Do Automated Trading Systems Dream of Manipulating the Price of Futures Contracts? Policing Markets for Improper Trading Practices by Algorithmic Robots
74 Pages Posted: 4 May 2014 Last revised: 22 Feb 2015
Date Written: May 2, 2014
The trading pits in which floor traders once shouted out bids and offers on futures contracts have given way to electronic, computerized exchanges where trading decisions are initiated and made – not by humans – but by automated trading systems (ATSs). Some ATSs use high-frequency trading (HFT) strategies to place trades in microseconds. Many ATSs have become “self-learning” in that they constantly modify and improve their trading strategies independently from human direction.
Concerns have been raised about HFT firms engaging in manipulative and disruptive trading practices. The Commodity Futures Trading Commission (CFTC) is tasked with keeping the markets free from manipulative and disruptive trading practices, but the question arises as to whether the causes of action available to the CFTC in the Commodity Exchange Act (CEA) can address improper ATS behavior. Most relevant causes of action require proof of a culpable mental state of at least recklessness, which has been described as behavior that departs so far from the standards of ordinary care that it is very difficult to believe the actor was not aware of what he or she was doing. Further, the law only looks for the requisite mental state in the minds of humans.
Accordingly, causes of action that require proof of reckless or intentional conduct are unhelpful where the humans involved with the trading lack the required mental state because an ATS perpetrated the improper acts. As a result, improper trading practices such as banging the close (buying or selling large volumes of futures contracts in the closing moments of a trading day to move the price of the contract), spoofing (placing orders for trades and then cancelling the orders before execution), and wash trading (taking both sides of a trade) could be considered illegal when committed by humans, but not when committed independently by ATSs, despite the fact that the behavior would have the same effect on the markets, regardless of whether the perpetrator was a human or an ATS.
This Article suggests that failure-to-supervise claims under CFTC Regulation 166.3 could hold persons accountable for improper trading practices by ATSs pursuant to a reasonableness standard in situations where registrants (people or entities that must register with the CFTC) fail to prevent ATSs from banging the close, spoofing, or engaging in wash trading. Alternatively, if Regulation 166.3 is viewed as not reaching such conduct, the CFTC could promulgate a rule dictating that registrants who use ATSs must make sure their employees supervise and monitor ATSs for trading practices that mimic prohibited activities. (Or the industry’s self-regulatory organization, the National Futures Association (NFA), could promulgate such a rule.) In the event that a CFTC or NFA rule is viewed as insufficient, Congress could amend the CEA to add an ATS supervisory requirement to the CEA.
Keywords: Dodd-Frank Act, market manipulation, trading practices, financial regulation, futures, swaps, derivatives, Commodity Exchange Act, Commodity Futures Trading Commission, high-frequency trading, automated trading systems
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