Contributeur : Stéphane DANIEL DJCE, Université Panthéon-Assas, 2011-2012 LLM, London School of Economics, 2012-2013
Superviseur : Jonathan FISHER QC Barrister, Devereux Chambers LSE visiting Professor
New Technologies and Market Abuses: Outdated Legal Frameworks, Short-Falling Reforms and New Proposals
ABSTRACT
The question addressed is whether the development of new technologies in financial markets, namely high frequency trading and dark pools, has an impact on financial market abuses and whether the US and EU legal frameworks enable competent authorities to prevent and punish them. My findings are that market abuses are quantitatively increasing and qualitatively evolving. However, despite on-going reforms, the enforcement models and the substantive laws on market abuses are inadequate. Ultimately, I formulate proposals attempting to remedy the identified legal deficiencies.
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TABLE OF CONTENTS
Introduction ...... 3
Part 1 – The Rise of New Technologies in Financial Markets ...... 5
I – A New Trading Technique: High Frequency Trading ...... 5 II – An Alternative Trading Venues to Traditional Exchanges: Dark Pools ...... 7
Part 2 – The Development of New Forms of Market Abuses ...... 10
I – The Empirical Nexus Between New Technologies and Market Abuses ...... 10 II - The New Possibilities for High Frequency Traders to Manipulate Market Price . 11 III - The New Possibilities for Traders to Practice Abusive Informed Trading ...... 14
Part 3 – The Challenges Faced by Regulators to Prevent and Punish New Forms of Market Abuse ...... 19
I - The Inadequacy of Enforcement Models with Modern Trading Environments .... 19 II - The Unequal Effort of the US and the EU to Improve Market Abuse Enforcement Efficiency ...... 20 III - Proposals to Improve Enforcement of Market Abuse Regulation in the EU ...... 23
Part 4 – The Incapacity of Market Abuse Substantive Laws to Encompass New Forms of Market Abuses ...... 25
I - The Regulatory Gaps of US and EU Laws on Market Abuses ...... 25 a) Market Manipulation ...... 25 b) Insider Dealing and Front Running ...... 26 II - The Shortfall of US and EU Substantive Law Reforms ...... 28 III - Proposals to Adapt the Substantive Laws on Market Abuses ...... 31
Conclusion ...... 33
Bibliography ...... 35
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Introduction
“Virtually gone are the days when nearly all securities were traded across the vast floors of stock exchanges by men yelling and wearing bright checkered jackets in order to stand out amongst the crowd.”1 Indeed, for the past decades, financial markets have dramatically changed. The end of historical exchange monopoly, the fragmentation of venues, the explosion of trading volume and the drop in trading cost have been accompanied by innovations, essentially computer-based trading, where trading orders are sent and executed automatically through superfast algorithmic devices without any human intervention.
That is why David Cliff recently explained that: “Human traders are an endangered species.”2 Professor at the Bristol University, he invented the Zero Intelligence Plus trading algorithm (ZIP), one of the first autonomous adaptive trading systems capable of learning from its actions. In 2001, it has been demonstrated that ZIP programs were invariably beating human traders by obtaining significantly larger gains3. This explains why machines, slowly but surely, are replacing humans in financial markets4.
As a result, the rise of the electronic market structure is nowadays a burning issue high in the global regulatory agenda5. Above all, the relationship between law and innovation is questioned. More than any other fields, financial law and financial regulation are confronted to cutting-edge and fast-evolving new practices challenging their foundations. It becomes more and more difficult for law makers and regulators to keep pace with financial developments. Therefore, this dissertation intends to analyse the potential disconnection between the current market abuse regulation in the US and the EU and the fraudulent behaviours potentially at work on today’s financial markets.
My question is then whether the development of new technologies in financial markets, namely high frequency trading and dark pools, has an impact on financial market abuses and whether the US and EU legal frameworks enable competent authorities to prevent and punish them6. My findings are that market abuses are quantitatively increasing and qualitatively evolving. However, despite on-going reforms, the enforcement models and the substantive laws on market abuses are inadequate. Ultimately, I formulate proposals attempting to remedy the identified legal deficiencies.
I will support this thesis through four different parts.
1 McGowan, Michael, ‘The Rise of Computerized High frequency Trading: Use and Controversy’, Duke Law Technology Review, n°016, 2010 2 Cliff, David, ‘Robot Traders and Evolving Markets: 15 Years of Automated Adaptive Algorithmic Trading’, Innovation and Algorithmic Trading Conference at University College London, 23 February 2011 3 Das, Rajarshi and others, ‘Agent-Human Interactions in the Continuous Double Auction’, The Proceedings of the International Joint Conferences on Artificial Intelligence, August 2001 4 Braconnier, Deborah, ‘Algorithmic Trading to Replace Humans in the Stock Market’, 14 September 2011
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In Part 1, I will set the basis of my demonstration by explaining the two main innovations of modern financial markets. They consist of new trading techniques called high frequency trading (HFT) and new trading platforms known as dark pools.
In Part 2, I will focus on the nexus between those new technologies and financial market abuses. Building on previous empirical studies, I suggest that market abuses are not only increasing but also taking new forms. I have identified two of them: market manipulation implemented by high frequency traders and informed trading i.e. traders exploiting confidential information about upcoming orders.
In Part 3, I will study the challenges faced by regulators to enforce market abuse prohibitions. Bringing together enforcement figures, I show the incapability of regulators to follow the pace of the increase in market abuses. I find an explanation in the explosion of market data coupled with the internationalisation of financial markets. I will then analyse and compare the enforcement models and on-going reforms in the US and the EU before reaching the conclusion that the former is much better than the latter. Consequently, inspired by the US system, I formulate two proposals for the EU: conferring to a federal authority the jurisdiction to investigate and prosecute cross-border market abuses and focusing on collecting and processing market data.
In Part 4, I will finally question the ability of US and EU substantive laws to encompass the abusive schemes identified in Part 2. Employing the syllogism method, I find that only the most classical forms of market manipulation fall within the scope of the regulation, leaving abusive quote stuffing and informed trading strategies unregulated. Thus, I consider if the current reforms remedy this deficiency and realise that even though they improve the market abuse legal framework, they fail to address the problem. As a result, I ultimately support two other proposals, namely the creation new quote stuffing and informed trading offences, for which I provide potential drafts.
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Part 1 – The Rise of New Technologies in Financial Markets
The rise of new technologies in financial markets has profoundly changed the essence of trading on exchanges. Traditional manual trading is being replaced by computerised trading (I) and traditional exchanges7 are being challenged by the development of dark pools (II).
I – A New Trading Technique: High Frequency Trading
HFT has been staggering in financial markets for the past twenty years. Today, it is widely reported that HFT accounts for over 60% in the US and 40% in Europe of the daily volume in equity markets8. This high growth development has taken place without any specific regulation. However, since a few years now, regulators from all over the world are questioning and debating the need to regulate those innovations and to adapt national financial market frameworks.
Despite the lack of any statutory definition of HFT, certain public authorities have attempted to provide their own. For the Securities and Exchange Commission (SEC), HFT is characterized by:
“The use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders; use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies; very short time- frames for establishing and liquidating positions; the submission of numerous orders that are cancelled shortly after submission; and ending the trading day in as close to a flat position as possible.”9
In comparison, the European Securities and Markets Authorities (ESMA) defines HFT as:
“Trading activities that employ sophisticated, algorithmic technologies to interpret signals from the market and, in response, implement trading strategies that generally involve the high frequency generation of orders and a low latency transmission of these orders to the market. Related trading strategies mostly consist of either quasi market making or arbitraging within very short time horizons. They usually involve the execution of trades on own account (rather than for a client) and positions usually being closed out at the end of the day.”10
Those two definitions highlight a number of HFT distinguishing features.
7 Lit markets are exchanges applying full pre-trade transparency. 8 Leo, Sarah, ‘Infographic: Trading at the Speed of Light’, 16 September 2012 < http://www.thebureauinvestigates.com/2012/09/16/infographic-trading-at-the-speed-of-light/> 9 SEC, ‘Concept Release on Equity Market Structure’, p.45, 21 January 2010 10 ESMA, Final Report, ‘Guidelines on Systems and Controls in an Automated Trading Environment for Trading Platforms, Investment Firms and Competent Authorities’, p.10, 21 December 2011 5
First, HFT is algorithmic trading. This means that computer programs are used to interpret signals and automatically enter trading orders as well as to decide on aspects of execution such as timing, quantity or price of the order11.
Secondly, these algorithms deploy trading strategies that are implemented through computer in an extremely fast automated fashion. Amongst others, the main are quasi market making and arbitrage12. The former refers to non-contractual provision of liquidity to the market on both sides of the book to earn the spread13 i.e. The latter consists in taking advantage of market inefficiencies, essentially mispricing of the same asset between two or more trading platforms, to earn the difference of price between them. Another interesting one is called news reaction: automatically acquiring and processing public information flowing from the Internet to subsequently trigger trading decisions to buy or sell accordingly14.
Thirdly, these algorithmic strategies are deployed through high frequency process. The speed element refers to the amount of time needed to access market data, process them, taking a trading decision and executing it. Without any doubt, fastness is the most important element of HFT business model. To this end, high frequency traders use different techniques. To begin with, HFT has recourse to colocation, whereby trading venues host HFT firms’ computers in their data centre against remuneration to reduce the length of cables transmitting information thereby reducing communication time15. Besides, instead of using the consolidated data feeds available to the public, high frequency traders pay trading centres to benefit from faster direct trading centre data feeds16. Furthermore, HFT firms generally enter into contract with broker dealer members of exchanges under which the latter provide the former with direct market access (DMA). This arrangement permits fast and anonymous trading by giving access to the market under the service provider’s name and enabling to send orders directly to the market17. Last but not least, certain exchanges offer against payment the benefit of flash orders. Flash trading entitles to view orders from other market participants fractions of second before them being displayed to the public18.
Fourthly, HFT involves proprietary trading. There is not much to say about it except that it involves the firm’s own money as opposed to its customer’s money. Thus, high frequency traders search to make a profit for themselves.
Fifthly, all of the above is implemented on an intraday basis. This means that HFT involves short term strategies searching to close the trading day with flat positions. The aim is
11 Foresight Report, p.165 (n.5) 12 Jones, Charles, ‘What Do We Know About High-Frequency Trading?’, Columbia Business School Research Paper No. 13-11, 20 March 2013 13 The spread is the difference of price between the bid and the offer 14 Angel, James and Douglas, McCabe, ‘Fairness in Financial Markets: The Case of High Frequency Trading’,
to mitigate the risk of loss arising out of holding positions over more than one day. Moreover, the massive order flow takes place within very short time horizon while the cancellation rate is usually very high (90%). This results in position being taken and abandoned in millisecond19.
In the end, the rise of HFT has radically changed financial markets. Individual traders and manual trades are being replaced by ultrafast computerised trading system. This major evolution is also accompanied by another important one with the development of dark pools and dark liquidity.
II – An Alternative Trading Venues to Traditional Exchanges: Dark Pools
There is nothing new in the concept of dark pool which exists in the equity market for many years20. The reason is that traders have always been extremely reluctant to disclose the full extent of their trading interest especially when they need to trade in large size. For instance, if the seller of a block of shares reveals his intention to the public, the resulting unbalance between the offer and demand is likely to result in a sharp drop of the stocks’ price. That is why market participants prefer confidential trades in order to avoid any adverse pricing impact. In the past, floor traders were slicing large orders in small ones and broker- dealers were providing over-the-counter liquidity.
In today’s financial markets, this old practice has taken the form of new types of exchanges known as dark pools. Tabb group recently estimated that trading on dark pools accounts for 32% of trades in 2012 against 26% in 2008 in the US equity market21. Even though it is a fast growing industry, the notion of dark pool still remains vague and heterogeneous. As for HFT, there is no statutory definition of what is it. The starting point is that they are electronic trading platforms operating without pre-trade transparency22. This means that pieces of information such as price, quantity or identity are not made available to the public before the trade is filled. Hence, these exchanges permit participants to dive in murky water to find dark liquidity, benefiting from anonymity and minimising price impact of large trades.
To better understand from a regulatory perspective what a dark pool is, it is possible to distinguish between regulated or alternative exchanges without pre-trade transparency (strict meaning) and other types of dark liquidity (large meaning)23.
To begin with the strict meaning, it is necessary to explain the divergence of regulatory frameworks in the US and in the EU.
19 Croning, Kevin, Statement at the SEC Market Structure Roundtable, 2 June 2010
In the US, the SEC explains that dark pool refers to alternative trading system (ATS)24 that do not publicly display quotations in the consolidated quotation data, which is the main element of pre-trade transparency in US equity markets25. Also, even though post-trade transparency is still required, a filled order must be reported, to the consolidated trade data, it is nuanced with the absence of obligation to identify the executing trading venue. In the US, there is no specific restriction for exchanges to offer dark liquidity services to investors.
On the contrary, in the EU, dark pool refers to exchanges exploiting waivers to pre-trade transparency laid down by the Market in Financial Instruments Directive (MiFID). Within the actual legal framework (MiFID I), dark pools are generally categorised as multilateral trading facilities (MTF)26 which is more or less the equivalent of US ATS. As such, they exploit three types of waivers to pre-trade transparency: waivers in relation to transactions which are large in scale according to an annexed table27; waivers in relation to MTF or regulated market based on a trading methodology by which the price is determined in accordance with a reference price generated by another system28; waivers in relation to MTF or regulated market formalising privately negotiated transactions but executed on the exchanges29.
In a larger sense, dark pool refers to any type of mechanism allowing trade without pre-trade transparency. Apart from the above described dark pools, this also regroups iceberg orders, systematic internalisers and crossing networks.
First, iceberg orders are large size single orders divided into smaller ones in order to hiding from other investors the market participant’s trading interest. As soon as the apparent small order is filled, it is replaced by another one of the same size, and so on until full execution of the original order. In the EU, these orders benefits from an exemption laid down by the MiFID30.
Secondly, systematic internalisers are investment firms which, on an organised, frequent and systematic basis, deal on own account by executing client orders outside a regulated market or MTF, matching them internally with other clients’ orders or within their own books31. However, they are exempted from pre-trade transparency when their activity is
24 SEC, Regulation ATS, 1998: “ATS means any organization, association, person, group of persons, or system that constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange” 25 SEC, ‘Regulation of Non-Public Trading Interest’, 17 CFR PART 242, Release n°34-60997, File n°S7-27-09 26 Article 4(15) of the Directive 2004/39/EC of 21 April 2004, MTF is “a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments in the system and in accordance with non-discretionary rules in a way that results in a contract” 27 Article 20, Regulation CE n°1287/2006 28 Article 18.1(a), Regulation CE n°1287/2006 29 Article 18.2(b) and 19, Regulation CE n°1287/2006 30 Article 18.2, Regulation CE n°1287/2006 31 Article 4(7), Directive 2004/39/EC 8
performed on an ad hoc and irregular bilateral basis with wholesale counterparties as part of dealings above standard market size and when the transactions are carried out outside the systems habitually used by the firm concerned32. Under these conditions, a systematic internaliser is allowed to enter into transactions freed from pre-trade transparency requirements.
Thirdly, crossing networks are non-regulated platforms. They refer to the practice of matching client order flows internally between them. Crossing networks differ from systematic internalisation systems in that the intermediary generally executes its clients' orders against those of other clients rather than against its own book. Being outside the scope of MiFID regulation, crossing network transactions are considered over-the-counter and outside pre-trade transparency obligations. However, given the vagueness of the crossing network characterisation, it offers room for regulatory arbitrage. Indeed, by choosing this qualification rather than the one of systematic internaliser, an exchange can be placed outside any regulation and hence outside market abuse prohibitions. This paper does not focus on this qualification issue but does recognise the need to further elaborate on it.
In the end, dark pools, apprehended either in a strict or large meaning, enable market participants to trade without the rest of the public being informed about the identity of the parties, the price of the transaction or the amount of securities being sold, thereby minimising adverse price impact. However, they are often contested on the reasons that they undermine the fundamental principle of financial market transparency and do not contribute to pricing efficiency.
As has been said, the rise of new technologies is impacting the nature of financial markets. For the past years, this has taken place outside any regulation. That is why today those two innovations now are under regulators’ scrutiny. Amongst others, the central concern stems from the question whether they increase and change the forms of market abuses.
32 Article 21(3), Regulation CE n°1287/2006 9
Part 2 – The Development of New Forms of Market Abuses
In this second part, it is suggested that the rise of new technologies in financial market increase market abuses (I) before explaining the new forms they take, namely market manipulation (II) and informed trading (III).
I – The Empirical Nexus Between New Technologies and Market Abuses
In this introducing paragraph, this paper asks the question whether the development of new technologies has increased market abuses.
First, the answer should be given focusing on statistical evidence. However, according to certain authors, there is simply no market data available. Irene Aldridge, a renowned expert in HFT, explained:
“One [misconception] is that all automated trading exists to abuse the market. I hear that again and again. But people do not have real proof of that […] the argument you hear is that, "You just have to watch the market, and you can see how automated trading abuses the market." But with no scientific examination, that's not a justifiable argument from my perspective.”33
In the same vein, researchers in the Foresight report on the future of computer trading in financial markets have also expressed the lack of direct evidence:
“Economic research thus far, including the empirical studies commissioned by this Project, provides no direct evidence that HFT has increased market abuse. However, the evidence in the area remains tentative: academic studies can only approximate market abuse as data of the quality and detail required to identify abuse are simply not available to researchers.”34
Nevertheless, the absence of empirical studies about market abuses is not completely true. Indeed, certain empirical studies do exist and show that, to a certain extent, HFT firms regularly manipulate financial market. In particular, a recent paper prepared by Credit Suisse provides statistical data and concrete examples showing that high frequency traders implement manipulative strategies35. Another paper focusing on quote stuffing explains that this manipulative strategy occurs each trading day on equity markets36. In a third research, it has been demonstrated that traders can implement order anticipation strategies and anticipate buying and selling pressure37. Brought together, those three papers constitute a good starting point to affirm that market abuses increased by new technologies.
33 Heires, Katherine, ‘Fives Questions: Irene Aldridge on High Frequency Trading’, April 2012 < http://www.institutionalinvestor.com/article.aspx?articleID=3009963> 34 Foresight Report, p.12 (n.5) 35 Credit Suisse, ‘High Frequency Trading - Measurement, Detection and Response’, 2012 36 Egginton, Jared and Van Ness, Bonnie and Robert ‘Quote Stuffing’, 2012 < http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1958281> 37 Hirschey, Nicholas, ‘Do High-Frequency Traders Anticipate Buying and Selling Pressure?’, 2011 < https://www2.bc.edu/~taillard/Seminar_spring_2012_files/Hirschey.pdf> 10
Secondly, this premise should now be supplemented by qualitative evidence based on market participants’ perceptions. The Foresight report, analysing testimonies found in specialised press and regulatory consultations reach a conclusion that strongly supports our precedent point:
“The evidence appears strikingly consistent in its flavour, even though it originates from different sources and regulatory areas: large investors believe that there is a clear link between abuse and high-speed trading techniques […] The abusive strategies evoked include ‘quote stuffing’, ‘order book layering’, ‘momentum ignition’, ‘spoofing’, and ‘predatory trading’ (sometimes referred to as ‘liquidity detection’ or ‘order anticipation’) […] Therefore the evidence on the perception of abuse seems compelling in its consistency across sources, perhaps a sign that something potentially damaging could be at work.”38
Consequently, building on these pieces of evidence, there is a nexus between the development of new technologies and the increase in market abuses. Hence, it is now time to explain the new forms they take: market manipulation and order anticipation.
II - The New Possibilities for High Frequency Traders to Manipulate Market Price
As previously seen, one of the main features of HFT is the implementation of trading strategies, which can be divided in two groups39. The “good” ones, comprising market making or arbitrage, contribute to market quality by increasing liquidity and improving pricing efficiency. The “bad” ones, regrouping quote stuffing, momentum ignition and layering, undermine market integrity by defrauding investors.
To begin with, quote stuffing consists in inundating the market with massive numbers of orders and cancellations in a very short period of time without any economic justification. The aim underlying the manoeuvre could be, for example, to create suboptimal trading conditions for other market participants, to disconnect the pricing of financial instrument on two exchanges in order to create arbitrage opportunity or to camouflage a fraudulent transaction such as a price manipulation. It has been demonstrated that quote stuffing is a widely spread practice. Analysing STOXX60040 data, Credit Suisse explained: “each stock on average experiences high frequency quote stuffing 18.6 times a day, with more than 42% of stocks averaging 10+ events per day.”41 In the same vein, another research reached the conclusion that: “quote stuffing is pervasive and over 74% of US exchange listed securities experience at least one episode during 2010.”42
Another strategy is momentum ignition, whereby entry of orders intends to start or exacerbate a trend and to encourage other participants to accelerate or extend it in order to create an opportunity to open/unwind a position at a favourable price43. Again, the Credit Suisse report provides preoccupying figures about it: “we estimate that momentum ignition
38 Foresight Report, p.92 (n.5) 39 Credit Suisse, High Frequency Trading – ‘The Good, The Bad, and The Regulation Market’, 2012 40 Stoxx 600 is an index tracking 600 publicly-traded companies based in one of 18 EU countries 41 Credit Suisse, p.2 (n.35) 42 Eggington and Van Ness, p.2 (n.36) 43 Foresight Report, p.167 (n.5) 11
occurred on average 1.6 times per stock per day […] we note that the average price move is 38bps, and the time it takes for that move to occur is approximately 1.5 minutes.”44
Last but not least, the layering strategy45 consists in entering hidden orders on one side of the book, and simultaneously submitting visible orders on the other side of the book to encourage others in the market to believe there is strong price pressure. Once the price moves up or down, the manipulator executes the hidden order and then cancels the visible orders46. Another variant is spoofing, which involves using, and immediately cancelling, limit orders in an attempt to lure traders to raise their own limits, again for the purpose of trading at an artificial price47. In both cases, when traders cancel their orders, this results in a phenomenon called order book fade where order book volume on same venue (price fade) or another (venue fade) disappears48. The layering strategy has considerably drawn the attention of regulators and HFT firms implementing it have been sanctioned in the US and in the UK.
In the US, the Financial Industry Regulatory Authority (FINRA)49 fined, as part of a settlement, Trillium Brokerage Services LLC, its director of trading, its chief compliance officer, and nine of its traders $2.26 million for illicit equities trading strategy50. The facts concerned a high frequency strategy implemented by nine proprietary traders on behalf of the firm consisting in entering massive orders without any intention to trade in order to create false appearance of buying or selling pressure. Once the price was manipulated either up or down and other market participants were following the illusory trend, the fraudsters were classically cancelling their initial orders while maintaining the contrary ones. The FINRA mentioned that the manipulators entered into 46,000 fraudulent transactions resulting in $575,000 illegal profit.
In a very recent and similar case, the SEC charged a New York brokerage firm, Hold Brothers On-Line Investment, as well as three executives, for having allowed overseas traders to access the market through the firm’s customer accounts and to manipulate market prices with layering strategies from January 2009 to September 201051. The fraudulent scheme involved 8 million orders, 325,000 fraudulent transactions and $1.8 million dollars profit52. The regulator also charged Trade Alpha Corporate Ltd and Demostrate LLC, created and partially owned by one executive, because their accounts have been used to carry on the fraud. Above all, the three executives were perfectly aware of the manipulation and recklessly turned a blind eye it. In total, the SEC reached a settlement where the individuals and entities involved agreed to pay $4 million in disgorgement and penalties53.
44 Credit Suisse, p.6 (n.35) 45 Sreenivasan, Ven, ‘Beware the potential abuse of high-frequency trading’, The Business Times - Singapore, 19 September 2011 46 Foresight Report, p.166 (n.5) 47 Angel and McCabe, p.13 (n.14) 48 Credit Suisse, p.4 (n.35) 49 FINRA is the largest independent regulator for all securities firms doing business in the US 50 Trillium case, FINRA Press Release
In the UK as well, the Financial Services Authority (FSA)54 sanctioned twice layering/spoofing strategies. In the first case, the FSA fined Swift Trade, a non FSA authorised Canadian company, £8 million for market abuse55. The company lodged an appeal which is still pending before the Upper Tribunal56. The firm is accused of having systematically and deliberately engaged, between 1 January 2007 and 4 January 2008, in layering resulting in small price movements in a wide range of individual shares on the London Stock Exchange, ending with £1.75 million profit earned. This case concerned “tens of thousands of trading orders by many individual traders sometimes acting in concert with each other across many locations worldwide”. Tracey McDermott, director of enforcement and financial crime at the FSA, explained: “This was a particularly cynical case where a business model was based on market abuse.”57
In the second case, the FSA issued proceedings against Da Vinci Invest, a UK- registered but Swiss-based fund manager, two related Singapore and Seychelles-based companies and three individuals who traded on their behalf, for having engaged, from August 2010 to July 2010, in layering strategies resulting in £1 million gross profit58. In response, the English regulator obtained a High Court injunction to stop such manipulation and to freeze the assets of those companies.
All of this supports the conclusion that market abuses are increasing and evolving. Increasing because in three years’ time five similar cases have been brought in two different countries with very important financial markets. Evolving because the modus operandi is completely new, bringing together millions of orders, slight price variations, thousands of transactions, millions of profit, all of that implemented at a large scale and involving several jurisdictions. And the biggest concern is that these identified fraudulent behaviours might be the tip of the iceberg, leaving the vast majority of them undetected and unpunished throughout the world.
In addition, it must be borne in mind that all the above mentioned strategies can be implemented on traditional exchanges but also on dark pools. In the latter case, detection becomes extremely difficult because it requires regulators to cross supervision in time between different venues, some of them being opaque. There is a particular method to manipulate price in dark pools using reference price from another market59. Generally, this matching point is the midpoint, that is to say the central point between the bid and the offer price. Hence, by distorting the spreads on referenced lit markets, it is possible to influence the price used by dark pools. Such practice has been referred to as “quote manipulation” by the Canadian regulator: “quote manipulation is trading activity intended to affect the price at which dark orders that are tied to prices on visible marketplaces, trade in dark pools or
54 The FSA has been split by the Financial Services Act 2012 between two new agencies : the Prudential Regulation Authority and the Financial Conduct Authority 55 Swift Trade case, FSA Administrative Proceedings
displayed marketplaces.”60 In fact, this paper prefer using the name “imported price manipulation” because the manipulation occurs on a lit market and is imported into the dark pool where the transaction is ultimately realised. The Credit Suisse report gives a concrete example of such practice:
“In particular, dark pools using a synthetic EBBO (consolidated book) for their reference price are at higher risk of being gamed by quote stuffing. Exhibit 10 shows an example in Ashmore Group, where the Primary Bid and Ask are static, but the Chi-X bid moves. The consolidated EBBO shows a locked book, with the bid equal to the ask at 356.2. This scenario could be exploited in EBBO-referenced dark pools. A gamer could place a sell order in the pool with a 356.2 limit, then place (and rapidly cancel) a Chi-X bid, also at 356.2. Any buy order pegged to mid would trade at the temporary gamed “mid” of 356.2 (as the EBBO bid and offer are both temporarily 356.2), paying the whole spread rather than half.”61
Therefore, high frequency traders are able to manipulate market price on lit market as well as dark pools. But, apart from the strategies explained above, there is another abusive behaviour that has now to be studied.
III - The New Possibilities for Traders to Practice Abusive Informed Trading
New technologies not only enable new forms of market manipulation but also the implementation of informed trading strategies. This dissertation understands informed trading as the situation in which a market participant obtains confidential information about an upcoming order and exploits it for his benefit to the detriment of the anticipated trader. An author has rightly pointed out this rising practice and its nexus with new technologies: “The existence of short-term informed trading based on some combination of uneven distribution of information, as well as different capabilities with respect to its acquisition, processing, and aggregation, stale quotes, and transaction cost and speed advantages is a permanent fixture of securities markets that is fueled by technological developments.”62 Here, the general term of informed trading is used to refer to many different practices known as abusive liquidity detection, front running, tape racing, order anticipation, latency arbitrage, gaming or predatory strategies. They all share one common denominator: exploitation of information asymmetry. This paper has identified three possibilities to get information advantage and subsequently exploit it: order anticipation/liquidity detection strategies, flash trading or dark pools information leakage.
First, market participants can detect liquidity and anticipate orders. This type of strategy has been given as example in the previous document to illustrate informed trading:
“One example of a market participant in today’s high-speed securities markets, is “a quantitative trader ... who performs bleeding edge statistical analysis on screaming-fast computing hardware .... [to] make reasonably confident predictions based on very strong
60 IIROC, ‘Proposed Guidance on Certain Manipulative and Deceptive Trading Practices’, 2012 61 Credit Suisse, p.3 (n.35) 62 Dolgopolov, Stanislav, ‘Insider Trading, Informed Trading, and Market Making: Liquidity of Securities Markets in the Zero-Sum Game’, 3 Wm. & Mary Bus. L. Rev. 1, 2012 14
alpha signals, thereby seeing something in the markets that others do not, or at least before they do.”63
Order anticipation strategy has been best explained by Arnuk and Saluzzi64. Using cutting edge technology, colocation, direct data feeds and HFT, traders can achieve “(almost) risk free arbitrage opportunities”. This is because, through speed advantage, they are able to know before other market participants the orders sent to the market and accordingly trade ahead of them. The two authors give a concrete example of latency arbitrage:
“1. The market for ABC is $25.53 bid / offered at $25.54. 2. Due to Latency Arbitrage, an HFT computer knows that there is an order that in a moment will move the NBBO quote higher, to $25.54 bid /offered at $25.56. 3. The HFT speeds ahead, scraping dark and visible pools, buying all available ABC shares at $25.54 and cheaper. 4. The institutional algo gets nothing done at $25.54 (as there is no stock available at this price) and the market moves up to $25.54 bid / offered at $25.56 (as anticipated by the HFT). 5. The HFT turns around and offers ABC at $25.55 or $25.56. 6. Because it is following a volume driven formula, the institutional algo is forced to buy available shares from the HFT at $25.55 or $25.56. 7. The HFT makes $0.01-$0.02 per share at the expense of the institution.”65
A few years ago, Paul Krugman also denounced this practice: “Some institutions, including Goldman Sachs, have been using superfast computers to get the jump on other investors, buying or selling stocks a tiny fraction of a second before anyone else can react.”66 Through such abusive behaviours, high frequency traders are able to anticipate orders and, trading ahead, to impose a slight additional transaction cost on every trade at the expense of the rest of the market.
Moreover, as previously seen in Part I, institutional investors go to great length to conceal their large trading positions either by slicing them into small orders or in trading into dark pools to avoid adverse price impact. Nevertheless, it still remains possible to detect liquidity and anticipate orders67. To describe this type of trading, Turbeville has used the metaphorical concept of “hunting whales”68. This consists in placing multiple small orders to be executed or cancelled immediately in order to detect the presence of a market participant accumulating or liquidating a large position. As soon as the small order pings, the high frequency trader trades ahead, buying all the available instruments between the bid/ask spread price. Once detected, the ‘whale’ is fished and will not be able to find any counterparty in the market but the HFT firm. The author explains the bitter end for the whale: “The algorithmic trader establishes a narrow band of absolute market power controlling the particular securities or derivatives that the whale seeks to buy or sell. The whale will be compelled to
63 Ibid p.14 64 Arnuk, Sal and Saluzzi, Joseph, ‘Latency arbitrage : the real power behind predatory high frequency trading’, Temis Trading White Paper, 4 December 2009 65 Ibid p.2 66 Krugman, Paul, ‘Rewarding Bad Actors’, New York Times, 2 August 2009 67 Angel and McCabe, p.11, (n.14) 68 Turbeville, Wallace, ‘Cracks in the Pipeline 2 High Frequency Trading’, February 2013
either abandon the market or transact at the price demanded by the algorithmic trader.”69 According to a HFT firm, such unfair practice is widely spread in the US equity market because of the abuse of the legal framework’s loopholes: “Using publicly-available data more intelligently than your competitors is a FAIR practice, even if the goal is to predict their behaviour. Jumping ahead of an order that was placed earlier at the same price by another trader is an UNFAIR practice, because it undermines the principle of PRICE-TIME priority on which our equity markets are premised. Unfortunately, this UNFAIR practice is widespread, due to a deficiency in Rule 611 of Regulation NMS. HFTs should not be blamed for exploiting it – in fact, many HFTs who exploit this deficiency do so unwittingly.”70
Confronted to liquidity detection and order anticipation, market participants trade their large position in dark pools. However, they are not protected anyways because the same unfair practices can still be implemented. Mittal has identified those occurrences in what he calls “toxic dark pools”71. They are slightly more complex because they bring together “fishing” strategies within a dark pool and subsequent market price manipulation of the referenced lit market. More specifically, there are three main steps: ensuring that a large buying/selling position is being accumulated/liquidated within a dark pool, manipulating the price of the referenced lit market and trading on that basis on the dark pool. This scheme is also very well described by Zero Hedge website:
“Dark pools are open to gaming, but it is a risky business, predicated on being able to guess both the existence of large liquidity and the pricing mechanism being used. As an example suppose that, by whatever means, you believe that there is a large amount of hidden liquidity, say a buyer pegged to the public bid price. If the public market has much less quantity than you suspect is hidden on the bid, you can buy a similar amount of the asset, pushing up the price. Once the price is high enough, you place a limit price buy order of sufficient quantity onto the public market and simultaneously place a limit price sell order for the total quantity you just bought on the dark venue. You now hope that the hidden order will cross with you at the current high price bringing the profit.”72
Second, it is also possible to practice informed trading through flash trading. Stricto sensu, flash trading refers to flash orders on lit market. However, this paper will use the term flash trading lato sensu to encompass actionable indication of interest in dark pools.
Flashing orders, as described in Part I, is a process through which exchanges, against payment, send first the orders received to selected market participants for a very short duration. The order is not yet included in the consolidated quotation data and recipients can trade upon it. If there is no filling, it is then cancelled or transmitted to the public73. Flash orders essentially developed in US financial markets with NASDAQ, BATS or Direct Edge74.
69 Ibid p. 11 70 Tradeworx, ‘Comments on SEC Market Structure Concept Release’, 21 April 2010
Interestingly, they seem to be inexistent in Europe75. In US law, even though Rule 602 of Regulation NMS requires exchanges to make their best bids and offers available in the consolidated quotation data, its paragraph (a)(1)(i)(A) excludes bids and offers that either are executed immediately after communication or cancelled or withdrawn if not executed immediately after communication76. Historically, such exception intended to facilitate manual trading where such “ephemeral” quotations were considered impractical to include in the consolidated quotation data77. Later on, with the rise of computerised trading, these orders developed with a duration time much shorter than the former manual quotations. Nowadays, flash orders have strongly been criticised by market participants. Charles Schumer, New York senator, best described what is wrong with flash orders:
“Flash orders allow certain members of these exchanges to obtain access to order flow information before that information is made available to the public, allowing those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity. While pre-routing programs can benefit markets by providing additional liquidity, this kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.”78
A very similar practice can also be found in dark pools with actionable indication of interest (IOI). Dark pools have recently started sharing IOI conveying substantial information that are not included in the consolidated quotation data to selected market participants79. These indications of interest are actionable because, despite not specifying the precise price and size of positions lying in the dark pool, they alert the beneficiary about a trading interest “in a particular symbol, side (buy or sell), size (minimum of a round lot of trading interest), and price (equal to or better than the national best bid for buying interest and the national best offer for selling interest).”80 Therefore, recipients can trade upon it by sending contra- side order provided that the position hasn’t been executed nor cancelled yet. That is why IOI are pretty much the same as orders not displayed to the public and hence contribute to create two-tiered market where privileged participants are notified trading opportunities not offered to the rest of the market81. And again, IOI can be the basis of informed trading strategies: “the IOI information may also be used by the recipient to game or trade ahead of the order in the dark pool, as the recipients of an IOI are generally under no obligation to trade against the investor's order.”82 This potential occurrence has also been described in Mittal’s already quoted paper about ‘toxic’ dark pool83.
75 Grant, Jeremy, ‘Europe Calm on Flash Orders’, 3 August 2009
As a result, both flash orders and IOI enable confidential information about trading positions to be shared by exchanges with certain privileged market participants. Using their speed advantage, such participants are then able to implement predatory strategies.
Third, informed trading is not only possible through speed advantage or flash methods, but also when dark pools illegally share confidential information about customers’ orders. This must not be confused with actionable IOI where information sharing takes place with the members’ knowledge and regulators’ tolerance. Here, dark pools are also “toxic” because they bypass the confidentiality owed to their members.
In the US, the SEC has recently sanctioned two dark pools for unauthorized information sharing. In the first case, Pipeline Trading System LLC (Pipeline) and two of its top executives have been charged with failing to disclose to customers that the vast majority of orders were filled by a trading operation affiliated with Pipeline84. Pipeline accepted to pay $1 million penalty to settle the charges as well as the two executives who paid $100,000 each85. More precisely, the SEC explained that (i) one of the affiliate was a trading entity owned by Pipeline’s parent company within which the manager had access to customer’s confidential information and (ii) another affiliate, Milstream Strategy Group LLC, was provided with special access to certain information about operations in the dark pool, which were used to try “to predict the trading intentions of Pipeline’s customers and trade elsewhere in the same direction as customers before filling their orders on Pipeline’s platform.” Therefore, where Pipeline advertised that the dark pool would not reveal the side or price of customer orders and would protect customers from pre-trade information leakage and front-running predators, it was actually doing the opposite by permitting the affiliates to perform informed trading strategies on the basis of illegally shared information.
In the second case, the SEC charged eBX LLC (eBX) for having failed to protect confidentiality over customers’ information as well as to disclose that it allowed an outside firm to use them while pretending the contrary86. EBX accepted to settle the charges by paying $800,000 penalty87. The regulator explained that the outside firm received an information advantage over other subscribers and was using it for its own profit. In the case in hand, the beneficiary of the information was not gaming the market but using it to fill more efficiently its client orders. However, this case shows that information leakage does happen and can end up with savvy trading entities fraudulently using them.
Consequently, dark pools are not always dark and instead sometimes have different shades of grey. They become then ‘toxic’ for their members in the sense that confidential trading interest are known by certain participants and enable them to practice informed trading.
84 Pipeline case, SEC Administrative Proceedings
Part 3 – The Challenges Faced by Regulators to Prevent and Punish New Forms of Market Abuse
New technologies in financial markets increase the quantity and modify the quality of market abuse. The question is then whether regulators are able to cope with it. This paper finds that these structural changes render supervision and enforcement more difficult for public authorities: the enforcement models are outdated (I) and the on-going reforms fall short in trying to improve them (II). Considering (I) and (II), this research will propose two reforms for the EU (II).
I - The Inadequacy of Enforcement Models with Modern Trading Environments
In Part I, the conclusion drawn from statistical and qualitative evidence is that the quantity of market abuses on financial market is increasing. Thus, assessing the ability of regulators to follow this pace requires a comparison with the number of sanctions imposed by competent authorities. To this end, this paper brings together in the following tables public figures released by the SEC88 and the ESMA89 about administrative sanctions imposed for insider dealing or market abuse for the period 2008 to 2010.
Table 1: US - SEC Year 2008 2009 2010 Insider trading 19 8 20 Market manipulation 20 6 10
Table 2: EU - ESMA Reporting the sanctions pronounced by the competent authorities of Member States Year 2008 2009 2010 Insider trading 78 45 83 Market manipulation 73 153 127
These tables clearly demonstrate the lack of any coherent trend in sanctions imposed by regulators in the US and in the EU. However, considering the increasing number of market abuses, this compilation should have showed an increase in regulators enforcement over the years. As a result, bringing together the fact that (i) market abuses are increasing and that (ii) enforcement proceedings are not, this paper concludes that regulators are not able to cope with new forms of market abuses.
This should not be surprising. Nowadays, regulators have to deal with superfast computers flooding lit exchanges as well as dark pools with millions of orders and cancelations. Hence, it seems that real time surveillance has become an illusion: "The biggest challenge with real time reporting is the increase in volume and the rapid rate at which trading activity occurs […] A lot of automated and high-frequency trading occurs on markets
88 SEC: 2008:
and that becomes harder to monitor because you've got massive amounts of volume in short periods of time.”90
Moreover, today’s financial markets are internationalised. This means that market participants come from all over the world and perform trading operations everywhere on the planet. They are able to perform regulatory arbitrage by establishing themselves in the most favourable jurisdictions eventually ending up within tax heavens as well as opaque and non- cooperative jurisdictions. Furthermore, trading activity is extremely fragmented, yet spread at the same time between several accounts, exchanges and jurisdictions. In a recent intervention, the FINRA admitted: “In today's fragmented trading environment, it is very plausible that market participants will spread their activity across multiple markets and accounts in an attempt to avoid detection of trading abuses such as wash sales, front running, insider trading, marking the close and open, and manipulative trading strategies like layering […] the risk of missing instances of manipulation, wash sales, abusive short selling and other improper "gaming strategies" is still unacceptably large.”91 In the same vein, The Foresight report best summarised this challenge explaining: “Detecting evidence of market abuse from vast amounts of data from increasingly diverse trading platforms will present a growing challenge for regulators.”92 On this point, the ability of regulators to meet these challenges leaves market participants perplex: “About 90% of respondents do not believe that regulators have sufficient data, technology or expertise to effectively detect market abuse”.93 This is not a mere feeling as the Boston Consulting Group (BCG) recently warned the SEC that: “The agency does not have sufficient in-house expertise to thoroughly investigate the inner workings of such [trading] algorithms (…) [and recommends that] The SEC should have staff who understand how to (…) perform the analytics required to support investigations and assessments related to high-frequency trading. (…) the SEC requires people who know how high-frequency traders use technology.”94
In the end, taking into consideration all the above difficulties, this paper reaches the conclusion that even the most advanced public authorities are overwhelmed by financial markets development and hence that enforcement models are outdated. Thus, the question is now whether the on-going reforms are capable to improve the regulators’ missions.
II - The Unequal Effort of the US and the EU to Improve Market Abuse Enforcement Efficiency
Faced with the challenges described above, regulators are trying to adapt their enforcement model. Without any doubt, the US take the leadership when it comes to do so. This is because their model is federal and thus capable to concentrate the available resources within few regulatory authorities having global jurisdiction for the US financial markets. On the contrary, the European model is delocalised, with the ESMA as coordinating institution and 27 national competent authorities in charge of enforcing market abuse regulation. Therefore, the enforcement being left to Member States, the available resources are divided
90 Dew-Jones, Steve, ‘Mission Impossible?’, Waters, April 2012 91 Luparello, Stephen, Testimony Before the Subcommitte on Securities, Insurance, and Investment Committee on Banking, Housing and Urban Affairs, 8 December 2010
and the supervision is fragmented, which ultimately undermines market abuse regulation efficiency. In both cases, on-going reforms try to improve enforcement.
In the US, the SEC is pro-actively trying to meet the challenges caused by the development of new technologies. Indeed, Mary Jo White, the SEC new chairman, explained very recently before the Senate Banking Committee:
“It will be a high priority throughout my tenure to further the SEC needs to be in a position to fully understand all aspects of today’s high-speed, high-tech, and dispersed marketplace so that it can be wisely and optimally regulated, which means without undue cost and without undermining its vitality. High frequency trading, complex trading algorithms, dark pools, and intricate new order types raise many questions and concerns […] I will work not only to ensure that the SEC has the cutting-edge technology and expertise necessary to enable it to keep pace with the markets and its responsibilities to monitor, regulate, and enforce the securities laws, but also to see around the corner and anticipate issues.”95
To this end, the SEC has taken several measures. In 2012, the US regulator has set up a Quantitative Analytics Unit dedicated to abuses that might arise from the use of HFT and dark pools96. This unit gathers together expert in mathematics, physics and computer science and is to play a key role in examining the most advanced computerised trading techniques. Moreover, this structure has joined force with the FBI to enhance its ability to tackle the threat of market manipulation posed by high speed computerised trading97.
In so doing, the SEC has set up the preliminary basis to process market data. Now, the regulator priority lies in collecting them via two specific innovations. The first one is the introduction of the market information data analytics system (MIDAS)98. This will aggregate trading information data: orders, modifications, cancellations, trade executions on lit market as well as on dark pools. It will enable regulators to understand the speed of quotes and subsequent cancellations, the full depth of book for liquid and illiquid stocks and the intraday volatility, which ultimately will enable to detect market abuses. The second one is the adoption of a new Rule 613 under Regulation NMS, requiring national securities exchanges and the FINRA to establish a market-wide consolidated audit trail (CAT)99. The aim is to significantly enhance regulators ability to monitor and analyse trading activity by identifying every order, cancellation, modification and trade execution across all US markets. Such mechanism will give the regulator the ability to reconstruct based-market events, eliminating delays and imprecisions, which will give the regulator a timely, accurate, complete and
95 Jo White, Mary, Testimony Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, 12 March 2013
accessible picture of the market state at any point in time. The difference with MIDAS is that CAT will gather public but also non-public data, for example the identity of the parties to a trade. On this point, the SEC explained: “A consolidated audit trail will increase the data available to regulators investigating illegal activities such as insider trading, wash sales, and market manipulation. In particular, increased data will facilitate risk-based examinations, allow more accurate and faster surveillance, improve the process for evaluating tips, complaints, and referrals, and promote innovation in cross-market and principal order surveillance.”100
Finally, in order to further improve market participants’ identification, the SEC has adopted two other important rules. It has established a large trader reporting requirement under which large traders have to identify themselves to the regulator which will in return assign them a unique identification number101. In addition, to ensure full transparency in trading activities, the SEC will now prohibit broker-dealers from providing customers with “naked” access to exchanges or ATS as well as requiring them to put in place risk management controls and supervisory procedures102. As small HFT firms are the main customers of DMA services, this new obligation will inter alia allow regulators to supervise their compliance with regulation more easily103.
To conclude, the SEC’s effort to collect market data and to have competent staff to process and understand them is a tremendous step to counter the resurgence of market abuses.
On the contrary, in Europe, there is clearly no such intense willingness to improve enforcement efficiency. Again, this is mostly because enforcement is left to Member States. Anyhow, the Markets in Financial Instruments Directive (MiFID)104 and the Market Abuse Directive (MAD)105 are currently being reviewed under MAD II106 and MiFID II107 and a few new rules would contribute to improve enforcement efficiency.
The MiFID review, following US law, provides for the creation of a European consolidated tape (article 61-68). The aim is to address market data fragmentation arising from the original MiFID. Accordingly, market participants would be required to publish their trade report through approved publication arrangement and market data would then be brought together by consolidated tape providers. Furthermore, the review also tries to ensure
100 Ibid 101 SEC Press Release, ‘SEC Adopts Large Trader Reporting Regime’, 26 July 2011 < http://www.sec.gov/news/press/2011/2011-154.htm> 102 SEC Press Release, ‘SEC Adopts New Rule Preventing Unfiltered Market Access’, 3 November 2010
that HFT firms are regulated. The project provides that all entities engaging in HFT must be authorised (article 2), subjected to organisational safeguards and appropriate risk controls (article 16 and 51) and must provide at least annually a description of the nature of their algorithms to regulators (article 17.2). Those few rules will indirectly enhanced regulators enforcement by giving them better access to market data and enabling them to identify and monitor more closely trading entities using HFT. Concerning the MAD review, the project wants to strengthen investigations by giving European regulators the power to enter private premises, to seize documents without prior court authorization, to request telephone and data traffic records held by investment firms and telecommunication providers as well as to receive communication of information by whistleblowers. Nevertheless, even though the previous changes are obviously welcomed as part of an harmonization effort, such possibilities already exist in many Member States and thus will simply perpetuate the existing statu quo.
To conclude on enforcement, the SEC’s measures are definitely the ones to follow as they properly address the identified challenges. However, in the EU, there is no willingness to meet them and the difficulties are ultimately left to each Member State.
III - Proposals to Improve Enforcement of Market Abuse Regulation in the EU
Drawing from the findings, this paper finally submits that the US enforcement model with its on-going reforms is more adapted to the new challenges posed by financial markets than the EU one. That is why I suggest that the latter should be reformed to take into account the benefits of the latter. Accordingly, I formulate the two following propositions.
The first one is to confer jurisdiction to the ESMA to investigate and prosecute cross- border market abuses while preserving Member States jurisdiction for internal market abuses. The main advantages would be the concentration of resources coupled with the extension of jurisdiction to the whole EU. This would better suit the globalised reality of modern financial markets. To this end, I suggest to reproduce the system of split jurisdiction used in EU competition law. Here, the Member States and the European Commission cooperate to tackle antitrust issues, sharing their competence and using procedures of renvoie. As always, one obstacle lies in the Member States’ reluctance to pass over sovereignty to federal institutions. Nevertheless, even though there would be certain European countries with important financial markets very concerned by this project, others would be more than glad to benefit from the synergies highlighted. Overall, this would harmonise the market abuse legal framework and prevent regulatory competition as well as legal arbitrage between Member States. Ultimately, the most important argument is that all the elements needed for the reform already exist: the institution (ESMA), the model (competition law), the legal framework (MiFID and MAD).
The second proposition answers the core challenge of enforcement which is access to and understanding of market data. Thus, I support the proposition that the ESMA should devote a significant part of his budget and energy to the collection of market data as well as to set up special units with the technological means and human resources to process them. Following the US current reforms, the aim would be to allow real time surveillance of financial markets for regulators.
The consequence would be a significant increase in market supervision and detection of potential global scale fraudulent behaviours. Even though concrete details have to be further elaborated, those two proposals would remedy the EU difficulties identified in Part 3. 23
Having seen enforcement challenges, this paper will now analyse another important element for regulators to tackle market abuses, namely substantive law on market abuses.
24
Part 4 – The Incapacity of Market Abuse Substantive Laws to Encompass New Forms of Market Abuses
In this final part, the question is whether the market abuse legal frameworks in the US and in the EU are capable to grasp the fraudulent behaviours previously described. This paper finds two serious gaps in both regulations (I) which would not be filled by on-going reforms (II). Accordingly, this research proposes the creation of new market abuses (III).
I - The Regulatory Gaps of US and EU Laws on Market Abuses
In order to audit the US and the EU legal frameworks, this paper will follow the syllogism method by applying the legal grounds of market manipulation (a) and insider dealing and front running (b) to the misconducts identified in Part 2. a) Market Manipulation
The substantive law on market manipulation is pretty similar in US and EU laws. In both instances, the actus reus consists in wilfully “creating false and misleading appearance” on the trading of a security resulting in price fluctuation.
Under US law, market manipulation is prohibited by Section 9(a) of the Securities and Exchange Act of 1934 (SEA):
“It shall be unlawful for any person, directly or indirectly, by the use of the mails or any means or instrumentality of interstate commerce, or of any facility of any national securities exchange, or for any member of a national securities exchange— (1) For the purpose of creating a false or misleading appearance of active trading in any security other than a government security, or a false or misleading appearance with respect to the market for any such security, (A) to effect any transaction in such security which involves no change in the beneficial ownership thereof, or (B) to enter an order or orders for the purchase of such security with the knowledge that an order or orders of substantially the same size, at substantially the same time, and at substantially the same price, for the sale of any such security, has been or will be entered by or for the same or different parties, or (C) to enter any order or orders for the sale of any such security with the knowledge that an order or orders of substantially the same size, at substantially the same time, and at substantially the same price, for the purchase of such security, has been or will be entered by or for the same or different parties. (2) To effect, alone or with 1 or more other persons, a series of transactions in any security other than a government security, any security not so registered, or in connection with any security based swap or security-based swap agreement with respect to such security creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others. [emphasise added]”
In the same vein, under EU law, Article 5 of the MAD states: “Member States shall prohibit any person from engaging in market manipulation.” Accordingly, article 1(2) defines market manipulation as follow:
25
“‘Market manipulation’ shall mean: (a) transactions or orders to trade: which give, or are likely to give, false or misleading signals as to the supply of, demand for or price of financial instruments, or which secure, by a person, or persons acting in collaboration, the price of one or several financial instruments at an abnormal or artificial level, unless the person who entered into the transactions or issued the orders to trade establishes that his reasons for so doing are legitimate and that these transactions or orders to trade conform to accepted market practices on the regulated market concerned; (b) transactions or orders to trade which employ fictitious devices or any other form of deception or contrivance; [emphasise added]”
First, when it comes to the identified market manipulations, there are no difficulties to apply those two definitions to layering and spoofing practices. Indeed, they both consist in exercising massive pressure on one side of the book which in the end definitely aims at creating false and misleading appearances and signals. That is why layering and spoofing techniques have already been sanctioned several times in the US and in the UK. Also, it makes no doubt that those two grounds could be applied to momentum ignition strategies. As layering and spoofing, the fraudster’s aim is to create an artificial level of supply and demand to lure other traders. On the contrary, quote stuffing strategies seem to be left unregulated. Here, the trader floods the market with huge amount of orders without any economic rationale in order to encumber traffic data, to slow down other market participants or to conceal another fraudulent behaviour. As a result, quote stuffing is not in itself market manipulation and therefore does not come under those two legal grounds.
Second, contrary to market manipulation, informed trading, whichever form it takes, does not create any false or misleading appearance or signals on the demand and supply of securities. In such case, the trader knows in advance, thank to speed advantage, flash trading or information leakage, the content of upcoming orders. It then trades ahead, buying all the available securities, thereby becoming the only counterparty available and controlling the price. Hence, as there is no artificial appearance or signal, the whole scheme building on real transactions, informed trading does not come under the legal ground of market manipulation. Nevertheless, two other grounds could potentially prohibit it. b) Insider Dealing and Front Running
Informed trading is sometimes referred to as insider dealing or front running. This is because those two market abuses are based on exploitation of information asymmetry. Therefore, prima facie, those two grounds seem to encompass this unfair practice.
Under US law, insider dealing and front running prohibitions are independent grounds which both protect financial markets integrity108. As regard insider dealing, it has been laid down by Section 10(b)-5 of the SEA and further developed by court interpretations:
108 Newkirk, Thomas, ‘Insider Trading – A U.S. Perspective’, 19 September 1998
“It shall be unlawful for any person, directly or indirectly […]: (a) to employ any device, scheme, or artifice to defraud, (b) to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of a security.”109
After several contradicting precedents, US law has finally been fixed by the Supreme Court decision US v O’Hagan, according to which insider trading is prohibited for insider as well as outsider on the basis of the misappropriation theory:
“The “misappropriation theory” holds that a person commits fraud “in connection with” a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.” 110
As regard front running, US law is rather complex and fragmented. Front running happens when a broker trades on a security while in possession of material non-public information concerning the imminent block transaction of one of his customers or passes such information to another who then trades on it. There is no general statutory rule prohibiting front-running in US law. Instead, there are many financial market self-regulatory organisations forbidding it. For example, one is to be found in Rule IM-21110-3 under Section 2100 (General Standards) of the NAD Conduct Rules111, currently under codification as FINRA Rule 5270 with an expanded scope112. However, the general anti-fraud provision contained in section 10(b) and Rule 10b-5 of the SEA has been construed by certain authors as prohibiting front-running: “it is clear that front-running does fall within the ambit of the insider trading prohibitions under section 10(b) and Rule 10b-5. Although a broker and his firm will likely escape liability under the “traditional theory” of insider trading, the “misappropriation theory,” where it is adopted, attaches insider trading liability to a broker and his firm for engaging in front-running activity. In more ways than one, it is now evident that broker-dealer front-running violates Rule 10b-5.”113
In Europe, the MAD prohibits insider dealing and front running114. The core difference with US law is that EU law does not require the insider to breach a fiduciary duty due to the source of the information. Indeed, article 2(1) of the MAD provides:
“Member States shall prohibit any person […] who possesses inside information from using that information by acquiring or disposing of, or by trying to acquire or dispose of, for his
109 SEC Rule 10b-5 codified at 17 C.F.R. 240.10b-5 110 United States v. O'Hagan, 117 S.Ct. 2199, 2211, 1997 111 NAD Conduct Rules
own account or for the account of a third party, either directly or indirectly, financial instruments to which that information relates.”
The article 1 of the MAD defines what is an inside information. Contrary to US law, the definition encompasses the traditional form of insider trading in paragraph 1 but also the notion of front running in paragraph 2:
“’Inside information’ shall mean information of a precise nature which has not been made public, relating, directly or indirectly, to one or more issuers of financial instruments or to one or more financial instruments and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments. […] For persons charged with the execution of orders concerning financial instruments, ‘inside information’ shall also mean information conveyed by a client and related to the client’s pending orders, which is of a precise nature, which relates directly or indirectly to one or more issuers of financial instruments or to one or more financial instruments, and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments.”
Now, going back to informed trading, it appears not to come under any of the two previous legal grounds. First, insider trading concerns trading upon non-public information related to a public company whereas informed trading concerns non-public information related to the nature of an upcoming order. Hence, even though they prima facie appear close, insider trading and informed trading are two different things: “It is critical to make the distinction between true insider trading and other forms of informed trading, despite the blurry economic and legal boundaries of these types of transactions […] this type of trading, whether justly or unjustly called “parasitic” or “predatory,” has little to do with true insider trading and its regulation.”115 Second, front-running arises from the fiduciary relationship between brokers and clients where the formers are prevented from trading on the latters’ upcoming orders without their approval. On the contrary, with informed trading hypothesis, there is no fiduciary relationship between the informed trader and the anticipated trader. In the end, this paper reaches the conclusion that this practice is left unregulated.
Finally, having audited US and EU substantive laws on market abuses, this paper has identified two important loopholes: quote stuffing and informed trading do not fall under market abuse regulation. This must be of great concern because they both undermine financial markets fairness and integrity. Hence, the question is now whether US and EU on-going reforms could fill in those gaps.
II - The Shortfall of US and EU Substantive Law Reforms
In the US and in the EU, substantive law governing technological innovations and market abuses is being reformed. This time, contrary to enforcement, the EU is implementing a much larger and wider effort than the US. This paragraph will compare the reforms and analyse to what extent the identified gaps are filled.
115 Dolgopolov, p.12 (n.59) 28
In US law, the scope of reform is quite narrow and focuses mainly on flash orders and actionable IOI.
First, concerning flash orders, the SEC is concerned with the fact that it creates a two- tiered market in which the public does not have access through the consolidated quotation data streams to all the best available prices. Moreover, it is also concerned by the possibility to implement informed trading strategies: “the 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 today’s 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. As 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.”116 Accordingly, the US regulator is proposing to amend Rule 602 of Regulation NMS under the SEA to eliminate the exception allowing the use of flash orders for equity and options exchanges117. If the proposal were adopted, flash orders would need to be included in the consolidated quotation data and their display to certain market participants would be prohibited.
Secondly, the SEC intends to amend the regulatory requirements of the SEA that apply to non-trading interest in National Market System to reform dark pools118. Amongst other propositions, the regulator is supporting two interesting rules which would have an incidence on market abuses. As flash orders, IOI creates a two-tiered market. That is why the SEC proposes to amend the definition of “bid” and “offer” in Rule 600(b)(8) of regulation NMS determining the public quoting requirement to apply explicitly to actionable IOIs. However, acknowledging the need for large trading interest to benefit from IOI, the new definition would only exclude actionable IOIs for a quantity of stock having a market value of less than $200,000. In addition, the SEC is proposing to lower the trading volume threshold in Rule 301(b) of Regulation ATS that triggers the obligation of ATS to display their best-priced orders in the consolidated quotation data from 5% to 0.25%. The aim is to prevent ATS from displaying IOIs to selected market participants and to ensure that more quotes are available to the public in the consolidation quotation data.
In the end, removing flash orders and actionable IOI from financial markets will cut two important possibilities to practice informed trading. This is a very good starting point because there is no substantive law prohibiting it. Nevertheless, this reform remains by far too narrow and should therefore get inspired by the more ambitious European project.
In the EU, the Commission is engaged in a wide review of the two main financial market directives, namely the MiFID and the MAD. If adopted, the two projects would significantly improve the European legal framework. Amongst numerous new rules, this paper will focus on those having an impact on market abuses.
First, similarly to US law, the MiFID II project provides for extending pre-trade transparency requirement to actionable IOIs (Title II, Chapter 1 – Article 3-6). As demonstrated above, this would result in mandatory publication of IOIs into consolidated data
116 SEC, p.21 (n.73) 117 SEC (n.73) 118 SEC (n.25) 29
feeds ultimately eliminating one mean to practice informed trading. As there is no flash order in Europe, the US and the EU would both have eliminated two possibilities to practice informed trading.
Secondly, even though it does not seem related to market abuses, the MiFID review contains a provision of great importance for our study: the creation of a new regulated venue119. Apart from regulated market and multilateral trading facilities (MTF), a new category of organised trading facility (OTF) would be introduced to regulate more closely dark pools120. Indeed, under the new qualification, operator of an OTF has discretion over how the transaction is to be executed whereas operator of a regulated exchange or MTF is bound by non-discretionary execution rules. The creation of the OTF category to cover dark pools makes then perfect sense in combination with the review of the MAD rules. According to them, the regulation scope is to be extended from regulated market only to MTF, OTF and also to any related financial instruments traded over-the-counter which can have an effect on the covered underlying market (Chapter I General Provisions). Bringing the two previous provisions together, the scope of market abuse regulation is going to be widely extended to cover dark pools qualified MTF, OTF or even crossing network. As a result, the EU regulation would now cover all the hypothesis of market abuses committed on dark pools. Those two propositions would most definitely fill in the serious gap which, since now, enabled market participants to perpetrate frauds within unregulated dark pools.
Thirdly, the MAD review, despite acknowledging that market manipulation grounds are sufficiently large to embrace HFT manipulative strategies, has decided that: “it is appropriate to specify further in the Regulation specific examples of strategies using algorithmic trading and high frequency trading that fall within the prohibition against market manipulation. Further identifying abusive strategies will ensure a consistent approach in monitoring and enforcement by competent authorities.”121 So doing, the review would target quote stuffing, layering and spoofing strategies. Even though such clarification is welcomed, it has been explained earlier that quote stuffing does not really amount to market manipulation and hence should be the object of an autonomous offence.
Fourthly, the reformed MAD would punish attempted market manipulation. The draft proposal explains: “there are situations where a person takes steps and there is clear evidence of an intention to manipulate the market but either an order is not placed, or a transaction is not executed. The Regulation expressly prohibits attempts at market manipulation, which will enhance market integrity.”122 Again, without being of an urgent nature, covering attempted manipulation is welcomed as it will provide regulators with a new tool.
Fifthly, without going into too much detail, the project provides for harmonised administrative sanctions by setting minimum rules for administrative measures, sanctions, fines and disgorgement (Chapter V)123. The review would also add criminal sanctions to produce a stronger deterrent effect in punishing market abuses (Article 2 and 3) or inciting,
119 MiFID II, Paragraph 3.4.1. (n.102) 120 European Commission Press Release, ‘New Rules for More Efficient, Resilient and Transparent Financial Markets in Europe’, 20 October 2011
aiding and abetting or attempting market abuses (Article 4)124. The aim is to prevent regulatory arbitrage and therefore to promote market integrity all over the EU.
In the end, the US reform of substantive law, while constituting a good starting point, remains by far too narrow. On the contrary, the MiFID and MAD reviews in the EU are more ambitious but still, don’t focus on the serious gaps that this paper identified. Ultimately, neither of them has been able to fully address the issues raised by the development of new technologies in financial market.
III - Proposals to Adapt the Substantive Laws on Market Abuses
I have demonstrated in this paper that quote stuffing and informed trading practices are unfair and undermine market integrity. As already seen, quote stuffing consists in flooding financial markets with artificial orders without any intention to execute them and informed trading enables market participants to take advantage of confidential information about upcoming orders. This eventually contributes to destroy market participant’s trust and confidence which determines the amount of capital invested as well as the duration of holding patterns. I therefore propose to extend the scope of market abuses to those fraudulent behaviours. Accordingly and together with the proposals of Part 3, this paper supports the introduction of new quote stuffing and informed trading offences.
As regard quote stuffing, this paper suggests the adoption of the following offence:
“It shall be forbidden, for any market participant, to send massive amount of orders to financial markets without any intention to trade and to subsequently cancel them in whole or in part for the main purpose of encumbering data traffic, slowing down market participants, camouflaging other wrongful behaviours or any other purpose incompatible with the general principles governing the functioning of financial markets”.
In this draft, I have decided not to include any specific reference to the number of orders sent or cancelled in order to confer to the competent authorities some discretion upon what should be considered an abusive behaviour. Also, this draft would be sufficiently flexible to suit any increase in trading speed resulting from potential technological improvements. More specifically, I consider that regulators should implement this market abuse focusing more on the actus reus rather than on the mens rea. It makes no sense to search for the intention underlying strategies automatically implemented by computers. That is why the offence should be characterised every time orders are massively sent without any other purpose than a fraudulent one. I ended up the drafting by giving a few examples as well as a general provision referring to the general principles governing financial markets to encompass any possible fraudulent misconduct.
As regard informed trading, this dissertation proposes the following offence:
“It shall be forbidden, for any market participants, to trade on the basis of material non- public information concerning the nature of an up-coming order such as the identity of the counterparty, the number or the nature of financial instruments, or any other relevant detail,
124 MAD II, Directive, Paragraph 3.3. (n.103) 31
where the said order has not yet been released to the public as a whole, as well as to pass such information.”
As already explained, informed trading is very close to insider trading and front- running. Therefore, I have been inspired by two abuses when elaborating this draft. Here, the real issue is when savvy traders get a piece of information about an upcoming order and generally - but not necessarily – trade ahead of it. In order to protect market participants from information asymmetry exploitation, I support the prohibition to trade on information relating to upcoming orders. I decided to focus on the main element of this unfair practice: the confidential information about an upcoming order. This would counter all the abuses identified in part 2: order anticipation, liquidity detection, flash trading or information leakage exploitation as well as would any other type of informed trading.
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Conclusion
To conclude, it has been studied that financial markets have known significant evolutions during the past twenty years, most of them having been fueled by ever-increasing technological innovations. This is questioning, more than ever, the adaptation of law to modern trading environment. Therefore, this dissertation focused on the interaction between the development of new technologies, amongst which high frequency trading and dark pools, and market abuses, in order to determine the adequacy of the US and EU legal frameworks to the new electronic infrastructure.
Building on statistical and empirical evidence, this combination of new trading techniques with alternative trading platforms appeared to offer new rooms for market abuses, thereby increasing their quantity. In addition, these frauds relying heavily on computer-based trading are evolving in quality. They consist mainly in high speed market price manipulation through layering, spoofing, momentum ignition or quote stuffing strategies as well as informed trading based upon exploitation of confidential information about upcoming orders obtained via speed advantage, flash systems or dark pools information leakage. Hence, savvy traders have now more opportunities to defraud other market participants than in the past.
Confronted to the resurgence of market abuses, this paper explored the reaction of competent regulators. Bringing together enforcement data from the US and the EU, I discovered the worrying absence of any trend in market abuse public sanctions. In fact, regulatory authorities are faced with unprecedented challenges rendering they supervision mission more difficult to accomplish, namely the explosion of market data and the internationalisation of financial market. Then, I turn on questioning the extent to which on-going reforms would be able to meet these difficulties. I found that the US are implementing an ambitious plan to improve their enforcement model whereas the EU is left far behind without any willingness to do so. That is why, inspired by the US model, I formulated two proposals to reinforce market abuse enforcement in the EU: to confer to a federal authority the jurisdiction to investigate and prosecute cross-border market abuses, and to focus on collecting and processing market data in order to ensure real time surveillance.
Then, this research analysed the appropriateness of the US and the EU substantive laws on market abuses to encompass the financial misconducts earlier identified. Applying the syllogism method by cautiously comparing the available legal grounds to the potential frauds, I reached the conclusion that only the most classical examples of market manipulation were reprehensible. Indeed, quote stuffing strategies and informed trading are left unregulated under current laws. Again, I then dealt with the current reforms to verify if there would be able to fill in those gaps. I realised that, even though they globally improve the legal framework, none of them really addresses the identified issue. In the end, concerned by those serious regulatory loopholes undermining market fairness and integrity, this paper offered two draft proposals in order to extend market abuses to quote stuffing and informed trading.
In the end and above all, this study has proven that, when it comes to financial market, nothing should be taken for granted. As a matter of fact, financial markets are evolving as fast as the speed at which high frequency traders operates. This is continuously challenging the foundations of the legal framework which then need to be readapted accordingly. This research has ultimately shown the current disconnection between market abuse regulation and potential fraudulent behaviours and its dramatic effect on market participants’ trust and 33
confidence. In the US as well as in the EU, the legal frameworks are partly outdated, the reforms fall short and urgent proposals must be implemented. Finally, such work is nothing but going back to Boileau’s French poem: “Hâtez-vous lentement, et, sans perdre courage, Vingt fois sur le métier remettez votre ouvrage”125.
125 In English: "Hasten slowly, and without losing heart put your work twenty times upon the anvil." 34
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