New laws, aimed at the financial industry, have forced both manual and high frequency traders of commodity futures and securities to rethink their trading practices.
Our lawyers advise clients on potential liability regarding securities litigation, regulation, and enforcement. Below, we will discuss the momentum ignition strategies which have been deemed unlawful in the wake of the financial crisis.
These issues affect all traders.
Even if you or your firm does not engage in algorithmic or high frequency trading, you may still be accused of using the tactics described below.
If you are concerned about potential liability regarding the issues discussed below, contact us for a consultation.
What is High Frequency Trading?
High frequency trading is an umbrella term for different trading strategies.
These strategies are characterized by fast speeds and faster turnover rates.
This speed is accomplished by using sophisticated computer algorithms that can buy and sell securities—fully autonomously of humans—in fractions of a second.
This is significant because the speed at which you are able to trade inevitably affects the price at which you ultimately purchase or sell your security.
Since its inception, high frequency trading has presented new challenges to the financial markets.
Is High Frequency Trading Illegal?
What concerns federal agencies like the SEC and the CFTC is market manipulation.
“While forms of algorithmic trading are of course lawful, using a computer program that is written to spoof the market is illegal and will not be tolerated.”
David Meister, Commodity Futures Trading Commission, 2013
Charges of market manipulation carried out through both manual and algorithmic and high frequency trading can lead to civil and criminal penalties being brought against you.
This could mean the seizure and eventual forfeiture of your money and assets, and a permanent ban from the financial industry.
Over the past three decades, high frequency and manual traders alike have struggled to initiate new compliance programs to avoid prosecution for allegedly inappropriate trading practices.
High Frequency Trading as Market Manipulation
Most high frequency traders rely on advantages in speed to make incremental profits. There is nothing wrong with that.
The problem is that high frequency trading creates certain conditions in the market which allow firms to take advantage of the speed and data they have in order to manipulate the market.
Title 7 of the United States Code, Section 13(a)(2), makes it unlawful for any person to “manipulates or attempt to manipulate” the price of any commodity.
It also makes it unlawful to “knowingly” delivers false, misleading, or inaccurate reports concerning “market information or conditions.”
Violating Section 13 is a felony and penalties for violating Section 13 include a fine of not more than $1,000,000 or imprisonment, not more than 10 years, or both.
High Frequency Trading as Fraud on the Market
Title 18 of the United State Code, Section 1348 makes it unlawful to “knowingly execute, or attempt to execute,” a scheme to defraud someone in connection with any security or commodity futures contract.
That means that in order to convict you of fraud on the market, the government must prove that you did so “knowingly.” The burden to prove this element of the offense is on the government and they must prove this element beyond a reasonable doubt.
Proving someone had specific knowledge prior to a given action beyond a reasonable doubt is undoubtedly a heavy burden for the government to bear. As discussed below in the “Establishing A Defense” section, this elemental burden may be a valuable tool to establishing your defense with your attorney.
Federal agencies like the SEC and the DOJ continue to bring civil and criminal cases against current and former traders for many of the tactics described below.
If you are concerned about potential liability regarding the momentum ignition strategies discussed below, contact us for a consultation.
Momentum Ignition Strategies Are Illegal
Momentum ignition strategies involve creating a false sense of demand in the market by making offers to buy or sell and then quickly deleting them before anyone can accept them.
When you post an order, other investors in the market can see your order, and that investor may decide to act on that information.
The problem arises when you place and cancel orders before they can be acted upon. By doing so, you may be creating a false sense of supply or demand.
Basically, momentum ignition strategies can be seen as a way for you to induce other players in the market to act in a certain way.
If your buying and selling strategies or algorithms involve these type of momentum ignition strategies, federal agencies may characterize your trading history as “market manipulation.”
Spoofing
Title 7, United States Code, Section 6c(a)(5)(C) describes “disruptive practices” and makes it unlawful to “engage in any trading, practice, or conduct…that is of the character of, or is commonly known to the trade as, spoofing.
This language means that in order to be found guilty of spoofing, the government must prove that you placed orders without intending to execute them in order to try to move prices in your favor.
When you or your computer place an offer to buy, other players in the market may raise their bids in response to your offer.
By causing others to raise their bids, your algorithm may be driving up the price of a security.
By not finalizing the offer to buy after the price has been driven up and, instead, selling at the inflated price, you may be engaging in spoofing.
Layering
Layering involves a similar technique as those described above but in a series of successive steps.
Traders place multiple bids at continuously increasing prices.
When other traders see the bids for a security or commodity increasing, they may follow the rising price and place a bid even higher.
This technique induces other traders and their algorithms into detecting a pattern in the market, in order to take advantage of their reaction.
When another algorithm or trader follows your lead and increases its offer, you can essentially sell at a price which is higher than the market value, because it is a price which you or your algorithm induced.
What’s amazing is that the entire sequence can take less than half a second to complete.
No matter how fast these trades are taking place, the SEC and other federal agencies are not backing down from bringing charges if they suspect you are taking part in these types of trading practices.
Quote Stuffing
Quote stuffing is a method of algorithmic trading which is used to slow down your competitor. It involves overloading the capacity of exchange servers with quotes and cancellations.
By loading the server with thousands of quotes in a fraction of a second, you may be able to slow down your competitor—or their algorithm—as they attempt to process this data. The rapid cancellation of quotes delays the speed at which trade information is reported.
By slowing down your competitor or delaying their algorithm with an excess of information in the form of quotes, you gain an advantage in time.
In the financial world, advantages in time are calculated by fractions of a second.
Every millisecond or microsecond your algorithm is slowing down your competitor’s algorithms with rapid-fire quotes can lead to potential liability.
Detection, Investigation, and Reporting
Financial markets in the U.S. are generally regulated by two government bodies: the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”).
While the SEC and CFTC have similar goals, they regulate different markets. The SEC focuses its regulation on stocks and bond markets, while the CFTC regulates derivative markets. Derivative markets are markets that consist of agricultural and financial commodities like oil or coffee.
But wait, there’s more…
Additional regulatory bodies which assist in the oversight of the markets include:
- Financial Industry Regulatory Authority (FINRA): If you sell stocks or bonds, your firm should be a member of FINRA. FINRA represents and regulates all stock and bond brokerage firms and their employees. FINRA also administers background checks and licensing exams to all employees registered to sell securities.
- National Futures Association (NFA): Like the CFTC, the NFA is a regulatory body of the derivatives market. The NFA administers background checks and licensing exams to all employees which engage in futures trading.
- Treasury Department’s Bureau of the Public Debt: Since treasury bonds are issued by the U.S. government instead of a corporation, the Treasury Department is in charge of regulating these bonds.
- Federal Reserve Banks: Banks are responsible for most foreign exchange trading and are regulated by the Federal Reserve. Foreign exchange trading is heavily regulated by both the Federal Reserve and U.S. Treasury Department.
- Self-regulatory organizations (“SRO”) also take on much of the responsibility for detection, investigation, and reporting. Brokerage firms and investment companies join these organizations to ensure problems are identified and the interests of the companies and their brokers are equally represented.
There is a lot of overlap between these agencies. Depending on whether you or your firm trade in securities or futures will most likely determine which agency will investigate, report, or bring charges and penalties against you.
Consequences of Being Convicted
Traders are facing increased penalties and jail time as a result of the broad U.S. crackdown on strategies like spoofing, layering, and quote stuffing.
What’s worse, traders are finding themselves as defendants in both civil and criminal cases, brought by two separate departments, with two separate punishments, and two separate fines, but for only one allegedly illegal action.
Sound crazy? It’s not.
Facing Both Civil and Criminal Proceedings
If you are found to have engaged in any of the practices described above, you may not only face civil penalties from agencies like the SEC and CFTC, but you may also face criminal charges brought by the Department of Justice (“DOJ”).
Being investigated, charged, and prosecuted for the same actions by both civil and criminal authorities does not violate principles of double jeopardy—which would normally forbid being charged twice for the same crime.
Since the SEC does not have criminal authority, they may refer matters to state and federal prosecutors at the DOJ for criminal prosecution—in addition to bringing civil penalties against you themselves.
If you find yourself to be a defendant in both civil and criminal proceedings, you must respond separately to each jurisdiction.
Civil Penalties
- Injunction
- Monetary penalties
- Bar from the industry
Criminal Penalties
- Imprisonment
- Monetary penalties
- Both imprisonment and monetary penalties
Although it may seem unfair to penalize someone twice for the same action, it happens all the time in the world of finance and high frequency trading.
In recent years, enforcement actions and probes have led to billions of dollars in payouts by some of the world’s largest banks. This includes jail time for broker-dealers, executive, and even computer programmers.
High Frequency Trading in the News
- The most recent win for traders came in April of this year when Andre Flotron, a former precious metals trader, was acquitted by a jury in Connecticut after only a few hours of deliberation. Mr. Flotron had been charged wit conspiracy to commit commodities fraud for allegedly engaging in certain momentum ignition strategies. Mr. Flotron’s acquittal raises the question of how many cancellations are too many. Meaning, how many cancellations are necessary to show an unlawful intent to manipulate the market.
- In 2018, the CFTC filed a complaint against a 41-year-old computer programmer, Jitesh Thakkar, after he had been accused of designing trading software to help an unnamed trader engage in spoofing. While the complaint was just filed in January of this year, it outlines allegedly illegal trading activity which took place during a few months in 2013.
- In January of 2017, Citigroup was fined $25 million for manipulating the U.S. Treasury futures market. According to the CFTC, five traders at Citigroup continuously used spoofing tactics between 2011 and 2012. The CFTC also stated that Citigroup should have had systems in place to detect the manipulation.
Establishing a Defense
Successfully defending against charges of market manipulation is possible.
Below we will discuss successfully implemented defenses in cases involving momentum ignition strategies.
If you are notified of an investigation into your trading practices or if you receive a subpoena in relation to the trading practices discussed below, contact us for a consultation.
Intent
A conviction for “spoofing,” “layering,” or “quote stuffing” requires the prosecution to prove you intended to affect the market when you placed the orders.
These charges force prosecutors to distinguish between ordinary trading and an intentional pattern of offers and cancellations that amount to manipulation.
The problem is that the majority of offers are canceled anyway.
In fact, according to a study conducted by the SEC in 2013, fewer than 5% of orders placed on stock exchanges were ever filled.
So how can a prosecutor distinguish between an ordinary offer and cancellation, and a criminal offer and cancellation?
They can’t.
It all comes down to the interpretation of your trade data.
Therefore, merely showing that an investor canceled trades on a regular basis may not be enough to prove the intent necessary for a “spoofing” violation.
Acquittals for charged like “spoofing” are proving that prosecutors need more than just your offers and cancellations to prove your actions amount to market manipulation.
If the prosecution cannot prove that you had the requisite knowledge or intent, you should not be convicted of this type of offense.
Manual v. Automatic Trading
Even if you place your orders manually, you can still be charged with all of the banned practices discussed above.
You do not need to use an algorithm or automatic trading to be found liable.
Manual traders have been accused and charged with things like “spoofing.”
Because again, it all comes down to the interpretation of your trade data.
If you place orders and cancel them, a prosecutor will make an argument that you intended to give a head fake other traders to act on that.
But your attorney can argue that by manually entering your trades, there was at least a chance the order would be filled.
This would negate the intent element and make it very difficult for prosecutors to prove that your goal was to manipulate the market.
Witness Credibility
The reality is that a prosecutor and your defense attorney can both use the same facts and come up with two completely different conclusions.
In many cases, the Justice Department relies on other traders who work for you—or with you—to testify. This usually involves the government extending offers not to prosecute these witnesses, in exchange for their cooperation.
If you’re a manual trader, maybe the prosecutor’s goal is to have the witnesses explain how you taught them to enter and then cancel orders to influence the direction of commodities and securities prices.
If you’re an algorithmic trader, maybe the prosecutor’s goal is to have the computer programmer who created your algorithm explain how you instructed him to design trading software to help you initiate momentum ignition strategies.
In cases like these, the witnesses leave their credibility open to questions as to whether they are pointing the finger at you in order to save themselves from prosecution.
Work with an Experienced Criminal Defense Attorney
We have successfully represented public and private companies, officers, directors, and employees, investment advisors, broker-dealers, futures and securities traders.
If you are notified of an investigation into your trading practices or if you receive a subpoena in relation to the trading practices discussed above, you must take action immediately. Contact us for a consultation.
