It is usually the case that there are not new frauds, just new avenues for deception. As the financial world has evolved into a high-speed race to trade assets while investment strategies are kept secret, both regulators and investors face the challenge of finding the fine line between permissible trading and manipulation aimed at generating unfair profits.
As the markets have changed, with high-frequency trading firms buying and selling financial instruments in the blink of an eye, so have the monikers used to describe misconduct. Yet the underlying goal of manipulating prices remains the same. Long ago, stock trades were reported over ticker tape, and one type of manipulation was called “painting the tape.†Traders would enter orders to give the appearance of activity in a stock to entice others to buy shares, thus pushing the price higher.
Today, a slightly more sophisticated scheme is called “banging the close,†in which transactions are made in one market at the end of the day to benefit a trader’s positions in another market, say derivatives. Same scheme, different means.
Few modern manipulative practices can be executed by individual investors because they usually require large amounts of capital and access to different markets. Manipulators thrive by making just a little bit of profit from lots of trades, unlike those trading on inside information who seek the big score through a quick strike before the information is disclosed.
The growth of high-frequency trading firms and transactions executed on alternative trading systems, called dark pools, have made it more difficult to police potential manipulative conduct. High-frequency traders buy and sell millions of financial instruments but rarely hold a position for more than a day. While such trading provides greater liquidity to the markets, helping to lower costs for all investors, it can also offer new opportunities for manipulating prices.
The very name dark pools connotes the lack of transparency sought by many firms that do not want to tip off the direction of their investments. Dark pools do not provide information about the best prices available in the trading venue. Nor do they engage in self-regulation, unlike so-called lit markets like the New York Stock Exchange or Nasdaq.
The challenge for regulators is ferreting out abusive conduct from permissible programs that may involve thousands of orders entered â€" and often canceled â€" in milliseconds. Trading through dark pools is especially difficult to police because it can be hard to track down exactly what types of orders were entered and whether they were part of ordinary market-making activity or an effort to manipulate the system.
Evolution in the types of investments available has also created new trading opportunities along with the means to abuse the markets. At one time, assets were simply divided between equities and debt, and usually there were minimal links between their values. Today, multiple classes of assets are closely tied together through swaps and derivatives, so price fluctuations in one market can have an effect on many others. That requires regulators to look beyond just the trading in one financial instrument to see whether manipulation may have occurred elsewhere.
Manipulation can also involve benchmark indexes, which are incorporated into a wide variety of transactions, including mortgage interest rates. When an index relies on reports provided by rival market participants, the temptation to furnish false information to affect its value can be powerful because a small shift in value can affect billions of dollars. Several large banks have already paid billions in penalties for manipulation of the London interbank offered rate, or Libor, and investigations are gaining steam into how currency prices were reported in the foreign exchange markets.
A new tool has just been introduced that can help battle manipulation in the futures markets. The Commodity Futures Trading Commission adopted Rule 180.1 in 2011, under authority granted by the Dodd-Frank Act, which allows the agency to pursue enforcement actions for reckless trading that may affect prices, what the rule calls a “manipulative device.â€
Before the adoption of this rule, the agency had to prove a trader intended to affect prices and was effective in doing so through market transactions. This high threshold meant the commission pursued few market manipulation cases. Now, it can take a more aggressive approach in policing trading strategies that can have a significant impact on the markets.
In October, the commission used Rule 180.1 for the first time in its settlement with JPMorgan Chase for huge trades in derivatives â€" the “London whale†trades â€" that cost the bank more than $6 billion in losses. The bank paid a $100 million penalty, and the case let the agency unveil a new approach that allowed it to punish reckless trading practices even without proving there was any intentional misconduct.
The rule is patterned after Rule 10b-5, which the Securities and Exchange Commission uses in a wide range of fraud cases, including those involving market manipulation. These provisions reach more than just actual trading that drives prices up or down because any “manipulative device†can be the basis for a violation, even if it did not actually succeed in causing harm to investors.
The JPMorgan settlement indicates that regulators are taking a much more aggressive approach to trading practices that can affect the price of a wide range of assets. In a speech in September, Mary Jo White, the chairwoman of the S.E.C., said that there would be “more actions relating to sophisticated trading strategies, dark pools and other trading platforms in the coming year.â€
The specter of greater regulatory vigilance for potential market manipulation presents a challenge to investment firms that specialize in high-frequency trading. They will have to discern the fine line between what is permissible and what may be considered a manipulative device.
High-frequency trading, for example, involves the use of algorithms to identify profitable trades in which computers prepare and enter a high volume of market orders in nanoseconds, but many are then canceled just as quickly. It is a low-margin business in which profits are often measured in fractions of a penny, but when multiplied over millions of trades, they can be quite lucrative. So any means to make profits will be considered.
When orders are entered and canceled in the blink of an eye, is that “order stuffing†intended to affect prices or just a common â€" if quite rapid â€" way of doing business? The answer is often difficult to determine without figuring out why the trading was done and how it affected prices. So determining when a trading strategy has crossed the line into manipulation may be more a matter of guesswork than applying a clear legal rule.
The potential breadth of Rule 180.1 and Rule 10b-5 for policing the markets means high-frequency trading firms have to be extra careful to ensure that they do not cross the line, for fear of setting off an investigation that can spook investors.
So as new means of investing and trading develop, regulators will have to figure out how age-old frauds might be perpetrated in new ways. For investment firms, it means being even more vigilant to ensure that a fresh strategy is not viewed as a manipulative device.
