The special counsel of a division of the Commodity Futures Trading Commission suggests that “high speed pinging practices violate at least four provisions of the Commodity Exchange Act.”
In the latest issue of the Connecticut Law Review, Gregory Scopino, special counsel of the division of swap dealer and intermediary oversight, includes the usual disclaimer, that his opinions as expressed in the article are his own “and do not reflect the views of other members of DSIO, other CFTC staff, the CFTC itself, or the United States.” Still, prudence certainly allows us to take an article like this as a straw in an important wind. The argument over high-frequency trading continues, and its opposition continues to gain traction among important publics.
Scopino observes that much of the public discussion of HFT thus far has focused on stocks, their exchanges and regulators. This is unfortunate, because the world looks somewhat different from the point of view of commodities exchanges and regulators. He quotes a joint report of the CFTC and SEC on the harmonization of regulation, issued in October 2009: The securities markets exist for the purpose of capital formation, and this fact suggests obligations of a fiduciary nature at work. Thus, the idea of a prohibition on ”insider trading” by those fiduciaries arises naturally. HFT sometimes is analogized to that. But in the commodities space, the purpose both of the exchanges and of the regulators is different, it is to provide a form for price discovery and risk management. Thus, in the words of that 2009 joint report, commodity markets “permit hedgers to use their non-public material information to protect themselves against risks to their commodity positions.”
To the extent, then, that HFT is analogized to insider trading, it is in trouble with the securities regulators but may yet be in the clear with commodity regulators.
Sharks and Whales
Scopino plainly doesn’t want it to be in the clear. He is taken by the analogy of HFT firms as whale hunters. At one point he imagines them as sharks hunting whales, but elsewhere he sees them as human hunters, endowed with sonar. Hence the aptness of the term “pinging.”
He quotes at some length from a comment submitted to the CFTC in December 2013 explaining HFT strategies thus:
Suppose a high-frequency trader has detected an institutional investor seeking to transact a large position in small increments. The HFT can discover this by pinging the market with small test orders at various price levels, immediately cancelling those orders that are not instantly filled. This technique is akin to using sonar to locate a whale underwater in order to harpoon it. Having established the presence of such a large trader, the HFT can position itself ahead of the trade, taking a small loss at first (to wipe out existing liquidity) before then making a big profit by flipping its position to the institutional investor….
Scopino’s broad point, though, is that the practice can be seen as a variant of other practices generally regarded as illegal, such as banging the close, wash trading, or spoofing. The nature of the commodities markets does nothing at all to rehabilitate these practices.
So: what are the four provisions of the CEA that pinging in the hunt for whales may violate?
- Section 4c(a)(2)(B), the prohibition on causing the reporting of non bona fide prices;
- Section 4c(a)(5)(C) , bidding or offering with the intent of canceling the bid or offer before execution, that is, spoofing;
- Section 9(a)(2) and Rule 180.(a)(4), prohibiting the delivery of inaccurate market information or reports;
- Section 6©(1) and CFTC Rule 180.1, the prohibition of reckless or fraud-based manipulation as understood by the federal common law as developed under the Securities Acts.
A prominent treatise on derivatives law defines such manipulation as “the elimination of effective price competition … through the domination of either supply or demand and the exercise of that domination intentionally to produce artificially high or low prices.” Its existence is a case-by-case factual question involving three questions:
1) Did the requisite domination exist?
2) Was the artificial price caused by the exercise of that power? And
3) Whether the dominant party specifically intended to bring about the artificial price.