We first heard about the SEC’s increased focus on high-frequency trading in June 2014 when the SEC announced its desire to promulgate new rules on high frequency trading to address the lack of transparency in dark pools and alternative exchanges and to curtail the use of aggressive, destabilizing trading strategies in vulnerable market conditions. However, the SEC and other regulators may not need to rely on new rules to regulate high frequency trading. The United States Commodity Futures Trading Commission special counsel Greg Scopino recently published an article in the Connecticut Law Review arguing that certain high frequency trading tactics violate federal laws against spoofing and wash trading.
The trade tactics at issue are called “pinging” and “front-running.” Pinging refers to entering small marketable orders (usually 100 shares) for trades in order to learn about large hidden orders in dark pools or alternative exchanges. Similar to a ship or submarine sending out sonar signals to detect obstructions or enemy vessels, high frequency trading firms can send out lighting fast “ping” orders to detect when large institutional investors will make large trades in futures contracts. If a large trade is detected, then the high frequency trading firms may engage in predatory trading activity by jumping in front of the institutional investor to buy up the liquidity in the futures contract and selling it back at higher or lower prices at the expense of the institutional investor who will end up receiving an unfavorable price for its large order. This type of predatory trading can also be construed as “front running.”
These types of trading tactics may violate provisions of the Commodity Exchange Act that prohibit fraudulent, manipulative or disruptive trading tactics. First, the Commodity Exchange Act prohibits wash trades, which are fictitious, prearranged trades for the same commodity that offset one another and create illusory price movements in the markets. Second, the Commodity Exchange Act also prohibits “spoofing.” Spoofing occurs when an individual bids or offers a trade with the intent to cancel the bid or offer before execution. In the high frequency context, when the high frequency firms “ping” the market and then immediately cancel their order to determine whether a large trade in futures contracts is detected, they may violate the Commodity Exchange Act provisions described above.
Although these trading tactics may violate provisions of the Commodity Exchange Act and provide federal regulators an additional avenue to pursue and curtail these types of manipulative practices, the regulators may have difficulty proving these types of cases. To establish that an individual or firm violated these provisions, prosecutors must prove that the market participant acted with some degree of intent, or scienter, beyond recklessness. Moreover, only circumstantial evidence is typically available to prove a state of mind element such as intent or scienter, adding to the difficulty federal regulators may face by pursuing charges against high frequency traders or trading firms. Despite this perceived hurdle, the United States Department of Justice indicted a high frequency trader under the anti-spoofing provision of the Commodity Exchange Act in October 2014 and ICE Futures United States Exchange enacted anti-spoofing rules on January 14, 2015 to prohibit disruptive trading. The recent uptick in federal regulators’ efforts to curtail spoofing suggests that this is an area ripe for further legislation and litigation in the coming years.