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«Congressional Research Service 7-5700 R43608 High-Frequency Trading: Background, Concerns, and Regulatory Developments Summary ...»

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High-Frequency Trading: Background,

Concerns, and Regulatory Developments

Gary Shorter

Specialist in Financial Economics

Rena S. Miller

Specialist in Financial Economics

June 19, 2014

Congressional Research Service

7-5700

www.crs.gov

R43608

High-Frequency Trading: Background, Concerns, and Regulatory Developments

Summary

High-frequency trading (HFT) is a broad term without a precise legal or regulatory definition. It

is used to describe what many characterize as a subset of algorithmic trading that involves very rapid placement of orders, in the realm of tiny fractions of a second. Regulators have been scrutinizing HFT practices for years, but public concern about this form of trading intensified following the April 2014 publication of a book by author Michael Lewis. The Federal Bureau of Investigation (FBI), Department of Justice (DOJ), Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), the Office of the New York Attorney General, and the Massachusetts Secretary of Commerce have begun HFT-related probes.

Critics of HFT have raised several concerns about its impact. One criticism relates to its generation of so-called phantom liquidity, in which market liquidity that appears to be provided by HFT may be fleeting and transient due to the posting of and then the almost immediate cancellation of trading orders. Another concern some have is that HFT firms may engage in manipulative strategies that involve the use of quote cancellations. In addition, some observers allege that HFT firms are often involved in front-running whereby the firms trade ahead of a large order to buy or sell stocks based on non-public market information about an imminent trade.

Another criticism is that HFT has increased the level of potential market systemic risk whereby shocks to a small number of active HFT traders could then detrimentally affect the entire market.

A related concern is whether HFT could exacerbate market volatility. These concerns have percolated since the “Flash Crash” of May 6, 2010, when the Dow Jones Industrial Average (DJIA) fell by roughly 1,000 points in intraday trading—the largest one-day decline in the history of the DJIA. The crash was analyzed in an investigative report by the SEC and CFTC which, among other factors, looked at the role that HFT may have played and determined that it was not the cause, but may have exacerbated the crash. Another area of criticism is that HFT often involves two-tiered markets, in which HFT firms pay extra for the right to access data feeds, or to collocate their servers within exchanges’ servers—all of which is designed to give some traders an advantage over others.

HFT’s supporters argue that the increased trading provided by HFT adds market liquidity and reduces market volatility. They argue that HFT is a technological innovation that is the latest evolutionary stage in a long history of securities market making. They assert that HFT has reduced the bid-ask spreads in stock trading, thereby lowering trading costs.

Congressional interest in HFT and the Flash Crash has manifested itself in the 113th Congress both legislatively and in the congressional oversight of the SEC and CFTC. Legislatively, S. 410 (Harkin), H.R. 880 (DeFazio), and H.R. 1579 (Ellison) would levy taxes on various financial trades, including trades conducted by HFT traders. H.R. 2292 (Markey) would require the CFTC to provide a regulatory definition of HFT in the derivatives markets it oversees and require those who do HFT to register with the CFTC.

In June 2014, SEC Chairman Mary Jo White announced that in response to concerns over “aggressive, destabilizing trading strategies in vulnerable market conditions,” the agency was pursuing several HFT-related reform proposals, including requiring unregistered HFT firms to register with the agency.

Congressional Research Service High-Frequency Trading: Background, Concerns, and Regulatory Developments This report provides an overview of HFT in the equities and derivatives markets regulated by the SEC and the CFTC. It also examines the Flash Crash of 2010 and the role that HFT may have played, as well as recent regulatory developments.

–  –  –

Contents Introduction

What is High-Frequency Trading?

Defining High-Frequency Trading

HFT Firms: Alternative Trading Systems, Electronic Communication Networks, and Dark Pools

HFT Technology: Trader Strategies

Analysis

The Current Equities HFT Landscape

Key Factors Behind the Emergence of High-Frequency Trading

Perceived Costs and Benefits of High-Frequency Trading

Some Supportive Arguments for HFT

Some Concerns and Criticisms of HFT

Market Crashes

The Flash Crash of 2010

Mini-Flash Crashes

Regulatory Activity and Response

The 2010 SEC Equity Market Structure Concept Release

Recent SEC Regulatory and Programmatic Initiatives

The European Union Proposes HFT Regulation

Ideas and Proposals for Regulating Equities HFT

HFT in Futures Markets and the CFTC

The CFTC’s September 2013 Concept Release

Contacts Author Contact Information

Congressional Research Service High-Frequency Trading: Background, Concerns, and Regulatory Developments Introduction On May 6, 2010, the Dow Jones Industrial Average (DJIA), a broad stock index, fell by nearly 1,000 points over the course of several minutes and then quickly rebounded. This was one of the largest intraday declines in the history of the DJIA and was described by one commentator as “one of those eye-opening events that exposed many flaws in the structure of the market.”1 Dubbed the Flash Crash, the event led to several analytical studies and reports and to greater scrutiny of a broad trading protocol known as high-frequency trading (HFT), a form of algorithmic securities trading, which has no formal consensus definition.2 In addition to the heightened scrutiny it received after the Flash Crash, HFT, which accounts for a large share of total domestic securities trades, has raised other public policy concerns. Among them are (1) whether it plays a role in exacerbating market fragility; (2) whether it may heighten the market’s systemic risk; (3) whether it enhances or harms the quality of those markets; (4) whether certain kinds of HFT may constitute an illegal form of front-running; (5) whether HFT helps foster a system of two-tiered trading markets that benefits certain traders at the expense of others due to their access to faster trading data and advantageous trade infrastructure; and (6) whether the presence of HFT has been to the detriment of non-HFT investors and investor confidence in the securities markets.





As in earlier major market disruptions, such as the October 1987 market crash (when the DJIA lost almost 22% in a single day, setting off a global stock market decline), congressional interest in the Flash Crash derives in part from its decades-old legislative mandate that, among other things, delegated to the SEC responsibility for investor protection (through a regime of mandatory disclosure) and maintaining fair and orderly markets.

In the 113th Congress, congressional interest in HFT has been reflected in legislation that would levy securities transaction taxes on securities trades, presumably raising the cost, thus reducing the incidence of conducting HFT. Specifically, in the 113th Congress, S. 410 (Harkin), H.R. 880 (DeFazio), and H.R. 1579 (Ellison) would levy taxes on various financial trades, including trades conducted by HFT traders. H.R. 2292 (Markey) would require the Commodity Futures Trading Commission (CFTC) to provide a regulatory definition of HFT in the derivatives markets that the agency oversees. It would also require such high-frequency traders in derivatives to register with the CFTC, submit semiannual reports to the agency, and conform to business conduct requirements that the CFTC may issue. H.R. 2292 would also grant the CFTC the authority to impose civil penalties under the Commodity Exchange Act for violations of a HFT regulation.

The amount of the fine would be based on the duration of the violation. In addition, in exercising congressional oversight authority over the SEC and the CFTC, a number of committee and subcommittee hearings have touched on the subjects of HFT and the Flash Crash.3 Flash Crash, Four Years Later, Still Haunts Wall Street, Wall Street Journal, May 6, 2014, available at http://blogs.wsj.com/moneybeat/2014/05/06/flash-crash-four-years-later-still-haunts-wall-street/.

These are trading systems that employ advanced mathematical models for making transaction decisions in the financial markets.

For example, see “House Financial Services Committee Holds Hearing on Oversight of the Securities and Exchange Commission,” Political Transcript Wire, April 29, 2014, available at http://search.proquest.com/docview/1519661206?

accountid=12084. “House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises Holds Hearing on Equity Market Structure,” CQ Congressional Transcripts, February 28, 2014, available (continued...)

–  –  –

Meanwhile, the CFTC and the Securities and Exchange Commission (SEC), which respectively regulate derivatives and equities, have both issued studies that provide far-reaching explorations of HFT. The studies also posed a number of questions about the value of HFT and posed several ways to further regulate it or to intervene so as to mitigate consequences that some consider to be problematic.

Interest in HFT has also been heightened by the release of the book Flash Boys by Michael Lewis, and its offshoots, including an interview with the author on 60 Minutes and an adaptation of the book in the New York Times. Among other things, a former securities trader at the Canadian brokerage firm RBC charges that HFT firms Lewis reports on have significantly relied on a form of “legalized front running” and observes that many major institutional investors, including various mutual funds, appear to have been unaware of the existence of such allegedly costly behavior to them.4 The Department of Justice (DOJ), Federal Bureau of Investigation (FBI), the CFTC, the SEC, the New York Attorney General, and the Massachusetts Secretary of Commerce are variously conducting investigations and probes into specific HFT firms, certain HFT strategies, and HFT in general.

Specifically, Attorney General Eric Holder has announced that the DOJ is “investigating [HFT] … to determine whether it violates insider trading laws.”5 In addition, the FBI is reportedly probing (1) whether HFT firms are trading ahead of other investors based on information that other market participants cannot see, a possible form of front running, a type of illegal insider trading;6 (2) practices in which a HFT trader submits trade orders and then cancels them to foster (...continued) at http://www.cq.com/doc/congressionaltranscripts-4431399?wr=Nng4dW84NzhVdzJDZ0JleXk2RktJUQ; “House Financial Services Committee Holds Hearing on Oversight of the Securities and Exchange Commission,” CQ Congressional Transcripts, May 16, 2013, available at http://www.cq.com/doc/congressionaltranscripts-4277174?wr= Nng4dW84NzhVdzFvOHpoOG5BZFAyZw; “House Agriculture Subcommittee on General Farm Commodities and Risk Management Holds Hearing on the Outlook for the Commodity Futures Trading Commission, Perspectives from End-Users, CQ Congressional Transcripts,” July 24, 2013, available at http://www.cq.com/doc/ congressionaltranscripts-4322599?wr=Nng4dW84NzhVdzJ2VDNhMGhCUlhGQQ; House Appropriations Subcommittee on Agriculture, Rural Development, FDA, and Related Agencies Holds Hearing on President Obama’s Proposed Fiscal 2015 Budget Request for the Commodity Futures Trading Commission, CQ Congressional Transcripts, March 6, 2014, available at http://www.cq.com/doc/congressionaltranscripts-4436311?wr= Nng4dW84NzhVdzJ2VDNhMGhCUlhGQQ. “House Appropriations Subcommittee on Financial Services and General Government Holds Hearing on President Obama’s Proposed Fiscal 2015 Budget Request for the Securities and Exchange Commission,” CQ Congressional Transcripts, April 1, 2014.



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