Last month, the City of Providence, Rhode Island filed a first-of-its-kind class action against Wall Street banks, securities exchanges and brokerage firms over alleged violations of federal securities laws stemming from the defendants’ involvement in so-called “high-frequency trading” (HFT). HFT has been subject of heightened focus since numerous regulators launched investigations into the practice, which some claim distorts stock market prices at the expense of the investing public. In simplified terms, HFT is when traders utilize complex computer algorithms to move in and out of securities positions within fractions of a second. As Michael Lewis explains in Flash Boys: A Wall Street Revolt, there are dozens of venues for trading stock (including public exchanges and private trading venues known as “dark pools”), which are situated at varying physical distances away from the originating order. An order to buy or sell might therefore take longer (albeit milliseconds or even microseconds) to reach one exchange versus another. According to Lewis and the City of Providence, HFT firms pay the exchanges for the right to place their computer servers as close to the exchanges’ matching engines as possible, giving them “nearly instantaneous” access to key data about the investor’s order, including its intention to buy or sell, its price sensitivity or margin requirements. With that data in hand, HFT firms then employ complex computer code to race to other exchanges, transact, and then fulfill the investor’s order. This not only prevents the investor from obtaining the best price available when it sent the order, but also causes the market to move—in the blink of an eye—in a direction that causes the damage to the investor.
In the complaint, Providence represents a purported class of public investors who traded stock in U.S. exchanges or dark pools between April 18, 2009 and the present and suffered loss because of HFT. The suit features an ambitious roster of defendants, including every SEC-registered national stock exchange (the Exchange Defendants), the 14 largest U.S. brokerage firms (the Brokerage Defendants) and 12 high frequency trading companies (the HFT Defendants). Plaintiffs allege the Brokerage Defendants and HFT Defendants represent a “class” of defendants comprising “hundreds” of unidentified brokers and traders allegedly complicit in the scheme.
The complaint tracks the history of securities trading since the 1970’s, depicting a “bold new world” in which sophisticated traders play “cat-and-mouse games” to gain clues about the investing public’s trading intentions and exploit that information to gain a market advantage. According to the plaintiffs, a 2007 SEC regulation called “Reg NMS” (or “national market system”)—which requires exchanges and brokers to execute customers’ orders at the most competitive price posted at any U.S. trading venue that displayed price quotes—may be partly to blame. While Reg NMS was designed to promote investor confidence by ensuring customers received the best possible price, it spurred the proliferation of new exchanges, all competing to entice new customer order flow by offering that best price. This fostered fragmentation of the stock market, boosting HFT firms’ ability to exploit latency times and jump out ahead of the investing public. Because of this, plaintiffs say, HFT has exploded—it accounts for 73% of all equity bids and orders volume on the market today.
In particular, plaintiffs allege the defendants engaged in the following manipulative HFT practices:
“electronic front-running” – where, in exchange for kickback payments, the HFT Defendants are provided early notice of investors’ intentions to transact by being shown initial bids and offers placed on exchanges and other trading venues by their brokers, and then race those bona fide securities investors to the other securities exchanges, transact in the desired securities at better prices, and then go back and transact with the unwitting initial investors to their financial detriment;
“rebate arbitrage” – where the HFT and Brokerage Firm Defendants obtain kickback payments from the securities exchanges without providing the liquidity that the kickback scheme was purportedly designed to entice;
“slow-market (or latency) arbitrage” – where the HFT Defendants are shown changes in the prices of a stock on one exchange, and pick off orders sitting on other exchanges, before those exchanges are able to reach and replace their own bid/offer quotes accordingly, which practices are repeated to generate billions of dollars more a year in illicit profits than front-running and rebate arbitrage combined;
“spoofing” – where the HFT Defendants send out orders with corresponding cancellations, often at the opening or closing of the stock market, in order to manipulate the market price of a security and/or induce a particular market transaction; and
“layering” – where the HFT Defendants send out waves of false orders intended to give the impression that the market for shares of a particular security at that moment is deep in order to take advantage of the market’s reaction to the layering of orders.
While the HFT Defendants and the Brokerage Defendants allegedly profited to the tune of billions of dollars by trading against investors using their informational advantage, the Brokerage Defendants also allegedly received kickbacks for directing their customers’ orders to certain exchanges and dark pools the Brokerage Defendants knew were “rigged” due to “informational asymmetries” caused by HFT. The Exchange Defendants also allegedly received payments for allowing the HFT Defendants to place their servers in close proximity to the exchanges’ matching engines (a practice known as “co-location”), giving the HFT Defendants a sneak preview of key customer trading data.
The suit includes three substantive counts: (1) Violation of §10(b) of the Securities Exchange Act and Rule 10b-5 promulgated thereunder (against all Defendants); (2) Violation of §6(b) of the Securities Exchange Act (against the Exchange Defendants); and (3) Violation of 20A of the Securities Exchange Act (against the Brokerage Firm Defendants and the HFT Defendants).
Plaintiffs will face a number of legal obstacles to victory, in particular, the definitional problems surrounding their depiction of the Brokerage and HFT Defendants as a “defendant class.” Plaintiffs appear to have lumped the Brokerage and HFT Defendants together in alleging they all engaged in similar illicit conduct, yet fail to allege specific fraudulent conduct by any particular defendant. As one writer has pointed out, “Plaintiffs will struggle to overcome some obvious problems with the seeming shapelessness of the defendant class and the problems associated with having class representatives that did not volunteer for the role.”
Plaintiffs may have a particularly hard time proceeding under §6(b), which does not appear to create a private right of action. Section 6(b) requires all nationally-registered exchanges to enact rules designed to promote the Exchange Act’s purposes—to prevent fraudulent and manipulative practices—but does not specify whom may enforce violations of this requirement. The plaintiffs allege they are the “direct intended beneficiaries of” and collectedly relied on §6, perhaps foreshadowing their argument that §6 contemplates a private right of action.
Plaintiffs will also have to overcome the heightened pleading standards of the Private Securities Litigation Reform Act, which requires plaintiffs to allege sufficient facts to create a “strong inference” of fraudulent intent against each defendant. That is no easy task considering the laundry list of defendants included in the suit. Also, proving the defendants engaged in HFT is not the same as proving they committed fraud; as some have written, HFT is not always predatory and may even benefit the market in unseen ways.
Expect the HFT debate to continue gaining traction in the months ahead. The New York Stock Exchange, for its part, has already paid hundreds of millions to the SEC to settle charges of HFT abuse.