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HIGH FREQUENCY TRADING AND THE CRIMINAL LAW

high frequency trading

In this extended essay, Dr Sarah Wilson (University of York) considers whether High Frequency Trading on the financial markets contravenes the new criminal market abuse offences located in the Financial Services Act 2012.

SPEED READ

High Frequency Trading (HFT) is a market practice which now accounts for nearly 50% of all financial securities trades across the US and Europe. It is closely associated with algorithmic trading and the use of electronically automated systems to place market orders. There has already been one successful enforcement case in the UK where a form of HFT was held to constitute market abuse, and other enforcement cases have involved variants of HFT known as “layering” and “spoofing”. It is uncertain whether the criminal offences in sections 90 and 91 of the Financial Services Act 2012, established in the wake of the LIBOR debacle, capture forms of manipulative conduct using electronic means. However, on any view the increased use of electronic means makes detection of market abuse considerably more difficult.

COMMENTARY

HFT and the changing face of financial market participation

High Frequency Trading (HFT) is a term of art which has been applied to high speed computerised trading within financial markets, which has dramatically increased during the last decade. As the Association of Financial Markets in Europe (AFME) explain,[i]  the term HFT is often not clearly distinguished from a term with which it is closely associated, that of algorithmic trading, stressing that the former is a term which is a broad one ‘covering various different types of activity’.[ii] But a setting in which trading is automated is clear from how the UK regulator, the Financial Conduct Authority (FCA), explains HFT as the ‘use of automated systems to place market orders at a much faster rate than possible if orders are placed manually’.[iii] This explanation arose from the FCA’s (successful) enforcement in a case involving the use of an algorithmic programme, and thereby facilitate a course of conduct involving a series of orders which were not genuine which was ‘designed to create a false and misleading impression of liquidity for these products’.[iv] In identifying HFT with automation (and where algorithmic assistance is also recognised), research suggests that HFT now accounts for nearly 50% of all trades across the US and Europe,[v] and this reflects how ‘the role and influence of technology in financial markets has grown and will continue to do so’.[vi]

This is of course a pervasive characteristic of the ‘digital age’, and it is the potentially detrimental consequences for financial markets of HFT which is increasingly automated rather than the technologisation of financial transacting per se which scopes regulatory concern with these practices. It is argued that technologisation has changed the character of financial market participation, and that as a symptom of this HFT is squeezing out traditional traders.[vii] For financial markets themselves, HFT associated with increasing automation, and increasing recourse to algorithmic trading, has attracted concerns pertaining to destabilising liquidity,[viii] and undermining resilience and even promoting contagion.[ix] It has also attracted bigger social justice concerns that HFT does not create value for the real economy, and so does nothing to serve goals of improving overall well-being.[x]

Most pertinent, HFT is regarded as being capable of promoting increased ‘abusive’ activity[xi] which can interfere with the effective functioning of financial markets to allocate capital to the sectors of the economy where this is most needed.[xii]These views are not universally accepted of course, with support for HFT mirroring arguments made against prohibitions of market abuse, stressing that such conduct can have beneficial effects for financial markets; with these attributed to adding to liquidity,[xiii] promoting quicker price discovery[xiv] and increasing the overall volume of trading and lower costs for investors.[xv] Indeed it has been asserted that the majority of academic research suggests that HFT activities improve market efficiency, through tighter spreads and increased liquidity.[xvi] And in this regard, even the International Organisation of Securities Commissions (IOSCO) has reflected on lack of evidence that HFT on liquidity, and with the risks identified with HFT being categorised as potential ones.[xvii]

The nature of HFT and detrimental effects for financial markets

Notwithstanding this apparently muted concern about HFT in some quarters, the attention which has been paid to HFT, along with algorithmic trading, by the European Commission in its review of proposals on the Market on Financial Instruments Directive (MiFID), has been interesting.[xviii] MiFID has been welcomed, with this being explicitly identified with how trading which is increasingly commonplace automated can lead to ‘abusive behaviour’.[xix] This and associated concerns about how automation and the retreat from more conventional means of trading can make abuses increasingly difficult to detect and thus to enforce can be seen in how the UK regulator has encountered it in the context of its civil enforcement regime under section 118 of the Financial Services and Markets Act 2000 (FSMA). This clusters around the successful enforcement actions it has undertaken in relation to conduct known as ‘spoofing’ and ‘layering’. In January 2013 the Upper Tribunal upheld the Financial Services Authority (FSA) decision notice issued against Swift Trade for ‘layering’ practices amounting to practices contravening market abuse prohibitions under section 118 of FSMA 2000.[xx] The FSA had reflected on ‘layering’ Order Book manipulation as being abusive in 2009,[xxi] and in August 2013 the FCA dealt specifically with abusive high frequency trading strategies in commodities markets.[xxii] This commentary was orchestrated around the case of Michael Coscia, who in July 2013 in a joint operation between the FCA and the US Commodities and Futures Trading Commission, was fined £597, 993 (USD 903,176). [xxiii]

Coscia was the first market abuse action involving HFT, which the FCA regarded as a victory for delivering on its ‘strategic objective’ of ensuring that ‘markets function well’.[xxiv]The FCA acknowledged the significance of increased reliance on automation and algorithms and the importance of preventing order book manipulation which had been so manifestly facilitated by this; and the ever greater ease in perpetrating abusive automated trading abuses across jurisdictions, particularly in increasingly fragmented global markets.[xxv] This would challenge the operational objectives underpinning the FCA’s strategic objective, with the former embracing securing appropriate levels of consumer protection and protecting and enhancing the integrity of the UK financial system (with this subsisting alongside promoting competition in markets for specified services), which in turn underpinned market abuse prohibitions.[xxvi]

In this setting the FCA explained that the use of algorithmic automated HFT had predominantly occurred in equities markets, but as Coscia demonstrated, such strategies could be adopted across other asset classes.[xxvii] In this instance the abusive behaviour amounted to providing a false impression of liquidity, and was thus capable of damaging the perceived integrity of legitimate liquidity provision strategies, but the FCA insisted that it would look to sanction abusive behaviour of this nature ‘regardless of the asset class or market in which abusive behaviour is undertaken’.[xxviii] This is further embodiment of the FCA’s continued pursuit of ‘credible deterrence’ initiated by its predecessor the FSA, in which the regulator is committed to deploying fully its enforcement machinery to achieve financial markets which are ‘fair, clean and orderly’.[xxix] Coscia involved enforcement under the market abuse regime under section 118 of FSMA 2000 showing this regime to be sufficiently flexible to accommodate innovation promoting ‘speed trading’ assisted by technology and human ingenuity as well as market fragmentation in a context of ever more permeable jurisdictional boundaries.[xxx] In this context, the stress placed on the need for new enforcement tools to be available to regulators by the EU Directive on Criminal Sanctions on Market Abuse (CSMAD) raises an interesting question.

The rationale of the Directive is that regulators need not only strengthened powers to respond to market abuse in a context of rapid innovation and increased jurisdictional fluidity, but actually require ones which are differently configured from at present. This was premised in turn on how much of the current regulatory apparatus of Member States is perceived to lack the ‘deterrent effect’ required to achieve it.[xxxi] Elsewhere it has been noted that, in the setting where the policy currently being pursued by the Directive represents a significant retreat from that embodied by the Market Abuse Directive (MAD) 2003, it was sometime prior to this that the FSA set out its stall as a regulator committed to using criminal enforcement wherever possible in response to market abuse.[xxxii] So would ‘criminal market abuse’ offences now located in the Financial Services Act 2012 be able to accommodate such practices with similar effectiveness as the non-criminal counterpart?

HFT and Criminal Liability in the UK

Given the nature of HFT the most pertinent provisions are likely to be ones located in section 90 relating to market manipulation arising from ‘any act or [engagement] in any course of conduct which creates a false or misleading impression as to the market in or the price or value of any relevant investments’.[xxxiii] The elements of this offence require the accused to have intended, by creating the impression, to induce another person to acquire, dispose of, subscribe for or underwrite the investments or to refrain from doing so or to exercise or refrain from exercising any rights conferred by the investments;[xxxiv] and to know the impression to be false or misleading or be reckless as to whether it is,[xxxv] and intends to make a gain for himself or another or to cause loss to another or expose another to the risk of loss.[xxxvi]

In this light it is interesting that Germany’s new High Frequency Trading Act 2013 is being analysed as pre-empting proposed EU legislation looking to revise MiFID and the MAD.[xxxvii] The Hochfrequenzhandelsgesetz proscribes a licensing requirement for HFT traders, imposes a number of conduct of business and organisational requirements on such persons. The Act also defines market abuse so as to include disruption/delay to the functioning of the trading system; or making difficult third party identification of genuine purchase or sale orders in the trading system; or creating a false or misleading signal about the supply of or demand for a financial instrument. The German legislation allows behaviour to amount to market abuse without a ‘trading intention’[xxxviii] and clearly embodies concerns about the effect of automated HFT trading on disruption to proper market function, and on what can be found expressed in jurisprudence concerning the ‘genuine forces of supply and demand’,[xxxix] and arguably intimates awareness of the anonymity conferred by such automated trading.[xl]

The section 90 offence clearly does not deal with some of these concerns specifically, such as how difficult anonymous trading makes it to for financial market participants to discern a genuine trade from one designed to create false impressions, or disruption and delay in trading systems directly. But much in its orientation is directed towards the ‘mischief’ underlying much of this. The language used to prohibit conduct creating false/misleading impressions of a market or pricing occurring within this in s.90 has been very closely replicated in the new German legislation. Furthermore, contextual readings of section 90 strongly invite concern to ensure that market participants are able to discern a genuine trade from one which is looking to affect investor interest and pricing. This makes its orientation very strongly that of the proper operation of market forces, and whilst ‘gain or loss’ must be intended, it does not actually have to materialise for liability to arise. Elements of the offence do require intention, such as intention to create the impression of that of a gain to be made or a loss avoided/caused to another,[xli] but liability can arise for a person who is reckless as to whether the impression is false or misleading as well as the one who knows that the impression is so.[xlii]

Situated alongside the section 90 offence is section 91 which creates a new criminal offence in making a false or misleading statement or the creation of a false or misleading impression in connection with the setting of a relevant benchmark.[xliii] The impetus for this new offence can be seen explained in amendments made to the legislative proposals embodying the MAD and the CSMAD made in 2011. The 2012 Amendments, enacted in the wake of the LIBOR fixing scandal, were so that ‘our legislative proposals on market abuse fully prohibit such outrages ... to ensure that manipulation of benchmarks is clearly illegal and is subject to criminal sanctions in all countries’.[xliv] The doubt as to whether conventional approaches to market abuse would accommodate this new challenge for market abuse laws lying behind the 2012 European Commission amendments also underpinned the creation of a new specific offence in domestic law in the Financial Services Act 2012. Would a similar approach need to apply in order ‘to ensure that’ HFT which is abusive can be appropriately sanctioned?

There is debate about whether allowing HFT subject to prohibitions is workable when an outright ban would be better for safeguarding market integrity and safeguarding the interests of financial market participants, but this has only limited support. Technology is here to stay, and even regulators themselves readily recognise the benefits of HFT alongside acknowledging concerns raised by it. Although the UK has not as yet opted into CSMAD it is looking to do so ultimately, and existing law may well benefit from directions taken in documentation prepared for the European Parliament’s endorsement. This has defined market manipulation to include entering a transaction (or any other behaviour) which ‘secures, or is likely to secure, the price of one or several financial instruments or a related spot commodity contracts at an abnormal or artificial level’[xlv], and identifies specifically the significance of conduct which ‘has, or is likely to have, the effect of fixing, directly or indirectly, purchase or sale prices or creates, or is likely to create, other unfair trading conditions’ for ‘behaviour . . . considered as market manipulation’.[xlvi]

Interestingly, the LIBOR scandal which led to the introduction of the new section 91 offence is regarded as a reminder in some quarters that ‘forms of manipulation not conducted using electronic means are very much alive’.[xlvii] Crafting criminal offences around HFT may have the benefits associated with ‘specific’ offences, by providing expedience[xlviii] in addressing the issues raised by HFT directly. However the reform movement leading to the Fraud Act 2006 was strongly identified with favour for a general offence approach to activity, where in any case constant innovation in fraudulent practices presented inherent challenge for the law, and where specific offences could quickly become obsolete.[xlix] This latter movement also recognized that increasing incidences of criminality had occurred alongside increased automation across a range of consumer dealings, with this being a pattern set to continue.[l] In the context of HFT specifically it has been proposed recently that automated and anonymous trades in financial markets will make identifying HFT ‘unambiguously’ as market abuse extremely difficult,[li] with it also being necessary for prosecutors to identify victims of abuse.[lii] There are many echoes of this with the origins of the Fraud Act 2006, and much of the spirit of the 2006 Act is evident in section 90’s orientation around conduct seeking ‘gain and loss’.

Is HFT appropriately criminalized and can it be effectively so?

If the merits of creating new criminal offences are apparent, caution should be applied in the light of how there is strong ambivalence about the harms emanating from HFT, and where the creation of new criminal offences must in any case be in accordance with the Criminal Offences Gateway published by the Ministry of Justice in 2011[liii] in response to the Law Commission’s work on Criminal Liability in Regulatory Contexts.[liv] It is also the case that, whether utilizing existing criminal law, or looking to create new criminal offences, enforcement is central. The current European emphasis on ‘credible deterrence’ must operate to ensure that regulators are suitably empowered to sanction behavior which is discovered, and that market participants are convinced that regulators are able to detect abuse. In this regard, it is significant that research points to lack of confidence that regulators have ‘sufficient date, technology or expertise to effectively detect market abuse’.[lv] This is a position which can only be exacerbated by automated dealing associated with HFT, and suggests that new mechanisms are required to address the generation and storage of data which permits both ‘real-time surveillance and ex- post investigations, and allow the identification of firms, and in some cases, clients’[lvi] to a much greater degree than is currently present. 






[i] Association of Financial Markets in Europe (AFME) Position Paper MiFID 2- Algorithmic & High Frequency Trading (April 2012).



[ii] Ibid



[iii] FCA ‘Press Notice FCA fines US based oil trader US $903K for market manipulation’, 22 July 2013 http://www.fca.org.uk/news/fca-fines-us-based-oil-trader



[iv] Ibid



[v] See D Cumming et al (2013) ‘High Frequency Trading and End-of-Day Manipulation’ available at http://www.northernfinance.org/2013/openconf/data/papers/283.pdf, and also A Gerig (2012) ‘High Frequency Trading Synchronises Prices in Financial Markets’ (University of Oxford, Said Business School).



[vi] AFME, MiFID Position Paper, and also see Government Office For Science (2012) Final Report on The Future of Computer Trading in Financial Markets: An International Perspective (London: Government Office For Science) Executive Summary, p. 9, para. 2, and p. 15, para 9.



[vii] Library of the European Parliament, High Frequency Trading (HFT) (2 September 2013).



[viii] AFME, MiFID 2 Position Paper.



[ix] Ibid.



[x] As posited for example in Government Science Office Final Report on the Future of Computer Trading in Financial Markets, Executive Summary ,p. 9 para 2.



[xi] As posited in numerous policy documents referenced herein.



[xii] See Government Science Office Final Report on the Future of Computer Trading in Financial Markets, Executive Summary, p. 9, para 2.



[xiii] With these being longstanding arguments against laws prohibiting insider dealing, as applied more recently to ‘market abuse’ more generally: see T.M Ashe and L. Counsell (1993) Insider Trading (Croyden: Tolley), especially pp. 22-25.



[xiv] Ibid.



[xv] Ibid.



[xvi] AFME, MiFID 2 Position Paper.



[xvii] IOSCO, Consultation Report (2011) Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (CR02-11 2011, IOSCO) p. 29.



[xviii] Following adoption of European Commission proposals by the European Parliament the plenary vote for revisions to MiFID is due to take place during December 2013.



[xix] AFME, MiFID 2 Position Paper.



[xx] 7722656 Canada Inc (Formerly Carrying On Business as Swift Trade Inc)  and  Peter Beck Third Party v Financial Services Authority Upper Tribunal (Tax and Chancery Chamber) June 2012  FS/2011/0017, FS/2011/0018.



[xxi] FSA Market Watch No 33, August 2009.



[xxii] FCA Market Watch No 44, August 2013.



[xxiii] See n.3 above.



[xxiv] Ibid



[xxv] Ibid.



[xxvi] Ibid.



[xxvii] Ibid.



[xxviii] Ibid.



[xxix] Margaret Cole, then FSA Enforcement Director (2009) “Delivering credible Deterrence” FSA Annual Financial Crime Conference speech, 27 Apr 2009, available at http://www.fsa.gov.uk/library/communication/speeches/2009/0427_mc.shtml



[xxx] See emphasis on the importance of ‘collaboration between agencies and across borders’ in FSA Chief Executive Martin Wheately’s recent speech:  ‘The changing face of financial crime’ FCA Financial Crime Conference (London, 1 July 2013), available at http://www.fca.org.uk/news/speeches/the-changing-face-of-financial-crime



[xxxi] European Commission ‘European Commission seeks criminal sanctions for insider dealing and market manipulation to improve deterrence and market integrity’ (Press Release, Brussels IP/11/1218, 20/10/2011). This has resulted in a new Regulation on Market Abuse and Directive on Criminal Enforcement (now known as CSMAD) and where following adoption by the European Parliament in December 2012, the plenary vote for the former occurred on 13 September 2013 and the latter is scheduled for 9 December 2013.



[xxxii] See G. Wilson and S. Wilson (2014, forthcoming) ‘The FSA, “credible deterrence”, and criminal enforcement - a “haphazard pursuit”?’ 21 (1) Journal of Financial Crime.



[xxxiii] S. 90(1).



[xxxiv] S. 90(2).



[xxxv] S. 90(3)(a).



[xxxvi] S.90(3)(b) and (4).



[xxxvii] Manuel Lorenz ‘Germany’s new High-Frequency Trading Act’ Baker & McKenzie Newsletter March 2013.



[xxxviii] Ibid.



[xxxix] See DPP (CTH) v JM [2013] HCA 30.



[xl] Library of the European Parliament, and see also Government Science Office Final Report on the Future of Computer Trading in Financial Markets, para. 5.2, for discussion on how ‘abuse is rarely identified unambiguously’.



[xli] S. 90 (3)(b) and (4).



[xlii] S.90 (a).



[xliii] According to s.93 Financial Services Act 2012.



[xliv] Internal Market and Services Commissioner Michel Barnier in European Commission “Libor scandal: Commission proposes EU-wide action to fight rate-fixing”, IP/12/846 25/07/2012.



[xlv] Article 8 1(a) with (b) illuminating the numerous ways in which behaviour which affects or is likely to affect price can be manifested.



[xlvi] As illuminated under (3).



[xlvii] Government Science Office Final Report on the Future of Computer Trading in Financial Markets, para. 5.1.



[xlviii] See Law Commission (1999) Fraud and Deception (Consultation Paper No 155, London: HMSO), para 4.9 referencing  R v Preddy [1996] AC 815 and Lord Goff’s two schools of thought around the criminalisation of fraud, identifying ‘specific’ and ‘general’ offence approaches.



[xlix] Law Commission (2002) Fraud (Report No 276, London: The Stationary Office) where the Law Commission submitted that ‘By relying on a range of specific fraud offences, defined with reference to different types of consequence, the law is left vulnerable to technical assaults’ (para. 3.19) as well as longstanding concerns that specific offences are prone to being ‘wrongly charged’ as a result of ‘over particularisation’ (para 3.20)



[l] Ibid see paras 1.5-1.7, including a discussion of Preddy ; paras. 4.9 et seq; and also paras 8.36 et seq ‘Misuse (Deception) of machines’. See also a prosecutoral perspective in and also R. Wright ‘The Investigation and Prosecution of Serious and Complex Fraud Towards the 21st century’, addressing the ISRCL Commercial and Financial Fraud Conference (Malta, 12 July 1999).



[li] Government Science Office Final Report on the Future of Computer Trading in Financial Markets, where Chapter 5’s Introduction states (p.87) that ‘the true extent of abuse will never be known’; see also para. 5.2.



[lii] Ibid, para. 5.2.1.




[liv] Law Commission Criminal Liability in Regulatory Contexts (CP No 195, London, The Stationary Office, 2010).



[lv] Government Science Office, Final Report on the Future of Computer Trading in Financial Markets, para. 5.4.2.



[lvi] Ibid.
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The views expressed in this article represent those of the author and not Bright Line Law.

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