Regulating high-frequency trading: man v. machine.

• Author: Gould, Alyse L.

Cite as 12 J. High Tech. L. 273 (2011)

1. Introduction

   Today's financial markets are light years away from those operating when the Securities Act of 1934 ("1934 Act") established the Securities and Exchange Commission ("SEC"). (1) The implementation of computers and advanced mathematics into trading has changed the way the United States and the world do business. (2) High-frequency trading and sophisticated algorithms are a product of the emergence of the internet and quantitative analysis in the 1990s, where speed and accuracy were necessary for best execution of orders. (3) Suddenly, a huge amount of shares could be traded quickly at a low cost. (4) Among the many benefits are high profits, low cost and accuracy in trade execution. (5) It is no surprise that today high-frequency trading techniques account for over fifty percent of trade volume. (6)

   The SEC has had the difficult task of keeping up with the changing market conditions and tools. (7) The risks of many technologically advanced trading tools, including high-frequency trading, as of the beginning of 2010 had yet to be realized while others such as "flash orders" garnered proposed SEC regulation. (8) Given the perceived benefits and unrealized risks, high-frequency trading has been left largely unregulated. (9) The market events of May 6, 2010, popularly known as the "flash crash," caused stock prices to plummet falsely and then sharply rise. (10) While the market stabilized itself rapidly after the faulty algorithm of a single trader took its toll, the event caused many to cry out for regulation of high-frequency trading. (11) The SEC quickly implemented circuit breakers reminiscent of the "Black Monday" market crash of 1987 and erroneous-trade rules. (12) These measures were swiftly implemented and have yet to become permanent. (13)

   Despite an earlier concept release in January 2010 on high-tech market tools, the SEC is now required by the Dodd-Frank Act to conduct research and propose legislation on high-frequency trading regulation. (14) The "flash crash" attributed to high-frequency trading practices caused market instability and dried up liquidity in a matter of minutes. (15) Regulation is required to prevent repeat occurrences based on algorithmic mistakes. (16) Part I discusses the evolution of the financial markets and provides an explanation of the benefits and risks of high-frequency trading. Part II provides background on the SEC's ability to regulate the financial markets and historical responses to advancing technology. Part III will explain specific legislation and regulations regarding high-frequency trading.

   Part IV details the market events of May 6, 2010 and explains the cause of the "flash crash." Finally, Part V will examine whether the SEC's proposed regulations and implemented pilot regulation are an effective way to deal with high-frequency trading. The "flash crash" is reminiscent of the 1987 "Black Monday" crash and so are the SEC's responses. In order to create effective regulation the SEC needs to look ahead in creating responses instead of providing a quick fix, band-aid that will be ripped off in the near future. Regulations should be flexible in order to allow the positive effects of high-frequency trading to continue and provide room for new technologically advanced tools in the future.

2. From Trader to Computer: A Glance at How the World Trades

   Trading floors and broker-dealer influence in the market is becoming obsolete. (17) Technology has knocked down barriers that once made the trading process slow and only possible through the use of a middleman. (18) These advances are, in large part, thanks to the invention of the Internet and direct connectivity from electronic communication networks ("ECNs"). (19) High-frequency trading has made it possible to replace human traders with sophisticated algorithms that can work under the direction of analysts and portfolio managers at a fraction of the cost. (20) The benefits of high-frequency trading are enormous to investment firms, but the risks can create a domino effect that proves the true interconnected nature of high-frequency trading algorithms. (21)

   1. Financial Markets: Evolving from Paper to the Click of a Button

      The stock exchanges of the 19th century required buyers and sellers to purchase seats on the floor of the exchange and be present in order to sell or bid. (22) Those with seats became market makers and were the only ones with access to the securities through the call method. (23) Competition among exchanges created twenty-four hour access to trading and an increased number of listed securities. (24) Additionally, competition caused market makers to eventually evolve into specialist firms in charge of certain securities who would keep a two-sided market--a bid price for themselves and a sell price for the investor instead of the old fashion call method. (25)

      The broker-dealer became the middleman through this two-sided market for investors buying and selling securities on a given exchange. (26) Those on the floor had a distinct advantage over the average investor with no access. (27) Broker-dealers in this manner were able to make a great deal of money by charging fees for their services in acquiring securities. (28) This hierarchy remained the framework for the U.S. financial system through the 1990s.29 Meanwhile, technology in the form of the telegraph, then stock ticker, and finally the telephone, increased the capability of market information sharing. (30)

      By the 1980s, investment firms were using computers for program trading to move large quantities of stock. (31) The electronic trading systems "aggregated market data across multiple dealers and exchanges, distributed information simultaneously to a multitude of market participants, allowed parties with preapproved credits to trade with each other at the best available prices displayed on the systems, and created reliable information and transaction logs." (32) The sophisticated electronic trading systems were initially reserved for select exchanges and networks and were not the trading norm. (33) It was not until the 1990s that the systematic computer-based trading associated with high-frequency trading emerged as the method of choice. (34)

      By the 1990s the Internet was introduced to the world and it changed the face of trading. (35) The Internet enabled investors to go out on the web and match buyers and sellers without the use of broker-dealers. (36) This process created electronic communications networks ("ECNs"). (37) ECNs work through algorithms in order to quickly match buyers and sellers at an optimal price. (38) The ability of ECNs to allow trades over the internet lead to the creation of online broker shops offering direct access to trading for investors, and essentially eliminated the need for investors to go through broker-dealers. (39) Additionally, the Internet created savvy new trading techniques to capitalize on the technology of the Internet. (40) Suddenly, traders and analysts became mathematicians and physicists in order to produce sophisticated algorithms to go out into these "liquidity pools" created by ECNs and place high volume trades quickly. (41) Speed in trading became essential to profit and high-frequency trading emerged. (42)

   2. Today's Tools of the Trade: High-Frequency Trading

      High-frequency trading ("HFT") is becoming one of the most popular trading tools around the world. (43) HFT accounts for over fifty percent of trading volume and those countries and investors who do not engage in the practice are at a disadvantage. (44) HFT functions on the "idea that properly programmed computers are better traders than humans." (45) Put simply, HFT uses sophisticated quantitative computer programs and algorithms to execute large quantity trades rapidly. (46) HFT traders hold positions in securities for a very short period of time and make profits by collecting fractions of a penny on each share of a large quantity trade. (47) Positions are not held overnight by these investors, which further reduces the cost and risk of the position as they return to cash. (48) Traditional securities traders and exchanges are feeling the pressure from the success of HFT. (49)

      The functionality of the algorithms used to execute trades varies depending upon the trader's goals. (50) Trading generally employs a variety of algorithms, however not all algorithms are meant for high-frequency trading. (51) Successful HFT requires, in particular, two types of algorithms: optimization algorithms and signaling algorithms. (52) Optimization algorithms seek to execute trades in the right amount, at the proper time and at the best price after the decision to transact in a security has been made by the trader or portfolio manager. (53) The signal algorithm, on the other hand, determines whether to trade a particular security or not--otherwise known as portfolio allocation. (54) Firms that utilize high-frequency algorithms enjoy the benefits of lightning-quick trading speeds in vast quantities, accuracy in execution and trading methods that cost significantly less than employing a human trader--all while generating large profits for the firm. (55)

      In addition to the various benefits HFT provides to the trader, it also provides a level of efficiency to the market as a whole. (56) For example, HFT is made possible because of ECNs, which are known as "liquidity pools." (57) HFT occurs on ECNs avoiding exchanges and broker-dealers, allowing the traders to transact in large quantities, adding liquidity to these pools. (58) With the addition of liquidity, reduced costs, and the typically error-free way in which HFT traders operate, it creates a more stable market through smoother operation. (59) Finally, in the interest of making profits and securing the best prices, traders are making technological advances driving the market into the future. (60)

      Despite the many perceived benefits of HFT, the practice...