Figure 5.1: Fines levied by the UK Financial Services Authority (FSA) for market abuse, 2003-
5.4 Future: how might the relationship between computer-based trading and market abuse evolve in the next ten years?
Concerns have been consistently expressed about the extent of abuse perceived to be conducted through computer-based techniques, and these perceptions may have damaging consequences for market functioning. Because we do not know the true extent of abuse, they should not be dismissed as divorced from reality. What are the available courses of action?
22 Similar or identical strategies are called “liquidity detection” and sometimes “front-running” although the latter expression is inadequate in this context.
23 Paul Squires, head of trading for AXA Investment Managers, (The Economist) 25 February 2012. 24 SR1, p. 51 (Annex D refers).
5.4.1 Leave it to market mechanisms
It is the case that ‘defence mechanisms’ are being developed by the private sector to address
perceptions of market abuse by high frequency traders. In the last quarter only, ingenious new trading systems have been launched specifically for institutional investors worried about predation, gaming and other strategies. These systems may feature one form or another of reduced pre-trade transparency, or they may reintroduce non-anonymity in trading, thus allowing a large investor to select the set of counterparties they wish to interact with, at the exclusion of, for example, proprietary traders. Other ‘solutions’ include software that assesses the ‘toxicity’ of order flow on each venue by examining patterns in recent activity and giving a ‘green light’ when trading is considered safe25. It has also been argued that dealing with HFT-driven abuse could be left to trading venue operators themselves, as they should have strong commercial incentives to provide order books that are seen as ‘clean’. However, such a purely market-driven approach may not adequately address perceptions of abuse for at least two reasons. First, many large investors doubt that trading venues have adequate incentives to be tough with high frequency traders, as HFT firms are one of their most important customer groups. Leaving it to trading venue operators to police abuse thus runs the risk of harming price formation by pushing investors to trade ‘over-the-counter’ (OTC) or in dark venues. This in turn increases the fragmentation of order flow across venues and aggravates order flow imbalances and volatility. Second, abuse is now possibly easier to conduct across venues and borders than in the past. Thus, market surveillance that puts too much reliance on individual trading venues is very unlikely to be effective. As a trader notes:
we monitor the use of our infrastructure to prevent market abuse. But a high-frequency, multi-broker, multi-exchange strategy could trade buy orders with us, for example, and the sell orders elsewhere. If we don’t see the sell order, it is very difficult for us to identify that instance of market abuse26 .
5.4.2 Address perceptions of the incidence of abuse
This strategy may cover two courses of action that are under active consideration in other mature markets and ought not, in principle, to be controversial. The details of implementation and the investment required are not trivial, however.
The first course of action is to convince market participants that regulators have the ability to deter abusers. This has two aspects: regulators must be able to levy penalties that are financially significant and they must also convince participants that the probability of abuse being detected and fines being incurred is not negligible27. Regarding the first aspect, the imposition of large fines in a few high- profile cases does not seem to have convinced investors that abusers have been deterred. Regulators seem determined to move on to the next level: making abuse a crime. This is most obviously the case in Europe under the proposed Directive on Criminal Sanctions for Insider Dealing and Market Manipulation. As for the second aspect, the market must also be convinced of the regulators’ ability to detect abuse. The qualitative evidence available suggests that there is considerable room for improvement, as large investors express a lack of trust in the ability of regulators to tackle abuse. From SR1:
About 90% of respondents do not believe that regulators have sufficient data, technology or expertise to effectively detect market abuse28.
25 Order flow on a venue may be described as ‘toxic’ when, if a market participant executes on that venue, the probability of incurring a large trading loss is high. The participant might incur such losses when trading counterparties have superior information or are able to anticipate the individual’s trading activity.
26 Holley (2012).
27 For a summary of the economics of corporate crime, including market manipulation, see The Economist (2012). 28 SR1, p. 24 (Annex D refers).
This in turn may comprise at least two areas for improvement:
• The generation and storage of data that would permit both real-time surveillance and ex-post investigations, and allow identification of firms and, in some cases, clients. This is being discussed at European level in continuing debates on transaction reporting, and in the USA, under the perhaps more ambitious header of ‘Consolidated Audit Trail’ (see EIA17 for more details)29. Requiring HFT firms to keep their trading code for some period, including a description of the rationale behind it, could also enable better enforcement.
• Once the data are available, there is a need to increase the regulators’ ability to process and interpret them. In the USA, a report by the Boston Consulting Group recently warned that the Security and Exchange Commission (SEC) had to substantially improve its sophistication in information technology to stand any chance of detecting market abuse30. The report notes that:
The agency does not have sufficient in-house expertise to thoroughly investigate the inner workings of such [trading] algorithms (…) [and recommends that] The SEC should have staff who understand how to (…) perform the analytics required to support investigations and assessments related to high-frequency trading. (…) the SEC requires people who know how high-frequency traders use technology31.
These issues affect EU regulators to the same extent. Individual brokers can contribute to market surveillance (by, for example, filling out Suspicious Transaction Reports (STR) introduced in the EU by the Market Abuse Directive of 2003). One level up, so can exchanges and trading venues, which operate a mix of real and delayed time abuse/manipulation surveillance systems. As discussed above, exchange-level surveillance will be particularly useful with respect to strategies that are focused on a single order book, for example quote stuffing or order book layering32. But it seems generally accepted that the hardest part of the task falls to regulators, who must implement monitoring and surveillance across classes of assets, across exchanges and across borders. This approach to curbing abusive practices entails both international coordination and substantial investment but these efforts should both reassure large investors and deter potential abusers.
The second course of action to affect perceptions of abuse is to correct or confirm them through the production of statistically significant empirical evidence. HFT activity leaves an electronic trail so, given the appropriate data, researchers could generate at least preliminary evidence on the prevalence of simple patterns consistent with abuse. Such evidence could also inform policy making, as the three scenarios discussed earlier may have very different regulatory implications. At one end of the spectrum, if abuse is chiefly conducted by high frequency traders taking advantage of slower agents, then ways of slowing down markets may be considered. At the other end, if abuse is largely a matter of perceptions of large investors who feel alienated from market processes as a result of a new trading environment made up of speed, fragmentation and/or reduced transparency, then perceptions should be changed. More large-scale statistical evidence will both help with perceptions and guide regulatory action. As SR1 concluded:
any regulation of AT or HFT should not be undertaken without substantially greater analysis and a better understanding of the issues by policy makers and regulators. Some believe that extensive research is required to determine whether there actually is a problem in the market stemming from AT or HFT33.
29 Very difficult technical issues are involved. An example is to synchronise clocks to the microsecond across the systems of different electronic venues to ensure that orders and trades can be reliably sequenced, a pre-requisite for any investigation of trading patterns. See EIA17 (Annex D refers).
30 Boston Consulting Group report (2011). 31 Ibid. p. 53; p. 260.
32 The London Stock Exchange disciplined one of its members for order book layering in 2009. See LSE Stock Exchange Notice N33/09.
5.5 Conclusions
Economic research thus far provides no direct evidence that high frequency computer-based trading (CBT) has increased market abuse, although this research is at an early stage and incomplete: its main focus is not on the measurement of market abuse during the continuous phase of trading. However, claims of market manipulation using HFT techniques are consistently reported by institutional investors (pension funds or mutual funds) internationally. While these claims are not substantiated by evidence, plausible scenarios can be constructed which show how such abuse could potentially occur.
Policy makers should take such perceptions seriously, whether or not they are true: the actual extent of abuse can never be known and it is perceptions that determine trading behaviour and investment decisions.
Currently, surveys show that institutional investors have little or no confidence in the ability of regulators to curb the behaviour that those investors describe as abusive. While market mechanisms will provide some help, it is likely that these concerns will need to be addressed more directly. This chapter has argued that the need for direct intervention in market operation is not demonstrated at this stage, but that increasing the ability of regulators to detect abuse and produce statistically significant empirical evidence on its extent would help either to confirm concerns or lay them to rest, and thus restore market confidence.
The Report has considered a number of aspects related to CBT and outlined some of the challenges that CBT presents. In the next chapter, the report considers policy measures that aim to address those challenges and what economic impact those measures might have.