European regulators are soon to impose rules on high frequency trading says Marleen Brouwer.
On 6 May 2010 the prices of many US based equity products plunged dramatically in a matter of minutes – before rebounding almost as quickly. The crash of the markets, known as ‘the flash crash’, caused major equity indices in both the futures and securities markets to plummet 5-6 per cent. Nearly five years later a criminal complaint was filed in the United Stated District Court in Chicago against Navinder Sarao because he allegedly contributed to the flash crash. Mr Sarao, who denies the charges, is accused of deliberately spoofing and manipulating the market over a period of nearly five years by placing, modifying and cancelling large volumes of orders at the same time using automated trading software. The placing of large sell orders would create the appearance of substantial supply and as a consequence drive the prices down. The allegation is that Mr Sarao had the intention to cancel those orders last minute before they were executed and used the manipulation of the market for his own personal benefit. In the event Mr Sarao is extradited to the US, he will face a total of 22 charges with a possible custodial sentence of up to 380 years.
The specific allegations
Mr Sarao is charged with one count of wire fraud and 10 counts of commodities fraud which carry a maximum custodial sentence for each count of 20 years and 25 years respectively. Both counts could be covered under fraud by misrepresentation contrary to section 2 of the Fraud Act 2006 in this jurisdiction. It may also be possible to prosecute the commodities manipulation and spoofing Mr Sarao is charged with under section 90 Financial Services Act 2012 (formerly under section 397 Financial Services and Markets Act 2000 - repealed on 1 April 2013). The behaviour could also fall under the civil regime of market abuse under section 118 (5) of the Financial Services and Markets Act 2000.
Spoofing is a relatively new offence under US law. President Obama signed a law which specifically prohibits certain 'disruptive practices' including ‘spoofing’ a few months after the flash crash.There is no specific offence of spoofing under UK law. However, it could be covered by market abuse which includes: 'behaviour which consists of effecting transactions or orders to trade which: (a) give, or are likely to give a false or misleading impression as to the supply of, or demand for, or as to the price of, one of more qualifying investments, or (b) secure the price of one or more such investments at an abnormal or artificial level”.
In the US, the offence of spoofing is specifically prohibited under section 747 of the Dodd-Frank Spoofing Prohibition which amended the Commodity Exchange Act. Spoofing is described as 'bidding or offering with the intent to cancel the bid or offer before execution'. The first spoofing case which is prosecuted under the Dodd-Frank Act is the case of Michael Coscia, a high frequency trader who allegedly manipulated commodities futures prices gaining illegal profits of nearly $1.6 million. The FCA imposed a financial penalty on Mr Coscia for ‘layering’, a specific form of spoofing via section 118 (5) FSMA 2000.
Is the US ahead of the game?
High frequency trading, a form of automated trading that uses computer algorithms for decision making to place, modify and cancel high volumes of trading orders in milliseconds, is not illegal and neither is cancellation of trade. However, it is to be expected that regulators will increase their monitoring of high frequency trading and review the volume, frequency, repetition and profit made.
Arguably, the US is ahead of the game by creating a specific offence to try and tackle fraudulent high-frequency trading. However the offence requires proof of 'intent to cancel the bid' at the time of bidding or offering. This may be a difficult task particularly when the trading is executed by automated software. It may be achieved by using the programming of the software but in the case of Mr Sarao, he contends that he manually cancelled the orders. It will be open to challenge and will undoubtedly lead to the instruction of experts on both sides.
The wording under section 118 (5) FSMA 2000 is broader; it refers to 'behaviour' which gives or are likely to give a false or misleading impression or secure the price of an investment at an abnormal or artificial level. As it falls under the civil market abuse provisions, the burden of proof is lower than in criminal cases. Moreover, the FCA can impose large fines for market abuse.
There does not appear to be a need therefore to follow the US in creating a specific offence, especially in circumstances where high frequency trading will be regulated from 2017 from a European perspective - anyone who engages in it will have to notify regulators. It seems that regulators on both sides of the pond are catching up on high frequency trading.