HIGH FREQUENCY TRADING IS IN THE FCA’S CROSSHAIRS

By Peter Wright and Julianna Tolan, Fox Williams

High Frequency Trading (HFT) continues to court controversy in the media, financial markets and the political sphere. Cases such as last year’s “Hound of Hounslow” have shone a greater light on the sector and caused many to question this line of finance.

Regulators are now under continuing pressure to police the methods being deployed by these hyper-fast technologies and algorithmic trading practices.

In response, a new piece of legislation, called the Market Abuse Regime (MAR) which came into effect across the EU in July 2016, makes far more explicit links to this industry than any legislation before it.

For firms involved in HFT, the question now is: what does this mean for the policing of their operations?

MAR is designed to tackle several types of manipulation of the financial markets and to empower domestic authorities to prevent, detect and punish this abuse in all its guises.

While much of MAR is directed at more traditional forms of manipulation, there are also signs that regulators are alive to the challenges posed by changes in the marketplace. For example, MAR applies to newer markets like the emission allowances market; and it reacts to recent scandals by expressly prohibiting the manipulation of financial benchmarks like Libor.

But it is the focus on HFT that really catches the eye. MAR provides clarity on what constitutes “market manipulation” when applied to algorithmic and HFT practices.The new regime identifies certain trading methods that would, if used, be likely to constitute market abuse. These include:

• “Painting the tape” – entering into orders to trade in a transaction or series of transactions which are shown on a public display facility to give the impression of activity or price movement in a financial instrument
• “Quote stuffing” –where large numbers of orders are placed and then withdrawn quickly, to flood the market with quotes to be processed
• “Pump and dump” – taking a long position in a financial instrument and thenundertaking further buying activity and/or disseminating misleading positiveinformation about the financial instrument with a view to increasing its price. Whenthe price is artificially high, the long position held is sold
• “Layering” –submitting multiple orders, typically on a single stock, to create the impression that it is highly liquid
• “Spoofing” – placing a large number of orders to sell shares, then rapidly cancelling the order, in order to create pessimism around their value, before purchasing them at a lower price

Conduct is also likely to be deemed market abuse where a trader sends orders to a trading venue by means of algorithmic trading without the intention to trade, and instead to do one of three things: disrupt or delay; obstruct identification of genuine orders; create a false or misleading impression about supply/demand.

Clearly, the FCA is stepping up the focus on HFT.

The question now vexing those working in this space is whether MAR actually changes things when it comes to proving wrongdoing and prosecuting it.

There is a feeling that MAR has in fact done very little to alter the status quo and some question whether it has gone far enough to address the increasingly sophisticated forms of HFT.

The “Hound of Hounslow”, mentioned above provides a good example of this debate. Navinder Sarao was accused of using HFT to cause a £500 billion markets “flash crash” in 2010. An automated trading program he built was used to “spoof” markets, generating large sell orders that pushed down prices. Those trades were then cancelled,before buying contracts at lower prices, profiting as their value increased again.

Mr Sarao challenged his extradition to the US on the basis that his alleged conduct wasn’t a crime in the UK. The challenge was unsuccessful and the Home Secretary signed an order for his extradition earlier this year.

Would MAR have changed the outcome of Mr Sarao’s extradition?

Having said that, the objectives of MAR are reinforced by new requirements introduced under another piece of new legislation – MiFID II. These mandate that a person must notify their home regulator if they engage in algorithmic trading.

Where a person uses a HFT technique, they will generally also be subject to regulatory authorisation. So if a person uses a HFT technique, they will need to consider the need to be authorised by the FCA and notify it that they are engaged in algorithmic trading.

So what does this all mean? Well, if you or your firm are involved in HFT, there is definitely a sharper lens focusing on your business. Indeed, another ‘flash crash’ in August 2015 significantly dented investor confidence and was again widely attributed to market disruption by HFT. While that view was contested by some, it only served to heighten the increased focus on the sector.

HFT operators should not ignore this, they must consider how to mitigate the risks that MAR now poses.

By Peter Wright and Julianna Tolan, Fox Williams

High Frequency Trading (HFT) continues to court controversy in the media, financial markets and the political sphere. Cases such as last year’s “Hound of Hounslow” have shone a greater light on the sector and caused many to question this line of finance.

Regulators are now under continuing pressure to police the methods being deployed by these hyper-fast technologies and algorithmic trading practices.

In response, a new piece of legislation, called the Market Abuse Regime (MAR) which came into effect across the EU in July 2016, makes far more explicit links to this industry than any legislation before it.

For firms involved in HFT, the question now is: what does this mean for the policing of their operations?

MAR is designed to tackle several types of manipulation of the financial markets and to empower domestic authorities to prevent, detect and punish this abuse in all its guises.

While much of MAR is directed at more traditional forms of manipulation, there are also signs that regulators are alive to the challenges posed by changes in the marketplace. For example, MAR applies to newer markets like the emission allowances market; and it reacts to recent scandals by expressly prohibiting the manipulation of financial benchmarks like Libor.

But it is the focus on HFT that really catches the eye. MAR provides clarity on what constitutes “market manipulation” when applied to algorithmic and HFT practices.The new regime identifies certain trading methods that would, if used, be likely to constitute market abuse. These include:

• “Painting the tape” – entering into orders to trade in a transaction or series of transactions which are shown on a public display facility to give the impression of activity or price movement in a financial instrument
• “Quote stuffing” –where large numbers of orders are placed and then withdrawn quickly, to flood the market with quotes to be processed
• “Pump and dump” – taking a long position in a financial instrument and thenundertaking further buying activity and/or disseminating misleading positiveinformation about the financial instrument with a view to increasing its price. Whenthe price is artificially high, the long position held is sold
• “Layering” –submitting multiple orders, typically on a single stock, to create the impression that it is highly liquid
• “Spoofing” – placing a large number of orders to sell shares, then rapidly cancelling the order, in order to create pessimism around their value, before purchasing them at a lower price

Conduct is also likely to be deemed market abuse where a trader sends orders to a trading venue by means of algorithmic trading without the intention to trade, and instead to do one of three things: disrupt or delay; obstruct identification of genuine orders; create a false or misleading impression about supply/demand.

Clearly, the FCA is stepping up the focus on HFT.

The question now vexing those working in this space is whether MAR actually changes things when it comes to proving wrongdoing and prosecuting it.

There is a feeling that MAR has in fact done very little to alter the status quo and some question whether it has gone far enough to address the increasingly sophisticated forms of HFT.

The “Hound of Hounslow”, mentioned above provides a good example of this debate. Navinder Sarao was accused of using HFT to cause a £500 billion markets “flash crash” in 2010. An automated trading program he built was used to “spoof” markets, generating large sell orders that pushed down prices. Those trades were then cancelled,before buying contracts at lower prices, profiting as their value increased again.

Mr Sarao challenged his extradition to the US on the basis that his alleged conduct wasn’t a crime in the UK. The challenge was unsuccessful and the Home Secretary signed an order for his extradition earlier this year.

Would MAR have changed the outcome of Mr Sarao’s extradition?

Having said that, the objectives of MAR are reinforced by new requirements introduced under another piece of new legislation – MiFID II. These mandate that a person must notify their home regulator if they engage in algorithmic trading.

Where a person uses a HFT technique, they will generally also be subject to regulatory authorisation. So if a person uses a HFT technique, they will need to consider the need to be authorised by the FCA and notify it that they are engaged in algorithmic trading.

So what does this all mean? Well, if you or your firm are involved in HFT, there is definitely a sharper lens focusing on your business. Indeed, another ‘flash crash’ in August 2015 significantly dented investor confidence and was again widely attributed to market disruption by HFT. While that view was contested by some, it only served to heighten the increased focus on the sector.

HFT operators should not ignore this, they must consider how to mitigate the risks that MAR now poses.