Market Manipulation: High Frequency Trading

The Security and Exchange Commission’s (SEC) Office of Compliance Inspections and Examinations and the Financial Industry Regulatory Authority (FinRA) are scrutinizing hedge funds and investment advisers that use high frequency trading (HFT) strategies employing algorithms.

In addition, there has been a marked increase in the algorithm and HFT regulatory requests made of hedge funds and investment managers.

The regulatory agencies are focused on anything that poses a risk to the investing public, including trading practices such as spoofing, wash trades, and excessive cancels and corrects. These forms of fraud and market manipulation and are under increased scrutiny during regulatory exams.

More and more, algorithms are driving trading strategies. The SEC has jurisdiction over hedge funds and investment advisers; FINRA does not. Yet, they both oversee broker-dealers and coordinate their oversight by sharing information. For example, the two bodies look at how algorithms react to different market conditions and what data feeds the firms use.

The SEC examines the strategies that are touted in the marketing materials of investment advisers to make sure that they’re not straying from those strategies. Trading firms that are engaged in market manipulation rise to the top, such 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.

Firms have made the news and been sanctioned by FINRA for spoofing. They spoof by placing small limit orders at prices that improve the national best bid and offer (NBBO) for a security, allowing the trader to take advantage of the improved prices by executing larger orders at another firm with execution guarantees at the NBBO. Once the larger order is executed at the artificially inflated price, the trader cancels the initial limit orders.

In one example, spoofing artificially impacted the price of a NASDAQ Stock Market security. The trader attempted to conceal his improper trading activity through the use of one of his 11 undisclosed outside brokerage accounts; he was fined $175,000 and is required to pay restitution of $171,740 for engaging in manipulative trading activity.

There are two major reasons these agencies are zeroing in on “algos” and high frequency trading strategies. One is the “Flash Crash” of May 6, 2010, after which SEC Chairman Mary Schapiro said regulators were investigating whether traders manipulated prices, encouraged volatility, or committed fraud by flooding the market with rapid-fire orders that were almost immediately canceled. The other is the SEC’s recent new hires in mathematics and experts in econometrics and computer science. In the past, the SEC has lacked the proper expertise to do the job adequately in this changing world of electronic stock trading.

HFT and algorithms are growing trends, with such trades now making up at least 50% of all U.S. stock trades; investment managers can expect the SEC to focus more on risks to ensure effective markets. The Flash Crash brought high frequency trading and algorithms’ roles into focus.

Traders are worried that such scrutiny is the tip of the iceberg. Regulators have requested trading information from broker-dealers and hedge firms required by the “Large Trader Rule.” What seems clear is that the regulators are investigating suspicious market activity.

The SEC sends out regulatory sweeps to all firms, but that is for more for market intelligence gathering. While there has been some filtering recently, the SEC has narrowed the scope on which types of firms it makes requests of. Some recent examples include firms that have patterns of behavior that might look suspicious. The broader point is that the SEC is investigating something specific that happened in the market.

Such information could be used to create new rules and/ or update existing rules for monitoring electronic trading. It could also be used to teach the SEC about new tactics and approaches to trading that they might currently not be aware of. The need for firms to police themselves is more critical than ever; their desire to stay off the regulators’ radar is enormous!