This article was written by Amrit Subhadarsi a student of National Law University, Orissa.
What is high frequency trading?
In today’s age of dematerialization of securities and electronic trading in securities in stock exchanges, use of complex algorithms and computer systems is the order of the day. Gone are the days when there used to be manual trading in securities through the help of stock brokers. Today, brokers with recognized stock exchanges use software to execute trading in securities, which becomes helpful in executing series of securities market trades and also in adding sufficient liquidity in the stock market. It is an acknowledged fact that substantial amount of liquidity in the stock markets helps in adding stability to the functioning of such markets. It is in this context that the issue of high frequency trading, hereinafter HFT, becomes important. Essentially, HFT is using of algorithms and complex computer systems to execute securities trade orders and to analyse market conditions. Because of quicker processing of orders, the mechanism provides more liquidity infusion into the capital markets of a particular country. Larger volumes of liquidity trade facilitate the price discovery process and result in more price discovery and more efficient prices during the trading day.[i] In securities trading terminology, what is common to all categories of securities trading is that on every trade executed for a particular security, there is a maximum price at which the buyer can purchase the security and simultaneously, there is a minimum price at which the seller can sell the securities to raise capital.
What HFT does in the aforesaid context is that it facilitates faster purchasing of securities by the buyer on the one hand and also quicker selling of securities by the seller on the stock exchange. This is so because; use of algorithms analyzes the market conditions quickly leading to quicker execution of transactions. Also, the more people are buying/selling any particular stocks in larger quantities, the smaller the difference between the buying and selling price will be.[ii] Therefore, theoretically speaking use of HFT in electronic trading in securities is a blessing for large companies willing to raise capital through stock exchanges. Moreover, because it facilitates quicker execution of trade orders, it also gives the buyer of the securities more purchasing power in terms of more allocation of securities within a reduced span of time, thus leading to win-win situation for both the investor and the seller of securities. However, there is also serious research in the US which challenges the claim by HFT proponents that their trades add volume and liquidity to markets.[iii]
Ethical concerns in HFT
The scenario is however not as rosy as it seems. In recent times, both in India and in other jurisdictions questions have been raised over the utility of such algorithmic trading. The reason is that firstly, market intermediaries such as brokers possess the potential to often make the market prices of a stock fluctuate to their advantage. This can affect institutional investors like pension funds, insurance companies, hedge funds, among others, who comprise the majority of investors as compared to retail individual investors who hardly comprise around to two to five per cent in the Indian capital markets. Hence, any manipulation of prices by the brokers of a stock exchange will inevitably have a bearing on the institutional investors. This is not to say that small investors would not be affected, as a securities market based on trading in accordance to market prices makes the market fairer for all categories of investors including the individual or the small investors. It is here that ethical concerns arise because of the fiduciary relationship between the broker and the investor, who is the client. Worse, it becomes very difficult to differentiate between innocent mistakes in executing trading orders and unethical practices. This is because even if a broker diligently pursues his client’s claim for a certain number of shares, it may be that due to the broker being located at distant locations from the stock exchanges and other brokers being in the close vicinity, they can take advantage of faster fibre optic cables and purchase such securities, ultimately offering such securities at higher price to the first broker, who can no longer allocate the number of shares the client had demanded. This can trigger flash crashes which can destabilize markets and can also significantly have a bearing on price of securities listed on stock exchanges. For instance, in 2010 the values of many securities listed on the Dow Jones Index in the US dropped by 9.2% approximately owing to a human error on a computer driven trade order. As a result, the share price of Progress Energy, an electric utility based company in North Carolina plummeted by nearly 90 per cent in a matter of seconds.[iv]
However, in certain cases ethical violations are crystal clear. For instance, at the time of writing, investigations into serious malpractices by the National Stock Exchange (NSE) are still underway by the Securities and Exchange Board of India (SEBI). The investigation began after a letter from a whistleblower was forwarded to SEBI and the finance ministry alleging that there was collusion among NSE officials, OPG Securities, which is a market broker company under the NSE. According to the findings of the Technical Advisory Committee (TAC) of the SEBI, the NSE officials in collusion with OPG Securities had allowed Sampark Infotainment, a non registered Internet Service Provider (ISP) to lay down a dark fibre in its premises which helped the broker company to manipulate prices of securities. The TAC was clear in its recommendation when it observed “NSE violated norms of fair access and allowed some brokers to benefit.”[v] As mentioned above, abuse of HFT can significantly impact institutional investors, and this was exactly observed in this case as well. What is even more intriguing is that even if SEBI had allowed the NSE to engage in algorithmic trading six years ago, the discussion paper to regulate such manipulations is only out now, which raises the presumption that many more such instances may have gone unreported in the mainstream media, ultimately causing losses to long term institutional investors. Considering the above, it is quite ironic that the SEBI chairman, U.K Sinha has in a recent speech acknowledged that “the continual expression, communication, and demonstration of ethical values and practice are essential if a board wishes its orgnisation to operate in line with its core values, and to enjoy the benefits which doing business ethically can bring.”[vi]
Litigation based on HFT
The logical conclusion from the aforesaid examples is that globally the financial losses of investors ought to result in law suits against market broker companies. Unlike in India, where there is hardly any existing evidence on securities fraud litigation based on HFT, in US the litigation based on HFT fraud can be based on grounds like manipulative devices violating rules of national stock exchanges under Rule 10-b5 of the Securities Exchange Act, 1934. Further, securities fraud class action law suits can also be used as a mechanism to hold errant companies accountable under FRCP Rule 23. To counter unfair practices, the ‘fraud on the market presumption’ doctrine is frequently invoked as a settled principle of US securities law. The biggest advantage of invoking this doctrine is that there is no need to prove individual damage suffered as a result of the investment made. All that this doctrine presumes is that an investor who buys or sells stock at the price set by the market does so is reliance on the integrity of the market price.[vii]
The Securities and Exchange Commission (SEC) in 2014 sued Athena Capital Research, a market broker firm, for executing a large number of trading orders just seconds before closure of the day trading of securities listed on NASDAQ. According to investigations, such pattern of trading was prevalent for approximately six months and constituted 70 per cent of the trades executed on NASDAQ. Further, it was also revealed that such pattern of trading involved manipulations of algorithms to ensure that the firm’s orders received priority over other orders that similarly traded on day-end price imbalances.[viii] Ultimately, the broker firm was asked to shell out $1 million as penalty and agreeing to a cease and desist order to refrain from future malpractices.
In light of the aforesaid discussion, it can be safely presumed that the principal capital market regulator in India, SEBI needs to bring its regulatory oversight in line with international standards. However, as has been highlighted above, SEBI had allowed high frequency trading much before, without going into any kind of public consultations or regulations on the same. This can erode the trust of many investors in the market regulator. But, the silver lining is that is that recent regulatory developments such as incorporation of class action suits under section 245 of the Companies Act, 2013, information exchange provisions with regulators from different jurisdictions under recent amendments to the SEBI Act, 1992, and existence of regulations such as SEBI (Investment Advisers) Regulations 2013, SEBI Prohibition of Unfair Trade Regulations, 2003 provide ample scope and powers to the regulator to keep an eye on securities market manipulation. Therefore, it is up to SEBI to bring in separate regulations on HFT pursuant to consultations with appropriate stakeholders, or bring in such practices within the fold of the aforesaid regulations. Either ways, the issue of HFT needs to be addressed quickly. In this regard, proxy advisory firms like the Institutional Investor Advisory Services (IIAS) should play an important role in monitoring such practices on the lines of the ‘Investors Exchange’, which has very recently been approved by the SEC to monitor unethical market manipulative practices.
[i] Michael J. Barclay & Terrence Hendershott, Price Discovery and Trading after Hours, 16(4) The Review of Financial Studies 1041-1073, 1043 (2003)