The Doctrinal Quandary of Manipulative Practices in Securities Markets: Artificial Pricing, Price Discovery, and Liquidity Provision.

AuthorDolgopolov, Stanislav
  1. Introduction 1 II. The Judicial Oak and the Scope of Market Manipulation 6 III. Section 9(a)(2) as Another Case Study 19 IV. Exploratory Trading as an Illustration of the Process of Price Discovery 23 V. Liquidity Provision and Market Makers 26 VI. Spoofing/Layering and Disruptive Trading 32 VII. The Limits of Open Market Manipulation 40 VIII. The Implications of the Market Structure Crisis 51 IX. Conclusion 63 I. INTRODUCTION

    Rarely out of the headline news, market manipulation has always been a permanent fixture of securities markets. Even the earliest experiences of a modern-style stock exchange in the 17th century provide evidence of manipulative practices listed by a contemporaneous commentator among "the craftiest and most complicated machinations which exist in the maze of the Exchange and which require the greatest possible cunning." (1) Among recent examples, one might mention numerous incidences of "spoofing" and "layering," (2) the mounting concerns about manipulation in volatility-based products, (3) the overlap of the manipulation-prone cryptospace with the regulatory regime governing securities markets, (4) and increasingly complex methods to detect market manipulation, whether broadly or narrowly defined. (5) Still, it is worth repeating a century-old observation:

    "The operation [of market manipulation] is more easily seen than defined since it is always easier to see something in retrospect than when it is actually taking place. Yet no subject relating to brokerage is more hotly debated and none possesses, perhaps, as much intrinsic interest." (6)

    Despite new iterations of manipulative practices and the rapid evolution of the modern electronic marketplace, there has not been an overhaul of the fundamental regulatory principles. Dating back to the New Deal era, the issue of market manipulation in the realm of securities regulation is still largely addressed by Section 9 of the Securities Exchange Act of 1934 (Exchange Act), (7) which contains specific anti-manipulative provisions, Section 10(b) of the Exchange Act (8) in tandem with Rule 10b-5 (9) promulgated by the U.S. Securities and Exchange Commission (SEC), which embodies a general antifraud ban on manipulative and deceptive practices, Section 15(c) of the Exchange Act, (10) a similar antifraud ban on manipulative and deceptive practices of broker-dealers in particular, and Section 17(a) of the Securities Act of 1933 (Securities Act), (11) yet another general antifraud ban. The antifraud nature of the last three provisions is consistent with the traditional understanding of market manipulation in securities markets as a fraud-based offense, inevitably coloring the very word "manipulation." (12)

    Some uncertainty about the very reach of legal tools aimed at market manipulation and their definitional clarity dates back to one of the earliest forays into the very possibility of creating federal securities law, the congressional Money Trust Investigation, also known as the Pujo Hearings. (13) The official report resulting from the hearings touched on many regulatory issues relevant for securities markets, for instance, in connection with corporate disclosure standards, insider trading, and short selling. (14) Not surprisingly, the topic of market manipulation had not escaped its attention, with the section labeled "Manipulation" addressing the following concerns:

    A very important phase of speculation on the New York Stock Exchange is the manipulation of prices up or down, as desired, without regard to the real value of the securities, and the creation of a false appearance of activity in particular stocks.... [T]his practice prevents the exchange from faithfully reflecting the current value of securities--one of its true functions.... (15) More specifically, the report pointed to some instances of "prices [being] artificially raised or lowered through the concentration of buying or selling orders" and "unreal appearances of activity... created through the giving by the same person or persons of simultaneous orders to buy and sell particular stocks." (16) Importantly, the report also proposed a comprehensive federal statute, which, among other things, proscribed "manipulation" defined as trading practices

    for the purpose of giving to such transactions or to the market in such securities, or to the public, a false or misleading appearance of activity, or to artificially depress, inflate, or otherwise influence the market price thereof in order to sell or purchase or procure the sale or purchase of any of such securities of such issue, or to attract public attention to such securities to induce the purchase or sale thereof by others [or] for the simultaneous or substantially simultaneous purchase and sale of any such security by or for or on behalf of the same persons or interests, whether accomplished by means of genuine or fictitious purchases or sales, or both. (17) Even this early effort to define and proscribe market manipulation had raised some lingering questions, such as the very definition of "artificial" price movements and whether false or misleading market activity expressed in terms of trading volume or any other metric could be logically separated from actual or intended artificial pricing.

    Overarchingly, an analytical framework for crafting a definition of market manipulation should consider the process of price discovery and liquidity provision as key market mechanisms. Broadly speaking, the process of price discovery is a simultaneous aggregation of trading interests in the marketplace, which is based on the applicable trading protocols and the mode of interaction of different trading venues, and the informational content of observed and perceived trading interests in order to arrive at some equilibrium price as a reflection of the marketplace's judgment with some degree of accuracy. (18) In its turn, liquidity provision represents a great variety of trading strategies--and a substantial portion of overall market activity--to enhance the interaction of other trading interests, and such strategies may likewise be performed by different types of market participants, including, but not limited to, designated market makers on organized trading venues. (19) Importantly, these two market mechanisms are interdependent: "Price discovery and liquidity provision interact in a mutually supporting manner: one would expect price discovery to be sharper in a more liquid market and, reciprocally, that liquidity provision would be more forthcoming in a market that delivers better price discovery." (20)

    An approach to market manipulation incorporating the process of price discovery and liquidity provision could be utilized for several pivotal issues that reflect the decades of grappling with practical concerns and the evolution of the architecture of securities markets. Notably, the doctrinal standing of the so-called "open market" manipulation, as a concept that does not involve any fictitious/prearranged transactions or any communication to the marketplace other than orders and consummated transactions, is still unclear in some jurisdictions. (21) At the same time, this concept does have a great deal of weight despite its inherently blurry boundaries between legal and illegal conduct--for instance, whether all orders exposed in the market at arm's length could be described as bona fide or what combinations of "real" orders are impermissible. Moreover, the modern electronic marketplace presents a host of issues relating to potentially manipulative practices, such as "spoofing" and "layering" now seen as being used to trick "market participants using algorithmic platforms" (22) or symbiotic relationships between trading venues and high-frequency traders (HFTs) based on inadequate disclosure, as exemplified by the monumental City of Providence v. BATS Global Markets, Inc. (23)

    This Article sketches a frame of analysis for the doctrinal quandary of manipulative practices in securities markets, drawing on the historical origins of the concept of market manipulation and the realities of the modern electronic marketplace. The essence of market manipulation is maintained to be in artificial pricing based on market activity, as opposed to other indicia of "artificiality," and this definitional approach is compared and contrasted to the process of price discovery and liquidity provision. The Article addresses several key themes relevant for today's securities markets, such as the phenomenon of exploratory trading, market making and the role played by market makers, the doctrine of open market manipulation, spoofing/layering and disruptive trading, and the implications of the market structure crisis. (24) The Article concludes by reassessing the doctrine of market manipulation, including its very scope and continuing relevance, and asserting that no truly radical reappraisal of this doctrine is needed in order for it to function in the modern electronic marketplace.

  2. THE JUDICIAL OAK AND THE SCOPE OF MARKET MANIPULATION

    The most important legal tool against market manipulation, Section 10(b) of the Exchange Act implemented through Rule 10b-5, "a judicial oak which has grown from little more than a legislative acorn," (25) is a more general--and concise--antifraud provision, which contains just one reference to "manipulative" devices in the Rule's caption without deciphering the meaning of this term. As summarized by a leading commentator, "The essence of the fraud in a Section 10(b) manipulation case is the creation of an artificial price." (26) To be...

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