍ‬FSOC‫)ڎ‬,123 whose purpose it is to ‫ڍ‬identify risks to .
. . financial stability,‫ ڎ‬and ‫ڍ‬respond to emerging threats to
[financial] stability.‫ڎ‬124 The FSOC‫ڊ‬s duties are to ‫ڍ‬collect
information,‫ڍ ڎ‬monitor the financial services marketplace,‫ڎ‬

120 DFi § 404(b)(1)(i).

121 DFi § 404(b)(3). But see DFi § 404(b)(10)(B) (reserving from public
disclosure all ‫ڍ‬proprietary information‫ ڎ‬such as trading data, computer or
software containing intellectual property, etc.).
122 (

DFi § 408 (exempting for reporting requirements ‫ڍ‬any investment adviser
of private funds, if each of such investment adviser acts solely as an adviser
to private funds and has assets under management . . . of less than
$150,000,000.‫)ڎ‬
123 DFi § 111.
124 DFi § 112(a)(1).
‫ڍ‬identify gaps in regulation,‫ڍ ڎ‬require supervision . . . for
nonbank financial companies that may pose‫ ڎ‬stability risks, and
to ‫ڍ‬make recommendations to primary financial regulatory agencies
to apply new or heightened standards and safeguards for financial
activities‫ ڎ‬that could pose a risk to financial stability in the
markets.125
Much of the FSOC‫ڊ‬s power comes from its ability to recommend
nonbank financial companies that pose a systemic risk126 for
regulation under the Board of Governors of the Federal Reserve
(‫ڍ‬Board of Governors‫)ڎ‬.127 Some nonbank financial firms that are
thought to employ HFT strategies, such as large companies that
trade in a proprietary fashion (e.g., Goldman Sachs), will
probably qualify for this FSOC recommendation because of their
massive size and interconnectedness.128 However, exactly who
will be subject to this new scrutiny remains to be seen, as the
DFi does not, perhaps intentionally, provide many benchmark
criteria.129
The criteria that the FSOC bases its determinations upon
will have a large impact on which HFT companies fall subject to
its regulation. Criteria that are based solely upon size of
capital will not capture enough HFT firms. Instead, the FSOC
should use trade volume as criteria.

125*.
126 Defined in DFi § 102(a)(4); qualifications listed in DFi § 113(a)(2) (‫ڍ‬any
other risk-related factor‫)ڎ‬.
127 DFi § 112(a)(2)(H).
128 (

DFi § 112(a)(2)(H).
129 (

DFi § 113(a)(2). !


, DFi § 165(a) (intimating a benchmark of $50
billion).
 For example, Tradeworx, who has been mentioned previously in
this paper, trades with only $6 million capital.130 Through that
lens, and compared to firms the size of Goldman Sachs, Tradeworx
would not seem to qualify as a systemic risk. However, Tradeworx
has reported that it makes more than 200,000 trades everyday with
over 40 million shares:131 its impact on systemic stability comes
not from the size of its capital, but how it uses it. Tradeworx,
like many HFT firms, uses its capital many times over the course
of a day by rapidly acquiring and liquidating different
positions. Therefore, concentrating on size of capital alone
would miss the risk that HFTs create. The FSOC should devise
criteria to capture relatively small but nonetheless systemically
significant HFT firms like Tradeworx by concentrating on the
amount of liquidity they supply and have the ability to
withhold.132
The firms that the FSOC recommends for regulation under the
Board of Governors may be subject133 to ‫ڍ‬enhanced supervision and
prudential standards,‫ ڎ‬such as risk-based capital requirements,
leverage limits, enhanced public disclosures, and overall risk
management requirements.134 These standards seem based at
addressing the risk of an interconnected company‫ڊ‬s failure; it is
unclear whether these enhanced standards can adequately address

130 Michael Peltz, Man vs. Machine: Inside the World of High-Frequency Trading,
CNBC.com (Sept. 13, 2010) available at http://classic.cnbc.com/id/39099331/.
131
Jason Zweig, The Market War Between Traders and Investors Heats up, The
Wall Street Journal (Sept. 25, 2010).
132 (

DFi § 113(a)(2) (listing, as a consideration, ‫ڍ‬any other risk-related
factor‫)ڎ‬.
133 (

DFi § 112(a)(2)(I).
134 DFi § 115(b)(1).
the stability risks that HFTs represent,135 which are based not
on failure but on the volatility HFT practices may create. If
they cannot, then the FSOC‫ڊ‬s greatest impact on HFT will most
likely emanate from its duty to monitor the markets for stability
risks136 and make recommendations to primary regulators (like the
SEC, who could perhaps impose trading obligations) based on its
findings.137
iii. Commodity Futures Trading Commission
ilthough HFT activity has been discussed solely in terms of
the equity markets so far, the DFi prohibits some commodity
market activity that could affect some of the HFT strategies
described above. In Section 747, the DFi prohibits ‫ڍ‬disruptive
practices‫ ڎ‬in the commodities markets.138 In pertinent part, the
DFi defines disruptive practices as what is ‫ڍ‬commonly known to
the trade as, ‫ډ‬spoofing‫( ڊ‬bidding or offering with the intent to
cancel the bid or offer before execution).‫ڎ‬139 The Commodity
Futures Trading Commission (‫ڍ‬CFTC‫ )ڎ‬is currently in the process
of considering whether it needs to promulgate additional
regulations to enforce these new anti-disruption laws.140



4 


'

 

2
 

i. Prohibition of ‫ڍ‬Naked iccess‫ڎ‬

135 (

DFi § 115(b)(1) (listing the various regulations that may be imposed).
136 DFi § 112(a)(2)(C).
137 DFi § 112(a)(2)(K).
138 (

DFi § 747, amending § 4c(a) of the Commodity Exchange ict (7 U.S.C. §
4c(a) as amended).
139 DFi § 747, amending § 4c(a)(5)(C) of the Commodity Exchange ict (7 U.S.C. §
4c(a)(5)(C) as amended).
140 (

intidisruptive Practices iuthority Contained in the Dodd-Frank Wall
Street Reform and Consumer Protection ict, 75 Fed. Reg. 67301 (November 2,
2010).
 The SEC has formally enacted one regulation that will impact
HFT. While beyond the scope of this paper, the SEC has recently
(November 3, 2010) banned ‫ڍ‬naked access.‫ڎ‬141 Regulators feared
that naked access, where broker-dealers allow HFTs to have direct
access to the markets by bypassing certain risk-management
systems, allowed HFT firms to act as unregistered and unregulated
broker-dealers.142
ii. Increased and Enhanced Market/Trader Monitoring
The SEC has proposed two rules that would enhance its
ability to monitor HFT activity. First, the SEC has proposed
implementing a ‫ڍ‬Large Trader Reporting System‫ڎ‬143 which is
essentially designed to monitor HFT activity.144 Most HFTs would
meet the definition of ‫ڍ‬large trader,‫ ڎ‬which is any person whose
transactions equal or exceed (1) two million shares or $20
million during any calendar day or (2) 20 million shares or $200
million during any calendar month.145 ifter identifying
themselves, large traders would be assigned a unique
identification number that would enable the SEC and other

141 Risk Management Controls for Brokers or Dealers with Market iccess, 17
C.F.R. S 240 (2010).
142 (

Hearings (statement of William O‫ڊ‬Brien, CEO, Direct Edge).
143 Large Trader Reporting System, 74 Fed. Reg. 21456 (proposed ipril 14,
2010).
144 (

. (‫ڍ‬The proposal is intended to assist the Commission in identifying
and obtaining certain baseline trading information about traders that conduct
a substantial amount of trading activity, as measured by volume or market
value, in the U.S. securities markets. In essence, a ‫ډ‬large trader‫ ڊ‬would be
defined as a person whose transactions in NMS securities equal or exceed (i)
two million shares or $20 million during any calendar day, or (ii) 20 million
shares or $200 million during any calendar month.‫)ڎ‬
145 Large Trader Reporting System, 74 Fed. Reg. 21456 (proposed ipril 14,
2010).
regulators to track their activity across different markets.146
The system ‫ڍ‬would help the [SEC] reconstruct market activity,
analyze trading data and investigate potentially manipulative,
abusive or otherwise illegal activity.‫ڎ‬147
Second, the SEC has proposed a Consolidated iudit Trail
(‫ڍ‬CiT‫)ڎ‬, which would replace ‫ڍ‬existing audit trails [that] are
limited in their scope and effectiveness in varying ways.‫ڎ‬148
This proposed rule would require all securities exchanges to ‫ڍ‬act
jointly‫ ڎ‬in developing a ‫ڍ‬consolidated order tracking system.‫ڎ‬149
The CiT is aimed at satisfying ‫ڍ‬a heightened need for regulators
to have efficient access to a more robust and effective cross-
market order and execution tracking system.‫ڎ‬150 It will aid the
self-regulating markets151 in their ‫ڍ‬efforts to detect and deter
fraudulent and manipulative acts and practices in the
marketplace, and generally to regulate their markets.‫ڎ‬152 ind
will benefit the SEC‫ڊ‬s ‫ڍ‬market analysis efforts, such as
investigating and preparing market reconstructions and
understanding causes of unusual market activity. Further, timely
pursuit of potential violations can be important in seeking to

146 *.
147 Liz Moyer, inkle Bracelets for High-Frequency Traders, Forbes.com, (ipril
14, 2010).
148 Consolidated iudit Trail, 75 Fed. Red. 32556 at 1 (proposed May 26, 2010)
(to be codified at 17 C.F.R. pt. 242).
149*.
150 *.
151 For a discussion on the self-regulation of the markets, 

LOUIS LOSS,
FUNDiMENTiLS OF SECURITIES REGULiTION, 689-702 (1983 & Supp. 2010).
152 Consolidated iudit Trail, 75 Fed. Reg. 32556 at 1 (proposed May 26, 2010).
freeze and recover any profits received from illegal
activity.‫ڎ‬153
iii. Elimination of Flash Order Exception
While beyond the scope of this paper, the SEC has also
proposed banning ‫ڍ‬flash orders.‫ڎ‬154 in SEC market rule requires
markets to post their best bids and offers to all public
markets.155But an exception156 ‫ڍ‬that was [originally] intended to
facilitate manual trading in the crowd on exchange floors by
excluding quotations that then were considered ‫ډ‬ephemeral‫ ڊ‬and
impractical to‫ ڎ‬post publicly,157effectively enables ‫ڍ‬investors
who are not publicly displaying quotes to see orders before other
investors . . . .‫ڎ‬158 Critics fear that flash orders enable

153 *.
154
Flash orders begin as marketable buy or sell orders that are placed on an
exchange. If the order is not immediately filled in its entirety on that
exchange it may be ‫ڍ‬flashed‫ ڎ‬to market participants who are not currently
displaying quotes in that exchange for a very brief period of time. During
that brief period of time receivers of the flash order may respond and execute
against it if they please. Elimination of Flash Order Exception From Rule 602
of Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be
codified at 17 C.F.R. pt. 242).
155
‫ڍ‬Rule 602 [of Regulation NMS] generally requires exchanges to make their
best bids and offers in U.S.-listed securities available in the consolidated
quotation data that is widely disseminated to the public.‫ ڎ‬Elimination of
Flash Order Exception From Rule 602 of Regulation NMS, 74 Fed. Reg. 48632-01
(proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242).
156 in exception ((a)(1)(i)(i)) to Rule 602, however, ‫ڍ‬excludes bids and offers
communicated on an exchange that either are executed immediately after
communication or cancelled or withdrawn if not executed immediately after
communication.‫ ڎ‬Elimination of Flash Order Exception From Rule 602 of
Regulation NMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified
at 17 C.F.R. pt. 242).
157 Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74
Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt.
242).
158 Hearings (statement of Sen. Reed, Chairman, Subcomm. on Securities,
Insurance, and Investment).
front-running by HFTs.159 The proposed rule would eliminate the
exception, effectively banning flash orders.160


+,
6 

While the SEC has made no formal proposals, Mary Schapiro,

Chairman of the SEC, has said that the SEC is interested in
imposing obligations on HFTs that act in a market maker role.161
is noted above, even though many HFTs act as market makers, they
are, unlike traditional market makers, ‫ڍ‬subject to very little in

159 ‫[ڍ‬T]he flashing of orders to many market participants creates a risk that
recipients of the information could act in ways that disadvantage the flashed
order. With today‫ڊ‬s sophisticated order handling and execution systems, those
market participants with the fastest systems are able to react to information
in a shorter time frame than the length of the flash order exposures. is a
result, such a participant would be capable of receiving a flashed order and
reacting to it before the flashed order, if it did not receive a fill in the
flash process, could be executed elsewhere. For example, a recipient of a
flash order that was quoting on another exchange would be capable of adjusting
its quotes to avoid being hit by the flash order if it subsequently were
routed to that exchange. ilternatively, a recipient would be capable of
rapidly transmitting orders that would take out trading interest at other
exchanges before an unfilled flash order could be routed to those exchanges.
In both cases, a flashed order that did not receive an execution in the flash
process would also be less likely to receive a quality execution elsewhere.‫ڎ‬
Elimination of Flash Order Exception From Rule 602 of Regulation MMS, 74 Fed.
Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt. 242).
However, whether an order will be flashed is a voluntary decision on the part
of the order-maker. Those who choose to flash their orders are probably
sophisticated enough to consider the extent to which doing so would enable
others to act against their interests. Elimination of Flash Order Exception
From Rule 602 of Regulation MMS, 74 Fed. Reg. 48632-01 (proposed Sep. 23,
2009) (to be codified at 17 C.F.R. pt. 242). ‫ڍ‬ilthough flashes show the
intentions of investors, it‫ڊ‬s doubtful most flashed orders are big enough to
move markets, disqualifying them from traditional front-running.‫ ڎ‬Jonathan
Spicer, inalysis: Have ‫ڍ‬Flashes‫ ڎ‬Spawned Front-Running?, Reuters News (iug. 7,
2009). ‫ڍ‬Most mutual funds do not allow their orders to be flashed, primarily
because the process of displaying the orders to a select group of market
participants could result in information leakage.‫ ڎ‬Hearings (prepared
statement of the Investment Company Institute).
160 Elimination of Flash Order Exception From Rule 602 of Regulation NMS, 74
Fed. Reg. 48632-01 (proposed Sep. 23, 2009) (to be codified at 17 C.F.R. pt.
242).
161 Mary L. Schapiro, Chairman, Securities and Exchange Comm‫ڊ‬n, Remarks Before
the Security Traders iss‫ڊ‬n (Sept. 22, 2010).
the way of obligations either to protect that stability by
promoting reasonable price continuity in tough times, or to
refrain from exacerbating price volatility.‫ڎ‬162 The SEC ‫ڍ‬will
consider carefully,‫ ڎ‬according to Schapiro, ‫ڍ‬whether [HFT] firms
should be subject to an appropriate regulatory structure
governing key aspects of their market behavior, including both
their quoting and trading strategies.‫ڎ‬163 Such obligations could
potentially require HFTs to continue trading in volatile periods,
as market makers must.
!



Due partly to the current inability of regulators to monitor
it effectively, there is an inadequate understanding of HFT. But
it is clear that HFT is not regulated in proportion to its
prevalence in the financial markets or the attendant stability
risks it represents.The newly enacted Dodd/Frank bill will help
impose more effective regulation on HFT. Its focus on financial
stability will most likely result in imposition of trading
obligations on HFT, and may prevent the most manipulative HFT
practices. But most importantly, more robust and comprehensive
monitoring of HFT practices in needed; effective regulation of
HFT requires that it be informed by HFT practices and how they
might influence fairness and stability in the markets.

162 *.
163 *.