Threatening equity markets, stock manipulation is among the hottest topics for investors today. Michael Lewis, author of Flash Boys: A Wall Street Revolt, describes the U.S. stock market as rigged in favor of High Frequency Trading (HFT) firms. In a 60 Minutes edition, Lewis stated that these firms are able to “identify your desire to buy shares in Microsoft and buy them in front of you and sell them back to you at a higher price.” With milliseconds of advantage, these high-speed electronic trading firms are able to earn fractions of a penny per trade, translating to large sums of profit due to sheer speed and volume of trading.
Virtu, the holy grail of HFT firms, boasted that in four years of trading—or 1,238 days— from January 1, 2009 to December 31, 2013, it netted a loss only once.
A method now executed by many investors, such as proprietary trading firms and banks, HFT now makes up over “half of all U.S. trading volume.” However, with stiffer competition due immensely to the evolution of technology, Virtu’s boasting and the release of Lewis’ book, rule makers have become intensely wary.
This algorithmic trading has regulators on edge as they painstakingly determine whether or not certain HFT transactions are acceptable or deceptive. While these trades are not necessarily illegal, it is the motivation behind them that brings the HFT into question. It is incredibly difficult to draw the line between legality and illegality due to the complexity of employed strategies.
Brad Katsuyama, former head trader for the Royal Bank of Canada (RBC) in New York, realized a serious problem he was facing when he placed large stock orders. After the order was partially filled at one price, he found that RBC would have to pay a higher price to purchase the remainder of the order. Katsuyama quickly discovered that while his orders traveled along fiber optic cables to the nearest exchange, HFTs would get a glimpse of his deal and beat him to the other twelve U.S. stock exchanges.
Their high-speed algorithms subsequently purchased the shares RBC ordered and sold them at a higher price. In order to solve the problem, Katsuyama and Ronan Ryan, Head of Electronic Trading Strategy, devised a system that enabled them to place their order first at the exchanges farthest away and last at the nearest locations. “Essentially, our fill rates went to 100 percent,” declared Katsuyama in a 60 Minutes interview.
Following the system’s success, Katsuyama headed up a new trading platform, IEX Group, Inc., as a dark pool trading system. He is currently the CEO while Ryan is the Chief Strategy Officer. Another recent problem has brought the Securities and Exchange Commission (SEC) into play.
In October, SEC announced that it was faced with “the first high frequency trading manipulation case.” When the SEC got seriously involved, it was discovered that New York City-based Athena Capital Research, a relatively small trading firm, stated that it was “owning the game” in internal emails due to its highly technical algorithm nicknamed “Gravy.” Allegedly, the company had been placing a vast number of aggressive trades in the last two seconds of nearly every day of trading during a six-month period in order to manipulate closing NASDAQ stocks that favored Athena profits. “Traders today can certainly use complex algorithms and take advantage of cutting-edge technology, but what happened here was fraud,” stated Andrew Ceresney, Director of SEC’s Division of Enforcement.
This tactic, known as “marking the close,” enabled Athena to make so many transactions in the final seconds before the 4:00 p.m. closing that their trades made up for over 70 percent of the total NASDAQ trading volume in specific stocks. Placing stress on the market’s available liquidity by overwhelming it with massive trades allowed Athena to push stock prices in its direction. The SEC released an order instituting administrative and cease-and-desist proceedings upon discovering the chicanery.
In the order, the SEC created an in-depth analysis of Athena’s proceedings and the mechanics of its trading strategy. The record shows that Athena made “imbalance-only” trading orders, also known as “collars.” Imbalance trading refers to a trade in which more orders are placed for shares than shares that are available to sell.
Traders typically expect prices of imbalanced shares to rise due to the high demand. Athena used sophisticated quantitative analyses ten minutes before the close of trading in order to place imbalance-only orders. On one occasion, in the ten minutes leading up to 4:00 p.m., Athena purchased thousands of EBAY shares for prices of $26.56 and $26.58 per share. The firm then let Gravy kick in and purchase 112,000 shares at $23.59 per share in the last two seconds before 4:00 p.m. At 4:00:03, NASDAQ ran its Closing Cross auction in which Athena sold 233,979 shares at 23.61, selling at approximately $.03 higher than the milliseconds before Gravy had run its course.
Although the company did not deny SEC’s charges, it stated that “its trading activity helped satisfy market demand for liquidity.” A $1 million fine was charged against the company, which it agreed to pay.
While innovation and free enterprise feed an economy, HFT firms should be flawlessly vigilant with their legal actions and abide by the law. There is a difference between manipulating stock prices and fairly trading according to genuine prices and actual supply and demand. Time has yet to tell whether or not regulators can come up with more clear-cut rules on determining if HFT firms have acted mendaciously or honorably.