The following post comes to us from Gregory Scopino, Adjunct Professor of Law at Cornell Law School and Special Counsel with the U.S. Commodity Futures Trading Commission (CFTC). It is based on his recent paper, “The (Questionable) Legality of High-Speed ‘Pinging’ and ‘Front Running’ in the Futures Markets,” which is forthcoming in The Connecticut Law Review and available here. The positions expressed here and in Mr. Scopino’s paper are his own, and do not represent the views of the CFTC, its Commissioners, or other staff members.
Institutional investors contend that high-frequency trading (HFT) firms engage in high-speed “pinging” and “front running” of their orders for trades. By sending out lightning fast “ping” orders for trades that operate much like sonar in the ocean, HFT firms can detect when institutional investors will make large trades in futures contracts. Once a large trade has been detected, an HFT firm rapidly jumps in front of the institutional investor, buying up the liquidity in the contract and selling it back at higher or lower prices (depending on if it was a buy or a sell order).
None other than Warren Buffett’s right-hand man, Charles Munger, has called the HFT practice “evil” and “legalized front running.” While many criticize these HFT tactics, they accept their legality at face value. But what if that understanding is incorrect?
Based on existing precedent and policy in civil enforcement cases, at least some high-speed pinging tactics arguably violate at least four provisions of the Commodity Exchange Act (CEA) – the statute governing the futures and derivatives markets – and one of the regulations promulgated thereunder by the derivative markets regulator, the U.S. Commodity Futures Trading Commission (CFTC).
The HFT tactic in question has most frequently been described as a form of front running, which is typically defined as trading with advance knowledge of material nonpublic information about an order for a large trade. The quintessential example of front running involves a broker who trades ahead of a customer order. Front running can be considered a subspecies of insider trading, which, generally speaking, consists of trading based on material nonpublic information received from a person who violated a duty of trust or confidence. Viewed this way, the HFT tactic in question is not front running because, inter alia, many HFT firms do not have customers and the tactic does not involve the use of nonpublic information.
The better approach, however, is not to view high-speed pinging as a form of front running, but as analogous to disruptive, manipulative, or deceptive trading practices, such as banging the close (influencing the price of a futures contract by submitting a high number of trades in the closing period), spoofing (submitting an order for a trade with the intent to immediately cancel it), or wash trading (self-dealing, or taking both sides of a trade), all of which are illegal, both in the futures and securities markets. These trading practices – banging the close, spoofing, and wash trading – are considered deceptive devices because they are said to give the false impression of activity or liquidity in the market to other traders, who are entitled to rely on the assumption that the prices of futures contracts are based on the legitimate forces of supply and demand – and not the result of manipulative contrivances.
The use of “ping” orders and trades by HFT firms to lure large traders into revealing themselves is analogous to tactics such as banging the close, spoofing, and wash trading, especially in situations where, in the process of seeking out large trades, the HFT firms cancel a majority of “ping” orders for trades before execution. (Some HFT trading strategies involve order cancellation rates of as high as 95 percent.) That is, the “ping” orders and trades serve as decoys designed to trick other market participants into revealing their intention to execute a large trade. The “ping” orders and trades give the HFT firms information that other market participants do not have. This is similar, for example, to spoofing and wash trading, which are said to lure others to trade in particular futures contracts by making it appear as if there is greater interest or liquidity in those contracts than is actually the case. Given that high-speed “pinging” deceives other traders in a manner that is similar to the three referenced trading practices whose illegality is well-established (i.e., banging the close, spoofing, and wash trading), some of the provisions of the CEA and CFTC Regulations that prohibit banging the close, spoofing, and wash trading also probably cover, and thus ban, high-speed “pinging” as well.
For example, the Dodd-Frank Act amended subsection 6(c)(1) of the CEA to include a provision that mirrors Section 10(b) of the Securities Exchange Act, which is the securities law catch-all prohibition against manipulative and deceptive devices that provided the SEC with the basis for promulgating Rule 10b-5. In 2011, the CFTC adopted a rule – CFTC Rule 180.1 – that is based on SEC Rule 10b-5. U.S. Senator Maria Cantwell, the author of CEA Section 6(c)(1), stated that her intent was to give the CFTC a strong, flexible tool with which to combat fraudulent market behavior, and that federal courts would be able to look to judicial precedent under Section 10(b) when interpreting CEA Section 6(c)(1).
That precedent is important because SEC Rule 10b-5 was intended to adapt and evolve as new methods of fraud emerged. Indeed, courts interpreting Rule 10b-5 have stressed that fraudulent schemes should not succeed simply because they are novel. Under existing precedent, banging the close, spoofing, and wash trading all violate Exchange Act Section 10(b) and SEC Rule 10b-5, which means that those tactics probably violate CEA Section 6(c)(1) and CFTC Rule 180.1 as well. Accordingly, because high-speed “pinging” is (for the reasons stated above) analogous to banging the close, spoofing, and wash trading, high-speed “pinging” also arguably violates CFTC Rule 180.1 (and SEC Rule 10b-5).
High-speed “pinging” also arguably violates the following CEA and CFTC regulatory provisions: (1) CEA Section 4c(a)(2)(B)’s prohibition on causing non-bona fide prices to be reported; (2) Section 4c(a)(5)(C)’s prohibition on spoofing and related activities; and (3) the prohibition in CEA Section 9(a)(2) and CFTC Rule 180.1(a)(4) on delivering false, misleading, or knowingly inaccurate crop or market information or reports. All of these provisions have been used to combat spoofing or similar tactics, which (as discussed above) are analogous to high-speed “pinging.”
Therefore, the popular belief that high-speed “pinging” and “front running” is legal is arguably incorrect, at least to the extent that the tactic involves sending and canceling “ping” orders for trades.