Mi Hyun Yoon, Trading in a Flash: Implication of High-frequency Trading for Securities Regulators Worldwide

• Jurisdiction: United States,Federal
• Citation: Vol. 24 No. 2
• Publication year: 2010
• topic: Securities Law,Technology

TRADING IN A FLASH: IMPLICATION OF HIGH- FREQUENCY TRADING FOR SECURITIES REGULATORS WORLDWIDE

INTRODUCTION

An investor logs into her online brokerage account to look up a real-time quote for General Electric Company ("GE"). The investor sees that the stock is trading at 15 bid and 15 1/4 offer on the New York Stock Exchange ("NYSE"). The 15 1/4 offer means that potential sellers are willing to sell a share of GE right now if somebody makes a bid at $15.25. Similarly, potential buyers are willing to buy their shares of GE at $15 per share. The investor places a buy order for 100 shares, which is quickly executed at the $15.25 offer price. The investor is happy because as far as she knows, she got the best market price for her shares.

Things have not always been this simple. If this investor were to trade in the 1970s, when the equity market was dominated by manual stock exchanges, her order would first need to go through a human stockbroker, and then through GE's representative on the floor of a stock exchange.¹The GE representative would then have to find another party on the exchange floor who is willing to execute that buy order. This longer process would incur higher transaction costs for the investor.

Now, imagine today, a large institutional investor, like a mutual fund, wants to buy 100,000 shares of GE. The mutual fund manager needs to execute this large order as quickly as possible to avoid someone else in the market detecting this demand for liquidity and trading ahead of the order.²However, upon detection of the mutual fund's demand for GE shares, a different trader immediately puts out buy orders to scoop up all of the available shares in GE at the best market price of $15.25. Once the mutual fund's buy order is disclosed to the public, the trader then turns around and sells its shares in GE to the mutual fund at a slightly higher price than the previous best market price-

$15.26, deriving a profit.³

The legitimacy of this transaction would depend on whether the trader detected this liquidity in a lawful manner without running afoul of any of the Securities and Exchange Commission ("SEC")'s regulations.⁴This Comment revolves around the legality of a set of methods employed by a select group of highly resourceful market players who detect and act upon such demands for liquidity using their technological advantages.

This Comment evaluates whether the controversial practice of high- frequency trading ("HFT") should be categorically banned and explains its implications in the context of global securities regulations. This Comment advocates global coordination in regulating certain types of HFT strategies that may potentially impose systemic risks on global securities markets. Finally, this Comment argues that such coordination will help prevent international regulatory arbitrage and a "race to the bottom" in international securities regulations.

Part I provides a general overview of the U.S. equity market, including some key players relevant to the HFT issue as well as the SEC's regulatory scheme and goals. Part II describes HFT and its emergence as the predominant source of activity and profits in today's U.S. equity market based on the current literature on this emerging topic. Part III analyzes the arguments for and against various forms of HFT and determines whether some mechanisms, such as flash orders, should be prohibited altogether. Part III suggests that, by failing to cater to the varying needs of different investors, the SEC's restrictive approach may be the root of the perceived HFT problem.

This Comment proposes that instead of instituting a categorical ban on HFT, the SEC should regulate only certain strategies that could potentially create systemic risks and result in harm to the U.S. equity market. This Comment also looks to the more flexible European approach in securities regulation as a possible model for the SEC to consider in future regulation of certain types of HFT. Most nations have not yet established regulations or restrictions on-let alone defined-HFT. This Comment argues for global coordination in defining and regulating HFT, finding support in the need for prevention of international regulatory arbitrage as well as the history of previous international cooperation in facing problems fueled by technological advances.

I. OVERVIEW OF THE U.S. EQUITY MARKET

The technical nature of this topic calls for a brief introduction to the structure, key players, and regulatory scheme of the U.S. equity market as they relate to HFT.⁵

A. Computerization of Trading Centers

The SEC implemented the Regulation National Market System ("NMS") in

1975 to create a national market for securities where market participants could get access to the best available "bid" and "offer" prices of securities regardless of where they were traded.⁶As of 1975, U.S.-listed stocks were manually traded on stock exchange floors.⁷However, technological advances have led to a dramatic transformation over the past three decades from manual to automated computer trading systems for order generation, routing, and execution.⁸This transformation provided better trade execution speed and decreased the spread.⁹It also fostered increased competition between automated trading centers for trading volume in the same stocks.¹⁰Such enhanced competition incentivized trading centers to offer a variety of trading services to different types of market participants in order to attract order flows.¹¹

B. Key Trading Centers

1. Registered Exchanges

Registered exchanges, such as the NYSE and NASDAQ, are self- regulatory entities that implement their own regulations upon approval by the SEC.¹²The SEC defines an exchange as an entity that "[b]rings together the orders for securities of multiple buyers and sellers" and establishes "non- discretionary methods (whether by providing a trading facility or by setting rules)" for order execution.¹³

2. Alternative Trading Systems

Alternative Trading Systems ("ATSs") are systems that meet the definition of an exchange but do not establish fixed rules governing the subscribers' conduct other than trading.¹⁴For example, ATSs can only discipline subscribers by means of prohibiting them from trading on the system.¹⁵ATSs can either function as registered exchanges or as registered broker-dealers¹⁶ with the SEC.¹⁷

3. Broker-Dealer Internalization

Broker-dealer internalization occurs when broker-dealers that are not members of any exchanges or ATSs trade NMS stocks internally within their affiliated institutions, such as proprietary trading firms or proprietary desks of broker-dealers ("proprietary traders").¹⁸More than 200 broker-dealers execute trades internally and act as "over-the-counter" market makers¹⁹or "block positioners."²⁰OTC market makers and block positioners use their own capital to trade as principals-therefore conducting proprietary trading-or trade on behalf of their customers as agents.²¹For example, OTC market makers receive a large portion of individual investors' trade orders from retail brokerage firms and execute these orders by either selling their own shares or buying shares with their own capital.²²Therefore, these internalized trades are executed based on liquidity that is not included in the consolidated quotation data, which is described in Part I.C.1.²³

C. National Market System: Linking All Trading Centers

1. Consolidated Market Data

Under the Exchange Act,²⁴the SEC has national market system goals, such as price transparency, best execution, fair access, and fair competition.²⁵To establish a unified national market system that links all trading centers, Regulation NMS created the consolidated market data²⁶that allow the public to access to "a comprehensive, accurate, and reliable source of information for the prices and volume of any NMS stock at any time during the trading day."²⁷

For pre-trade transparency involving quotes (bids or offers), a customer need not display limit orders²⁸to be included in the consolidated quotation data if displaying such orders would go against the customer's trading objectives.²⁹

However, these orders cannot be selectively displayed to only certain traders since that will lead to "two-tiered access to pricing information."³⁰Simply put, the SEC mandates that if limit orders are displayed, everyone in the market should be able to see them. For post-trade transparency, the registered exchanges and FINRA-affiliated trading centers or broker-dealers must report all transactions of their listed NMS stocks for inclusion in the consolidated quotation data.³¹These entities are required to work together to disseminate these consolidated data on quotations and transactions for NMS stocks through a single processor.³²

2. Trade-Through Rule

As part of Regulation NMS, the trade-through rule requires that all trades must be executed at the best price nationwide, even if it means a trading center has to fill a customer order through its competitor upon failure to provide the best bid or best offer.³³For instance, under this rule, if a trading center cannot match a marketable³⁴buy order at the best national offer, it can either (1) cancel and return that order to the customer, or (2) route the order to another trading center that does display the best price, and therefore, fill the order.³⁵

This way, all trading centers are linked not only by the consolidated quotation data, but also in terms of trade execution.³⁶

A simple illustration in a more familiar context may help. A customer who wants to buy a gallon of gasoline goes to Shell, which offers $2.59 per gallon. However, imagine there is an online consolidated data stream that displays all offering prices for a gallon of gasoline by other gasoline stations. At that time, the best offer in the nation is $2.57 per gallon offered by ExxonMobil. Here, under the trade-through rule, Shell cannot sell its gasoline to the customer since $2.59 is an inferior price compared to the national best offer of $2.57...