High-Frequency Trading Falls in the Cracks of Criminal Law

Words like “rigged” and “scam,” which have been used to describe how high-frequency trading firms make money in the markets, usually indicate something illegal has occurred. The attorney general, Eric H. Holder Jr., added to that perception when he confirmed at a congressional hearing on Friday that the Justice Department was investigating high-frequency trading “to determine whether it violates insider trading laws.”

Federal prosecutors will join with the Securities and Exchange Commission and the Federal Bureau of Investigation, both of which have been scrutinizing high-frequency trading for some time. The investigations are sure to pick up steam on the heels of the publicity surrounding Michael Lewis’s new book, “Flash Boys: A Wall Street Revolt.”

Mr. Lewis portrays how firms use the advantage of just a few milliseconds to trade ahead of the rest of the investing world to reap profits by snatching the best prices for stocks. This plays into what New York State’s attorney general, Eric T. Schneiderman, has called “Insider Trading 2.0,” a call for greater regulation of trading to level the investment playing field.

The problem, though, is that the firms’ trading methods do not fit comfortably into any of the typical theories of securities fraud that have been used to pursue misconduct.

High-frequency trading comes in different forms, so there is no single way to describe how it is done. One common method involves paying the stock exchanges for faster access to information about the flow of orders so that the firms can try to predict the direction of the market. Using algorithms to analyze data about unfilled orders to buy or sell stocks, they can trade ahead of other investors to take advantage of impending changes in a stock’s price.

When one investor has information not available to the rest of the market to trade profitably, that certainly sounds like the type of insider trading Mr. Holder mentioned in his testimony. On closer inspection, however, high-frequency trading firms probably fall outside the ban on insider trading as it is currently defined, at least if all that the firms are doing is buying information from exchanges.

The cornerstone of insider trading law is identifying a misuse of confidential information that constitutes a breach of a fiduciary duty. The high-frequency trading firms pay the stock exchanges for access to their order information, so there is no violation when they use what has been legitimately purchased. Indeed, as Andrew Ross Sorkin wrote in his DealBook column, it is the exchanges that “are enabling - and profiting handsomely - from the extra-fast access they are providing to certain investors.”

High-frequency traders get the best prices by stepping ahead of others in having their trades executed first, making the transactions of other investors a bit less profitable. This sounds like front-running, in which a broker buys or sells before execution of a client’s order to take advantage of a more favorable price.

The Financial Industry Regulatory Authority, the brokerage industry’s self-regulatory agency, has a rule that specifically prohibits brokers from trading ahead of their clients. But this rule, No. 5320, does not apply to high-frequency trading firms that are not acting on behalf of a client and are only trading for their own accounts. There is no small paradox in the stock exchanges profiting by selling access to information that can be used for something that looks an awful lot like front-running, while Finra enforces a rule prohibiting brokers from doing the same thing.

The S.E.C. has started to crack down on a type of market manipulation called “layering” or “spoofing,” in which a trader sends out orders to create the appearance of activity in a security to induce others to buy or sell, only to cancel the orders. In an administrative proceeding filed last week, the S.E.C. imposed a civil penalty and required repayment of profits of more than $1 million from this type of conduct.

One way in which high-frequency traders try to gather information about the flow of orders is by “pinging” different markets. That means a firm sends multiple orders out into the markets to determine whether any will be filled, which can give an indication of the direction of a stock. It is estimated that over 90 percent of the orders are canceled.

Can this be the basis for pursuing charges against high-frequency trading firms? The problem with proving market manipulation is that the government much show either an intent to artificially affect stock prices or to defraud others.

High-frequency traders send out orders to learn the best price so they can trade ahead of others, not necessarily to drive the price up or down. In fact, they usually do not want the price to move until after they have traded.

Proving intent to defraud requires purposeful or reckless conduct to deprive the victim of property. That standard would be difficult to prove when an algorithm makes the investment decision in the blink of an eye and the firms have no real interest in the underlying value of the companies whose shares they trade.

The government also has the option of pursuing a case through its trusted standby: the wire fraud statute. But high-frequency trading does not appear to deprive anyone of property, a prerequisite to proving a violation.

The ability of some traders to jump in first does not defraud other investors, even though it smacks of unfairness in much the same way as someone cutting to the front of the line at an amusement park.
In fact, Disney now sells access to its most popular rides to those willing to pay a little extra.

Building a criminal case against high-frequency traders, or even a civil enforcement action, will be a problem because the firms are pursuing what Wall Street does best - finding a new way to make money from other traders. They exemplify Bernard Baruch’s comment, “The main purpose of the stock market is to make fools of as many men as possible.”

Even if high-frequency trading does not violate any of the current rules on permissible stock trading, that does not mean using speed to grab the best prices is right. As Joe Nocera pointed out in a New York Times Op-Ed column, “The tactic smells to high heaven, creating an unlevel playing field that costs investors money.”

The question is how to restore at least the perception of fairness in the markets without undermining what the firms argue are the benefits brought by high-frequency trading â€" increased liquidity and narrower spreads between the bid and ask prices. Investors often lose out on the best possible price, but at the same time may be getting better prices than they would have without this type of trading.

That means regulators, particularly the S.E.C., will have to figure out a way to balance the benefits while combating the widespread view that the markets are rigged. Criminal law is not equipped to do that, so don’t expect to see prosecutions against high-frequency traders any time soon.