Stanislav Dolgopolov’s recent paper for the Journal of Law, Technology & Policy, at the University of Illinois, College of Law, looks at the issue of the interface of regulatory system and order types.
The paper has a not-especially snappy title, “High-Frequency Trading, Order Types, and the Evolution of the Securities Market structure: One Whistleblower’s Consequences for Securities Regulation.”
The “whistle blower” that Dolgopolov references there is Haim Bodek, the long-time developer of quantitative strategies for, among others, Hull Trading and UBS, who has published a series of articles explaining how the proliferation of different order types allow the HFT traders to get to the head of the line in the grocery store of stock buyers.
Bodek charges, here for example, that exchanges have created various special order types precisely to attract the HFTs, especially the “hide and light” orders, which hide prices precisely that they won’t count as protected quotations under Reg NMS.” He is also featured prominently in Scott Patterson’s recent book, DARK POOLS.
So, that’s who Bodek is. Who is Dolgopolov? He’s a former assistant adjunct professor at the UCLA School of Law and at present a consultant, at Decimus Capital Markets.
After a quick summary of what Bodek and others have been saying about order types, Dolgopolov gets to his own concern, whether order type abuse counts as fraud under existing securities statutes. He lists several “possibilities to consider”:
- Situations in which an order type “simply has undocumented features.”
- Those in which the undocumented features “potentially violate some regulatory norm,”
- And those in which the functioning of an order type contradicts its formal documentation via an SRPO rule.
The first, simplest scenario comes about through nondisclosure of the relevant features for the trading venues. “In theory, this scenario should be prevented by the mathematically precise nature of the disclosed documentation, but it is still feasible, while perhaps narrow in the legal sense….” This is a bit akin to the , movement of assets and liabilities off the balance sheets of corporations, sometimes in order to hide their nature. In both cases, the simple nondisclosure can continue without constituting fraud, simply because the relevant practices change quite quickly, and the relevant rules haven’t kept pace.
Dolgopolov considers the possibility that even this simple undocumented-features scenario might contribute to an argument that the non-disclosing parties are “inside traders.” But he notes the “doctrinal hurdles,” such as that ”the substance of an order type’s functionality by itself does not have a direct impact on a security’s market price.”
In terms of the violation of regulatory norms through these order types, Dolgopolev observes, as has Bodek, that HFTs and trading venues alike have worked hard to fit their practices into the Reg NMS framework. As a consequence, violations of NMS “are unlikely” Dolgopolov writes, “to provide a basis for civil liability of HFTs who use such orders because of their compliance – however formalistic – with this regulatory norm.”
Finally, though, he believes there “might be a private right of action under the federal antifraud prohibition” in the third scenario listed above, that in which the functioning of an order type contradicts its formal documentation.
A 2011 decision of the Second Circuit Court of Appeals, VanCook v. SEC, might prove heartening to potential plaintiffs in such a matter.
The appeals court there upheld an order of the SEC that had found that a stockbroker had wilfully violated the antifraud provisions of the ’34 Act by virtue of orchestrating a scheme that facilitated late trading in mutual funds.
Though it is not a foregone conclusion how courts will rule on challenges to HFT proceedings, Dolgopolov writes that the violation of SRO rules by HFTs “should not be sheltered from liability even when the SRO in question is complicit.”
What about lawsuits against the SROs themselves? One difficulty here is that SROs benefit from the doctrine of regulatory immunity for official actions in the context of the broad regulatory scheme. One complication here is that not all the actions of an SRO are official actions in this case. SROs are or at least may be “subject to private lawsuits for tjheir activities as private businesses.”