HIGH FREQUENCY TRADING9 December 2014

Darragh K. ConnellBarrister

HFT AND ITS DISCONTENTS

“The love of money, we know, is the root of all evil, but not the thing itself. The fault does not lie in the money, but in them that use it. It may be used ill: and what may not? But it may likewise be used well: it is full as applicable to the best, as to the worst uses. It is of unspeakable service to all civilized nations, in all the common affairs of life. It is a most compendious instrument of transacting all manner of business, and (if we use it according to Christian wisdom) of doing all manner of good.” -“The Use of Money” John Wesley (17th February 1744)

WHO NEEDS TO UNDERSTAND LEGAL ISSUES WITH HFT?

• HFT Trading Firms• Institutional Investors• Dark Pool Operators – Broker/Dealers• Other Market Participants• Regulators• Stock Exchanges• Advisers to all of the above

OVERVIEW• What is HFT and how did HFT arise in modern

markets?• Merits of HFT/De-bunking Myths• Legal risks? Market Abuse• Financial risks? FTT• The future of Regulation? – AMF Disclosure

Rules, German HFT Law, MiFID II

DEFINING HFT – OFFICIAL VIEW• Definitional Difficulties• A “high-frequency algorithmic trading technique” is defined in Article 4(1)(39)

of MiFID II as: “an algorithmic trading technique that is characterised by: (a) infrastructure intended to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity hosting or high-speed direct electronic access; (b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders;

and (c) high message intraday rates which constitute orders, quotes or cancellations.”

• ESMA required to further clarify definition and presented two options in June 2014. Obsession with the number of intraday messages – do IMs count?

DEFINING HFT – PRACTICAL VIEW

• In broad terms, HFT = high speed algorithmic proprietary trading using publically available information with the aim of finishing intra-day trading as flat as possible i.e. positions are not held over night

• Extraordinarily high-speed and sophisticated quantitative and algorithmic computer programs for generating, routing, and executing orders are of paramount importance for the financial success of high-frequency traders.

• Trading strategies employed by high-frequency traders are manifold including market making (making a profit on the bid/ask spread) and statistical arbitrage (exploiting temporary price discrepancies)

• High-frequency trading has been a focus of considerable public and regulatory attention since May 6, 2010 known as “the Flash Crash” when $1 trillion wiped off market value in minutes. A subsequent investigation by the SEC cleared high-frequency traders of directly having caused the flash crash (it was a large mutual fund’s order that triggered the sell off) but the Flash Crash illustrated market dependency on automated trading

MODERN ORIGINS OF HFT

• Technological developments involving fibre optic cables and server co-location to enable HFT firms to execute multiple trades in less than 10 milliseconds

• Two Key External Factors precipitating the growth of HFT:(i) Market Fragmentation – more exchanges, more order rules, more dark pool trading(ii) Regulatory Changes – Reg NMS vs. Best Execution Principle containing in MiFID

US Equities Market Fragmentation- More than 12 recognised

public exchanges- 40% of all equities trading

done off-market either by way of OTC trades, block trades or dark pool trading platforms

- More trading venues dispersed geographically enhances the latencies in information flow

- Greater information asymmetries exist when a large institutional order is to be filled across several venues

US v UK Transaction ExecutionUS UK

Regulation National Market Standard (Reg NMS)

Best Execution Principle under MiFID

Introduced by the SEC in 2005 with aim to foster both competition among individual markets and competition among individual order

Current formulation introduced in 2007 with aims of protecting investors; sustaining the integrity of price formation; increase access to transparent markets and promoting competition

Reg NMS requires brokers to guarantee clients the National Best Bid and Offer Price (NBBO)• Price is king under Reg NMS• Timing of price dependent on latencies• NBBO updated infrequently throughout

the day• Reg NMS enables orders to be filled

across exchanges where better NBBO is available

Multi Factorial Test: Article 21 of MiFID requires firms to take reasonable steps to obtain the best possible result for clients when executing orders, taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order

Unintended Consequence: Reg NMS has made it more important to be able to display the best bid and offer prices. A heavy flow of orders can increase the chance an exchange has the best prices. Rebates and complex order types used to attract greater number of trades = liquidity

Unintended Consequence: Recent FCA thematic review in July 2014 found 36 UK institutions did not fully understand or apply the best execution factors properly. Most investment firms lack the capability to effectively monitor order execution or identify poor client outcomes.

MERITS OF HFT

• HFT firms act as market makers• Increase liquidity = high volume of

trades• Narrow the bid/ask spread for the

benefit of all market participants • Increases market efficiencies• Decreases transactions costs for

investors• Assists true price discovery

HFT ≠ FRONT-RUNNING

• One of Michael Lewis’ main objections to HFT is that it allegedly involves front-running which is, of course, illegal market manipulation. FALSE!!!!

• Actual front-running is when a market participant with a fiduciary duty to act as your agent uses knowledge of your trades to make their own trades.

• HFT does not involve front-running since HFT firms generally have no clients and only use publically available information albeit information they have obtained quicker than the rest of the market

• HFTs generally use direct connections to exchanges in order to post bids and offers and collect market data, rather than relying on the centralized SIP feed. This is because the SIP feed is unacceptably slow.

• But that order is already in the market before the HFT firm can see it. HFTs never know what a customer's order is before it's in the market. HFTs cannot owe fiduciary duties to non-existent customers.

DARK POOLS• Dark pool = a type of private stock market usually

operated within a financial institution • The price of a given stock is determined by supply

and demand. When a trader decides he wants to make a large trade, demand has changed in a significant way. As a result, the price of the stock will change a well.

• Unlike public exchanges, supply and demand is kept private in a dark pool until after trades are executed

• Investors that use dark pools may be seeking better prices by masking their trading strategies

• Minimises price distortion

HFT-RELATED CASES VS. BARCLAYS

• Several ongoing cases involving allegations of fraud and tortious liability regarding the operation of Barclays’ dark pool, LX and the routing of orders

• Allegations of misrepresentation regarding amount of HFT within dark pool

• Alleged sale of confidential client information to HFT firms

• Use of client information by Barclays prop. desk• Allegations all denied = preliminary motions to

dismiss

BARCLAYS LATEST DEVELOPMENTS• 5th December 2014• Preliminary Hearing in nationwide class action• Sullivan & Cromwell on behalf of Barclays looking for

a New York federal judge to hear all the cases owing to the complexity (Bank want Judge Jesse Furman to hear it as he’s already hearing 4 of the cases)

• In Re Barclays Liquidity Cross and High Frequency Trading Litigation, MDL No. 2589, U.S. Judicial Panel on Multidistrict Litigation (Washington).

• The Schneiderman case is New York v. Barclays Capital Inc., 451391/2014, New York State Supreme Court, New York County (Manhattan)

LEGAL RISKS? MARKET ABUSE• Critical to have processes and procedures in place to combat risk

of market abuse i.e. behaviour prohibited by S.118 of FSMA• Michael Coscia, HFT trader at Panther, subject to enforcement

action by the FCA in 2013 – he was fined £600,000 for deliberate manipulation of the commodities markets amounting to market abuse under S.118(5) of FSMA.

• In that case, the FCA found that, for a six-week period between 6 September 2011 and 18 October 2011, Mr Coscia used an algorithmic program that he had designed to engage in a form of manipulative trading known as “layering” the order book i.e. rapidly placing and cancelling large orders with the intention of creating a false market in oil futures

• October 2014: Coscia indicted before Chicago Federal Court for commodities fraud and “spoofing” contrary to Dodd-Frank

• 2 important points:– No fine for Panther (importance of practices and procedures)– Coscia received a 30% discount owing to co-operation and

executive settlement procedure (Fine would have been £750k)

Market Abuse Changes• Market Abuse Directive (MAD 2) – UK have opted out but UK

criminal law will be updated to cover scope• Market Abuse Regulation (MAR) – Regulation (EU) No

596/2014 on Market Abuse• Previous four market abuse directives repealed• Effective date 3 July 2016• European Securities and Markets Authority (ESMA)

consulting on technical advice to the Commission• FCA’s Handbook will be significantly revised and much may

change because of the new Regulation and technical standards

• ACTION POINTS: ENSURE CLIENTS UPDATE PRACTICES AND PROCEDURES IN ADVANCE OF IMPLEMENTATION

FINANCIAL RISKS? LATEST ON FTT

• Financial Transaction Tax/Robin Hood/Tobin Tax

• The European Commission first proposed a financial transaction tax in 2011, but only 11 countries have so far committed to the idea.

• The Commission initially proposed a 0.1% tax on share transactions and bond trades and 0.01% levy on derivative transactions

• FTT due in January 2016 in those 11 Member States but deadline will be missed = more discussion particularly regarding derivatives in Latvian presidency commencing in January 2015

• Yesterday 11 EU Finance Ministers failed to agree FTT plans with dispute as to how to tax derivatives: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/11279594/EU-plans-for-Robin-Hood-tax-fall-into-disarray.html

FUTURE REGULATORY ENVIRONMENT

France - AMF• New French banking law coming into force at the start of 2015 will

require any firm using a high-frequency trading system to document the nature of that system and report it to the French regulatory authority, AMF.

• Lack of clarity as to implementation of new reporting rules• No official translation on AMF website• The rules specifically relate to systems used to trade “securities

issued by companies having their head office in France”, which will primarily be stocks listed on Euronext's Paris market.

Germany - BaFin• Germany implemented new HFT rules at the start of 2014,

included a requirement for the firms to be authorised by BaFin. • Numerous delays, moving deadlines. Eventually authorisation took

place. Manageable.

MiFID II & MiFIR

• A firm engaging in a HFT currently takes advantage of the exemptions set out in Articles 2(1)(d) or 2(1)(j) of MiFID will no longer be able to do so due to the revision of these exemptions under MiFID II

• MiFID II will impose licensing requirements on HFTs, order flagging rules and order-to-trade ratios as well as obligations on market-makers.

• A firm engaging in algorithmic trading will be required to have in place effective systems and risk controls to ensure its trading systems are resilient and have enough capacity, are subject to appropriate thresholds and limits which prevent sending erroneous orders

CONCLUSIONON LIBERTY OR ON THE ROAD TO SERFDOM?

• Innovation is relentless– More microwave networks – Increased use of Lazers– Increased Cost (increasingly tight margins)

• Speed not only advantage? • Learning algorithms and self-improving artificial

intelligence• Regulatory Arbitrage• Market Verdict? Outlook Positive for HFT

– 8th December - Temasek purchased 10% stake in Virtu Financial Trading for $200million:

http://www.reuters.com/article/2014/12/08/us-virtu-fincl-m-a-temasek-holdings-idUSKBN0JM06V20141208