High-frequency trading in the U.S. is getting much heat from the FBI and SEC, which teamed up against potentially manipulative trading practices powered by ultra-sophisticated algorithms.
The technology is said to have given rise to rogue strategies such as quote stuffing – flooding the market with quotes – and layering, which can artificially create price movement.
Will Canada’s market regulators ramp up relationships with law enforcement—the RCMP’s Integrated Market Enforcement Team (IMET), perhaps—in a bid to mimic the crackdown south of the border?
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Brandon Barnes, a securities lawyer at Davis LLP, says Canada’s not immune to the manipulative elements of high-frequency trading, adding the issue is timely given that National Instrument 23-103, which targets various risks associated with direct electronic access to markets (DEA) came into effect on March 1.
NI 23-103 mandates risk management and oversight mechanisms for trades. This includes automated pre-trade controls, post-trade monitoring, the ability to disable automated order systems, and an expectation that those responsible for compliance understand electronic trading platforms.
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“The initial discussion about NI 23-103 highlighted the worry that there would be regulatory arbitrage if the Canadian and U.S. markets differed in their administrative and policy management of electronic trading,” Barnes says.
“Given [the trend] towards greater international access to the Canadian capital markets, keeping Canadian rules consistent with the direction in the U.S. is important.”
Last month IIROC weighed in on abusive trading strategies based on algorithmic and high-frequency trading, formally banning such practices.
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However, some say the entire issue of HFT-related market manipulation is overblown.
The vast majority of computer-generated strategies don’t violate the law, says Doug Clark, managing director of research at ITG. And for that reason, law enforcement agencies on both sides of the border may well be chasing a chimera.
“The FBI is reacting to a loud, often under-informed outcry from traditional players who are ill-equipped to succeed in the evolving marketplace,” says Clark, whose research areas include market structure, liquidity events and market impact. “We applaud the FBI for taking these allegations seriously, but suspect they will walk away without having made any enforcement actions.”
He holds similar views of IMET’s efforts.
“The RCMP IMET group has made some noise about market manipulation,” says Clark, “[but] I suspect they are a long ways off from pursuing any one player.”
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While conceding there will be some manipulation in large markets, Clark says concluding the technology is broken or unfavorable to investors would be a stretch.
“The average investor is doing far better today – in terms of the market impact costs of making a large trade – than at any time in history,” he asserts.
The trick for regulators, he argues, lies in being able to selectively target predatory strategies rather than the technology itself — something he says IIROC’s been doing effectively.
“They are now able to take a scalpel to remove the small unwanted activities instead of using a hatchet to a swath of good and bad players from the market,” says Clark.
The real issue, he adds, is monopolistic stock exchanges that control the markets and are perversely incented to act in a manner that isn’t always in investors’ best interests.
“Exchanges catering to HFT players promote increased trading volumes, with little or no regard for the impact on natural investors,” he says. “But it would be a massive stretch to even suggest that any of this activity comes close to being criminal.”
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And, market fraud is already a criminal offence in Canada, Barnes notes.
“Section 380(2) of the Criminal Code criminalizes ‘fraud on the market.’ It’s a very broadly worded section that only requires an intent to defraud (regardless of the means) and an effect on the public market price of shares (or any security) to contravene the section. It carries a maximum imprisonment of 14 years, but is relatively new to the Criminal Code and does not have a long track record of use,” he explains.