REGULATING HIGH-FREQUENCY TRADING: THE CASE FOR INDIVIDUAL CRIMINAL LIABILITY.

• Author: Cosme, Orlando

1. INTRODUCTION

   Technology has crept into most aspects of modern society, and securities trading is no different. (1) Gone are the iconic days of traders yelling in the "pits" of stock exchanges. (2) Nowadays, trading occurs on computer screens in digital markets. (3) Trading has moved from the New York Stock Exchange (NYSE) to data centers, fiber optic cables, and supercomputers located far from Wall Street. (4) One trading strategy, high-frequency trading (HFT), leverages this advancement in technology by utilizing sophisticated computer programs that trade at ultrafast speeds to obtain an edge in the market. (5) While HFT has many benefits, such as increased market efficiency, (6) it also has "increased market susceptibility to certain forms of criminal conduct." (7)

   The 2008 Financial Crisis brought the regulation of financial markets under increased scrutiny. (8) This increased scrutiny coincided with the rise of HFT. (9) The public, frustrated with the financial sector, demanded reforms to ensure that Wall Street did not continue with business as usual. (10 ) Events such as the Flash Crash--during which on May 6, 2010, several markets, aided partly by HFT, quickly collapsed and rebounded--ensured that HFT did not escape these calls for more regulation." However, Congress passed the Dodd-Frank Act, the main legislative response to the financial crisis, in 2010--a few years before HFT obtained market hegemony. Accordingly, the law has no provision that specifically regulates HFT. (12) But what should this regulation be? One tool that governments can use to regulate high-frequency trader misconduct is individual criminal liability. In August 2017, the U.S. Court of Appeals for the Seventh Circuit affirmed United States v. Coscia, (13) upholding the first criminal conviction of a high-frequency trader for spoofing--increasing the relevance of individual corporate criminal liability for illegal high-frequency trading. (14)

   Following the example in Coscia, prosecuting traders in HFT--as opposed to the entities that the traders work for or other forms of regulation--would better serve the government's goal of promoting fair and efficient financial markets. While scholars have discussed which legal tools should be used to regulate and police high-frequency trading, (15) no one has analyzed individual criminal liability as a possible solution. This Comment does so. But it leaves further discussion on the topic--like potential HFT criminal legislation or ways to increase criminal HFT enforcement--to future scholarship.

   First, this Comment provides necessary background information. This includes an explanation of HFT and the issues that arise in attempting to regulate the practice, elaboration of the current HFT regulatory landscape, and a description of the laws currently impacting HFT. Next, this Comment shows how criminal law can better ensure that high-frequency traders are not penalized for legitimate trading activity, which is a major concern of HFT regulation, (16) while still deterring other high-frequency traders from engaging in wrongdoing. Finally, this Comment argues that within criminal law, individual liability should be used because it better furthers the goal of deterrence. Culpable individuals are easily identifiable in HFT, and, when applied to HFT, individual criminal liability leads to preferable consequences. Therefore, criminal enforcement of wrongdoing through individual liability should be utilized to regulate HFT.

2. BACKGROUND

   1. AN OVERVIEW OF HFT

      Although pinning down a precise definition has confounded regulators, (17) the fundamental mechanism at the core of HFT is fairly straightforward: trading firms execute large volumes of trades at lightning fast speeds with the help of computer software. (18) An example of a simple HFT strategy, exchange arbitrage, is illustrative. In exchange arbitrage, high-frequency traders take advantage of the minor discrepancies in a security's price that occur between different exchanges. (19) The trader buys low on one exchange and then sells high on another. (20) The speed at which these trades are executed is vital because the price discrepancies between exchanges only last for a very short period of time--often fractions of a second. (21) Although such price discrepancies are extremely small, significant profits can be made with high volumes of trades. (22)

      Speed is vital to any HFT strategy. To ensure that they are trading the fastest, HFT firms lease or purchase property as close to exchange data centers and servers as possible. (23) HFT firms also purchase (from exchanges) special access to high-speed cables--allowing them to trade on the exchange more quickly. (24) Accordingly, HFT gains its market advantage by superior and faster trading connections.

      Concerns over HFT have grown since the Flash Crash, (25) which I will discuss later in Part II of this Comment, and as the percentage of HFT in terms of total trading volume has increased to between "40 to 70 percent of all trading." (26) As of 2016, HFT constituted a $28 billion industry. (27)

      Although the rise of HFT has raised some concerns, there are many positive effects of the practice. First, it can be very profitable for the trader and trading firm. (28) Second, HFT is beneficial to capital markets because it increases liquidity. (29) Liquidity is one of the most, if not the most, important market characteristics that investors consider. (30) By acting "as a sort of shock absorber," liquidity smooths volatile price swings. (31) Additionally, increased liquidity from HFT increases the willingness of intermediaries that buy and sell securities on their own account (market makers) to transact trades, which in turn further increases liquidity and trading volume. (32 ) Increased liquidity from HFT has also decreased transaction costs. (33 ) Finally, HFT arbitrage closes gaps between markets and allows prices to more quickly reflect new information. (34) Thus, HFT makes markets more efficient. (35)

      Some of these perceived benefits, however, may actually negatively impact the market. Scholars have noted that HFT can harm traditional investors. (36) For example, consider the following scenario: An individual calls their broker to submit an order to buy $60,000 worth of a certain stock. The broker can currently buy the stock for $60 per share, requiring 1,000 shares at that price to fill the individual's order. The broker notices that 500 shares of the stock are being offered on NASDAQ, 300 shares are being offered on the NYSE, and 200 shares on the BATS Global exchange. The broker submits orders in all three exchanges to purchase the 1,000 shares. However, after clicking "submit" on his computer, the broker receives a notification that he purchased less than 1,000 shares. Surprised, he looks at his screen and sees that the cheapest offer for the stock is now above $60. (37) Due to their speed and information edge, high-frequency traders were able to notice "the first portion of the broker's order on one exchange, registered that he was interested in purchasing that security, bought it themselves on the second exchange, and offered it back to the broker at a higher price when his request reached the second exchange." (38 ) Because the high-frequency traders anticipated a larger trade when the order first began to fill, the traditional investor either had to settle with less than the 1,000 shares she ordered or fill the order at a higher price. (39) Thus, by quickly buying and selling securities, HFT unnecessarily raises prices for non-HFT firms. (40)

      Furthermore, even though HFT has been noted to smooth out volatility, it can also paradoxically increase volatility. (41) Situations may occur where, due to HFT being a form of algorithmic trading, "a predatory algorithm can lock in a profit for a proprietary firm from an artificial increase or decrease in price." (42) This can cause a security's price to move substantially for no tangible reason, causing traders to lose significant amounts of money. (43)

      Additionally, the speed at which high-frequency traders can execute trades "has increased market susceptibility to certain forms of criminal conduct." (44) One such strategy is spoofing (45)--where traders enter buy and sell orders for a security with no intention of executing the order, but rather to manipulate the price of the security in a certain direction so that they profit. (46)

      Moreover, another key feature of HFT is that it can blur the line between legitimate trading activity and market manipulation. (47) Market manipulation was prohibited as part of the Securities Exchange Act of 1934. (48) The relevant provision states:

      It shall be unlawful for any person, directly or indirectly ....

      (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 registered on a national securities exchange, any security not so registered, or in connection with any security-based swap or security-based swap agreement with...