Monday, April 7, 2014

Is High-Frequency Trading a Crime?

Last Friday, U.S. Attorney General Eric Holder appeared before a congressional hearing and told the congressional representatives that the Justice Department was looking into the practice of high-frequency trading to determine whether the practice violates insider trading laws.  This is an issue that the Securities and Exchange Commission and the Federal Bureau of Investigation are already analyzing. 
In high-frequency trading firms obtain trading information from stock exchanges and obtain a time advantage of a few milliseconds to trade before the rest of the investors.  The result is to reap benefits by trading at a more advantageous price than the rest of the investors.  When the trade involve extremely large numbers of shares, profits can be very large.
One type of high-frequency trading involves traders paying stock exchanges for more immediate access to order information.  Then, using algorithms, the firms attempt to predict the movement of the market regarding various stocks.  Based on the predictions, the firms trade in anticipation for future market moves.
The problem confronted by criminal prosecutors, as well as civil enforcement officials, is that the practice does not meet all of the elements of insider trading.  One of the elements of insider trading is that the movement of confidential information must be a breach of a fiduciary duty.  In the scenario provide above, the purchase of the order information does not result in any fiduciary breach.
The second issue involves the possibility of "front running."  This is the practice of a firm trading on its own account ahead of placing trades for its customers to obtain better trading prices.  The Financial Industry Regulatory Authority prohibits "front running" by brokers; however, this prohibition does not apply to high-frequency trading firms that are only trading for their own accounts. 
There may also be a problem with a market manipulation theory of prosecution.  In market manipulation there must be intentional or reckless conduct leading to the manipulation of a stock's price.  There is a potential problem with this theory revolving around the requisite mental state for conviction.  High-frequency traders are not trying to make a stock price rise or fall.  Thus, there is no intent to manipulate the market.  They are attempting to anticipate the movement of the market using an algorithm.  The question becomes whether this action is enough to satisfy the recklessness requirement of any stock movement.  This seems like a theory that would be best tried in a civil context by the SEC before DOJ attempts a criminal prosecution based on it.

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