The Legal Case that HFT is Illegal

The Legal Case that HFT is Illegal

May 28, 2014 Uncategorized
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(Last Updated On: January 18, 2017)

The (Questionable) Legality of High-Speed ‘Pinging’ and ‘Front Running’ in the Futures Markets

Abstract:

Institutional investors contend that high-frequency trading (HFT) firms engage in high-speed “pinging” and “front running” of their large orders for trades. By sending out lightning fast “ping” orders for trades that operate much like sonar in the ocean, HFT firms can detect when institutional investors will make large trades in futures contracts. Once a large trade has been detected, an HFT firm rapidly jumps in front of the institutional investor, buying up the liquidity in the contract and selling it back at higher or lower prices (depending on if it was a buy or a sell order).

None other than Warren Buffett’s right-hand man, Charles Munger, has called the HFT practice “evil” and “legalized front running.” While many criticize these HFT tactics, they accept their legality at face value. But what if that understanding is incorrect?

This Article posits that at least some high-speed pinging tactics arguably violate at least four provisions of the Commodity Exchange Act – the statute governing the futures and derivatives markets – and one of the regulations promulgated thereunder. The better approach is not to view high-speed pinging as a form of front running or insider trading, but as analogous to disruptive, manipulative or deceptive trading practices, such as banging the close (submitting a high number of trades in the closing period to influence the price of a contract), spoofing (submitting an order for a trade with the intent to immediately cancel it), or wash trading (self-dealing, or taking both sides of a trade), all of which are illegal.

Alpha Highlight:

Banging the close:

A manipulative or disruptive trading practice whereby a trader buys or sells a large number of futures contracts during the closing period of a futures contract (that is, the period during which the futures settlement price is determined) in order to benefit an even larger position in an option, swap, or other derivative that is cash settled based on the futures settlement price on that day.

Spoofing:

utilizing a computer algorithm that was designed to illegally place and quickly cancel bids and offers in futures contracts

Wash Trading:

 Entering into, or purporting to enter into, transactions to give the appearance that purchases and sales have been made, without incurring market risk or changing the trader’s market position. TheCommodity Exchange Act prohibits wash trading. Also called Round Trip TradingWash Sales.

 


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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.