Are you afraid of the dark? How the New York Attorney General is shedding light on dark pools and high frequency trading.

• Author: Marciello, Jordan M.

"And then there is maybe the greatest cost of all: Once very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system up further, or to remain silent as they watch it being screwed up by others." (1)

1. INTRODUCTION

   Similar to nearly every industry in the world, technology forever changed Wall Street. (2) Electronic trading effectively started to replace human buyers and sellers in the early 1990s, but few could anticipate the speeds at which high-frequency trades occur today. (3) Savvy quants--mathematicians who use quantitative techniques to make market predictions--began to dominate the finance world in the early 2000s through the use and development of complex trading strategies and algorithms. (4) These changes altered the trading landscape as more venues, known as pools, became available to participants in the U.S. equity market, such as the dark pool alternative trading system (ATS). (5)

   Dark pools became attractive to investors because, unlike trading in "lit" pools, such as New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotation (NASDAQ), trading that occurs in dark pools does not reveal buyer or seller identities, and transactions are not initially displayed to the public. (6) This structure is ideal for investors looking to make large trades because it cloaks investors' actions from competitors, minimizing price movements and predatory trading. (7) The obscurity of these pools, in conjunction with the sophisticated minds behind these trades, ultimately led to widespread manipulation and legal front-running. (8)

   Until June 2015, there had been little legal action against the firms taking advantage of investors through high-frequency trading (HFT). (9) The New York Attorney General (NY AG), Eric Schneiderman, brought the first big case under a little-known state law from the 1920s, the Martin Act, which grants the NY AG the power to regulate and investigate securities fraud. (10) In efforts to boost investor confidence and ensure the markets work for the entire general public, Schneiderman hopes to stifle the fundamentally unfair situations that HFT has created at the expense of the rest of the market. (11)

   This Note aims to provide a useful overview of the development of the U.S. stock market and show how lawsuits, such as the one against Barclays, will shape the U.S. stock market's future. (12) Part II of this Note will present a detailed assessment of HFT, relevant SEC regulations, and a history of the Martin Act. (13) Part III will discuss the current case against Barclays and how regulators should proceed in handling contemporary dark pool and HFT crises affecting the U.S. stock market and, in turn, its investors. (14) This Note advocates for an approach that seeks a balance between a free market economy and clear regulations, so as to avoid further market exploitation. (15)

2. HISTORY

   1. From Buttonwood Trees to Pushing Buttons

      In mid-May of 1792, twenty-four brokers stood under a buttonwood tree on Wall Street and signed an agreement that would start the trade of securities and create what is known today as the NYSE. (16) Although trading still conjures up an image of a frantic exchange floor, crowded with men yelling in expensive suits, that picture is no longer accurate. (17) Virtually no traders have worked on the floor since 2007, a trend that began after the 1987 stock market crash. (18) When the market fell by 22.61% on Black Monday, October 19, 1987, brokers deliberately did not answer their phones, making it impossible for small investors to sell stocks; this response, or lack thereof, triggered the gradual switch to computers. (19)

      At the time of the Black Monday crash, nearly all trades went through middlemen, known as market makers. (20) This system forced ordinary Americans to utilize these brokers if they wanted to trade on the major exchanges; thus their services came at a hefty fee. (21) This fee, called the "spread," was the difference between what the market maker paid for a stock and what he charged to sell it back to investors. (22) For decades, market makers were the financial elite, profiting off of the average Joe saving for retirement and college educations; this exploitation spurred the movement to computerized trading, as both programmers and the SEC sought to level the playing field through eliminating these middlemen. (23) The crash of 1987 serves as more than a turning point in this analytical timeline: it reveals the interconnectedness of the events in Wall Street's insidious history that have contributed--and are strikingly analogous--to the current situation involving HFT and dark pools. (24)

   2. Need for Speed

      Until 2002, eighty-five percent of stocks were traded on either the NYSE or the NASDAQ (never both), but three years later, the two exchanges became public, for-profit corporations. (25) This transition incited an influx of competition, and, by 2008, there were thirteen exchanges, and stocks were no longer limited to trading on a single one. (26) The SEC initially pushed the exchanges to incorporate in efforts to respond to public complaints of "cronyism" into their practices, though arguably this change just prompted the creation of a new hierarchy centered on speed. (27)

      Electronic trading utilized order-matching algorithms to bring buyers and sellers together, capitalizing on operational efficiencies and risk management, while simultaneously decreasing transaction costs and trading errors. (28) While spreads were significantly smaller than those that market makers made, HFT firms cashed in, due to the sheer volume of transactions they were able to execute in seconds, or more specifically, microseconds. (29) In addition to pure numerosity, the firms quickly exploited other ways to stay ahead through the use of order types and colocation. (30)

      1. Coding Decoded

         The algorithms high-frequency traders used are so complex that it took some time for even experienced traders to understand what occurred behind trades. (31) Algorithms begin by first determining the best way to slice up an order because orders are typically large and attempting to buy all the shares at once would drive up the price. (32) In addition to determining the number of shares to be purchased, the algorithms also dictate when to purchase orders, as well as at what price. (33) These algorithms, known as order types, communicate trader intentions and indicate how buy or sell orders should interact with other orders. (34) Limit orders are most prevalent, as they allow traders to specify constraints, whereas market orders instruct the exchange to buy regardless of market conditions. (35) More complex, compound orders, not widely known by the general trading community, quickly surpassed these original order types; this is one angle high-frequency traders utilized to swindle investors. (36)

      2. Location, Location, Location

         In addition to abusing the plain limit orders, high-frequency traders also exploited server proximity, which gave high-frequency traders market data before everyone else; this coveted proximity became known as colocation. (37) Despite the fact that some exchanges are located hundreds of miles apart, this propinquity gave traders access to price information even faster than if they were to be located on the same street. (38) This dramatically affected high frequency traders' profits because, as a result of their advance knowledge, they were able to capitalize on price discrepancies between exchanges.39 Traders began to use this same strategy to also profit off price discrepancies between dark pools and the lit market. (40) This strategy benefited both public and private exchanges, as it incentivized traders to fragment the marketplace; more sites, where the same stocks changed hands, meant more opportunities to front-run investors. (41) Many critics contend that, over the years, SEC regulations inadvertently supported the proliferation of dark pool trading and, more generally, HFT. (42)

   3. Regulators or Instigators?: A Brief History of the SEC and Relevant Regulations

      Following the Depression and the Stock Market Crash of 1929, the federal government decided to regulate the securities market, which subsequently led to the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934 ('34 Act). (43) The former affects the primary market and sought to mandate disclosure of material information by issuers. (44) The latter, which created the SEC, focuses on secondary market transactions--those made between investors with little involvement by the original issuer. (45) In 1975, Congress enacted Section 11A of the '34 Act, linking the various securities markets through increased communication and updated data processing facilities, known as securities information processors (SIP). (46) The objective of this national market system was to increase overall market efficiency and enhance competition by disclosing more information to brokers, dealers, and investors. (47) Following this structural change, dark pools emerged in the 1980s and remained formally unregulated until the adoption of Regulation ATS (Reg ATS) in 1998. (48)

      Due to the increase in private pools, Reg ATS mandated these venues to either register as a broker, become an official exchange, or remain exempt due to limited transaction volumes. (49) By authorizing the existence of these other venues, the SEC concurrently expressed its dissatisfaction with the exchange duopoly present at the time. (50) Many of the properties that make dark pools attractive to investors, such as their opacity, nonetheless undercut the fundamental principles of the national market system's structure. (51) For instance, a major challenge posed by the existence of dark pools is that they increase competition among individual markets, known as "fragmentation," which, as previously...