The New Market Manipulation

• Publication year: 2017

The New Market Manipulation

Tom C. W. Lin

THE NEW MARKET MANIPULATION

Tom C.W. Lin^*

Abstract

Markets face a new and daunting mode of manipulation. With this new mode of market manipulation, millions of dollars can vanish in seconds, rogue actors can halt the trading of billion-dollar companies, and trillion-dollar financial markets can be distorted with a simple click or a few lines of code. Every investor and institution is at risk. This is the new precarious reality of our financial markets.

This Article is about our ominous financial reality, this dangerous new mode of market manipulation, and the need for pragmatic policies to better address the rising threats to manipulate our financial markets. To start, the Article offers an overview about the recent rise and regulation of new financial technology. It begins with a close examination of The Flash Crash of 2010 and the publication of Flash Boys by Michael Lewis. Next, the Article surveys the changing landscape of market manipulation. It identifies traditional manipulation methods like cornering, front running, and pumping-and-dumping, as well as new manipulation methods like spoofing, pinging, and mass misinformation. It explains how new cybernetic market manipulation schemes that leverage modern technologies like electronic networks, social media, and artificial intelligence are more harmful than traditional schemes. The Article then grapples with why this new mode of market manipulation will present critical challenges for regulators. Finally, it recommends three pragmatic proposals for combating the new threats of cybernetic market manipulation by improving intermediary integrity, enhancing financial cybersecurity, and simplifying investment strategies. Ultimately, this Article provides an original and improved framework for thinking and acting anew about market regulation, market operations, and market manipulation.

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Introduction...........................................................................................1255

I. The Flash Crash and Flash Boys...............................................1259

A. The Flash Crash ..................................................................... 1260

1. The Initial Story................................................................ 1260
2. The Trillion-Dollar Man ................................................... 1262

B. Flash Boys: A Wall Street Revolt ........................................... 1265

1. The Setting ........................................................................ 1265
2. The Villains ....................................................................... 1266
3. The Heroes ....................................................................... 1268
4. The Fallout ....................................................................... 1269

II. The New Financial Reality........................................................1270

A. The New Marketplace............................................................. 1270
B. The Early Regulatory Response ............................................. 1277

III. Old and New Market Manipulation.......................................1280

A. Traditional Market Manipulation........................................... 1281

1. Cornering and Squeezing ................................................. 1281
2. Front Running .................................................................. 1283
3. Wash Trading ................................................................... 1283
4. Pumping-and-Dumping .................................................... 1284
5. Benchmark Distortion ...................................................... 1286

B. New Market Manipulation ...................................................... 1287

1. Pinging and Spoofing ....................................................... 1288
2. Electronic Front Running ................................................. 1290
3. Mass Misinformation ........................................................ 1292

IV. Regulatory Challenges............................................................1294

A. Of Resources........................................................................... 1294
B. Of Detection ........................................................................... 1296
C. Of Enforcement....................................................................... 1300

V. Implications and Recommendations........................................1303

A. Intermediary Integrity ............................................................ 1303
B. Financial Cybersecurity ......................................................... 1306
C. Investment Strategies .............................................................. 1310

Conclusion...............................................................................................1314

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Introduction

Wall Street is an illusion.¹ The New York Stock Exchange, the real-time tickers, the traders, the bankers, the brokers, and the bronze charging bull all create the image that Wall Street, and its people make up the center of a transparent, fair, and efficient financial universe. In reality, much of the action today takes place far below and far away from Wall Street—in machines, data centers, super computers, and fiber optic cables located in anonymous buildings on non-descript streets.² In this new financial reality, billions of dollars can disappear in minutes, a handful of individuals can fundamentally transform financial operations, a rogue actor can halt the trading of Fortune 500 companies, and trillion-dollar financial markets can be manipulated with a simple click or a few lines of code.³

In the Fall of 2015, the perils of this new financial reality manifested in an unprecedented Department of Justice announcement of charges against three individuals who allegedly hacked numerous American banks and businesses, "perpetrated one of the largest thefts of financial-related data in history," engaged in massive dissemination of fraudulent market information, and orchestrated a global, multi-million dollar stock manipulation scheme.⁴

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According to the unsealed indictments, the hackers generated over $100 million in illicit gains using only their computers to hack into private servers and manipulate the markets for certain stocks.⁵ Preet Bharara, then U.S. Attorney for the Southern District of New York, described their criminal market manipulation activities as "securities fraud on cyber steroids."⁶

This Article is about this new, perilous financial reality, the emerging mode of new market manipulation, and the need for better pragmatic policies to address the rising technological threats to manipulate financial markets. This Article offers an original, early examination of the new high-tech forms of market distortions that it calls cybernetic market manipulation, explains the critical consequences of these dangerously disruptive actions on the marketplace, and proposes sensible policies to better protect investors and safeguard the financial system.

Building on the author's previous works on new financial technology, and drawing upon a growing literature relating to modern financial regulation, this Article seeks to make three contributions.⁷ First, it aims to provide a cogent,

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early narrative for understanding and explaining the new financial marketplace. Second, it aims to highlight the emerging ways that new financial technologies, electronic communications, and information systems can be leveraged to manipulate financial markets to unfairly privilege the few to the detriment of the many. Third, it aims to recommend workable steps that policymakers and investors should consider to better secure the integrity of the marketplace against new modes of market manipulation. Undoubtedly, pursuing these objectives in a rapidly evolving, dynamic marketplace will necessarily result in a dated and daunting work in progress. Nevertheless, however dated and daunting, such an endeavor is also a useful and worthy one for it can offer insight about the profound, unfolding changes in our marketplace and shed light on the future of financial markets and market manipulation. Ultimately, this Article aspires to provide an original and effective framework for policymakers to think and act anew about market regulation, market operations, and market manipulation.

This Article constructs this framework in five parts. Part I provides background. It examines the Flash Crash of 2010 and the publication of Flash Boys by Michael Lewis, two seminal events that brought market manipulation and new financial technology to the forefront of public attention.⁸ First, it explores the Flash Crash, an unprecedented market event where a trillion dollars disappeared from the marketplace in a matter of minutes. It critiques the 2010 joint investigative report of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) on the event, and the subsequent arrest of a trader in connection with the Flash Crash five years later in 2015. Second, Part I studies the facts and fallout associated with the publication of Flash Boys, a book that lifts the veil on the illusion that is

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contemporary Wall Street and reveals the fraught manipulative inner workings of American capital markets. Through the remarkable tale of an unlikely band of reformers and their battle against high frequency traders, the book explains and exposes how new financial technology has created new ways to "rig" markets.⁹ Part I establishes a foundation for discussing market manipulation and the new financial reality.

Building on that foundation, Part II offers wider context. It does so by connecting the Flash Crash and Flash Boys to the larger sea change occurring in the financial markets. It explains why the Flash Crash and Flash Boys are truly about much larger happenings in the financial...