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«LAW’S ACCELERATION OF FINANCE: REDEFINING THE PROBLEM OF HIGH-FREQUENCY TRADING Frank Pasquale† High-frequency traders automate stock trading, ...»

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PASQUALE.36.6.2 (Do Not Delete) 8/19/2015 9:48 AM

LAW’S ACCELERATION OF FINANCE: REDEFINING

THE PROBLEM OF HIGH-FREQUENCY TRADING

Frank Pasquale†

High-frequency traders automate stock trading, placing thousands of orders

over fractions of a second. Their algorithmic strategies are all too often mere

rule manipulation or methods of using brute speed to gain advantages over rivals. Normative evaluation of finance’s algorithms must take into account the sector’s social function: to spur efficient, fair, and sustainable investment practices. The complex modeling deployed in high-frequency trading does not reliably contribute to these goals. Therefore, rather than straining to accommodate high-frequency trading strategies, regulators should eliminate many of them.

TABLE OF CONTENTS

INTRODUCTION

I. THE ACCELERATION OF FINANCE

A. Defining High-Frequency Trading

B. Evaluating High-Frequency Trading

1. Efficiency and Liquidity

2. Price Stability

II. THE MINIMALIST AGENDA OF REGULATORS

A. Punishing the Unfair Use of Early Information

B. Responding to Misrepresentation of Market Conditions

III. DECELERATING FINANCE

† Professor of Law, University of Maryland Carey School of Law. I wish to thank Helen Nissenbaum for the invitation to present on algorithmic trading at the New York University Law School conference “Governing Algorithms.” The interdisciplinary conference gave me an opportunity to present these ideas to experts in computer science, finance, law, and economics, and they offered insightful comments. I also thank Christopher Yoo for an invitation to present this piece at the University of Pennsylvania’s Second Annual “Computer Science and Law” conference. I thank Moritz Hardt and Tal Zarsky for their very thoughtful comments on a draft, and also thank Felix Wu, Martha McCluskey, Jennifer Taub, and Zephyr Teachout for their insights. Aaron Moss provided excellent research assistance.

–  –  –

A. The Preconditions for Pursuing a Minimalist Agenda

B. Toward a Substantive Finance Policy Agenda

CONCLUSION

INTRODUCTION

With the publication of Michael Lewis’s book Flash Boys, the computerization of finance has finally entered the limelight.1 Lewis’s bombshell book accused high technology traders (and complicit exchanges) of rigging the stock market.2 Though concerns about misuse of technology had been growing for years, mass media attention spurred a flurry of regulatory activity.3 Cases against leading firms and “dark pools” are now pending, and Congress has investigated trading practices.4 Regulators are aiming to separate the wheat from the chaff, permitting legitimate forms of high-frequency trading (HFT), while punishing or effectively prohibiting more destructive forms.5 Unfortunately, current policy responses to HFT are unlikely to improve capital markets significantly. Legal commentary on HFT suffers from a fundamental misconception about the nature of the relationship between law and finance.6 Whereas most legal commentators assume that the technology of finance is independent of legal rules, such rules are in fact a prime driver of technological developments in finance. The literature on HFT also tends to assume 1 MICHAEL LEWIS, FLASH BOYS: A WALL STREET REVOLT (2014). Lewis made more accessible an argument pioneered by Scott Patterson, Sal Arnuk, and Joseph Saluzzi. SAL ARNUK & JOSEPH

SALUZZI, BROKEN MARKETS: HOW HIGH-FREQUENCY TRADING AND PREDATORY PRACTICES ON

WALL STREET ARE DESTROYING INVESTOR CONFIDENCE AND YOUR PORTFOLIO (2012); SCOTT

PATTERSON, DARK POOLS: HIGH SPEED TRADERS, AI BANDITS, AND THE THREAT TO THE GLOBAL

FINANCIAL SYSTEM (2012) (discussing quants who pioneered early algorithmic trading, and came to see its later development as predatory).

2 LEWIS, supra note 1, at 265–66. High-frequency trading (HFT) is the use of computer algorithms to rapidly place, modify, or cancel orders, often in just fractions of second. IRENE

ALDRIDGE, HIGH-FREQUENCY TRADING: A PRACTICAL GUIDE TO ALGORITHMIC STRATEGIES AND

TRADING SYSTEMS 13 (2013) (discussing definition used by the Commodity Futures Trading Commission).

3 See John McCrank, Exclusive: SEC Targets 10 Firms in High-Frequency Trading Probe – SEC Document, REUTERS (July 17, 2014, 5:19 PM), http://www.reuters.com/article/2014/07/17/ussec-investigation-highfrequencytradin-idUSKBN0FM2TW20140717.

4 Conflicts of Interest, Investor Loss of Confidence, and High Speed Trading in U.S. Stock Markets Before the S. Permanent Subcomm. on Investigations, 113th Cong. (2014) (testimony of Bradley Katsuyama, President and CEO of IEX Group).

5 Concept Release on Equity Market Structure, Exchange Act Release, 75 Fed. Reg. 3594, 3606 (Jan. 21, 2010) (to be codified at 17 C.F.R. pt. 42).

6 In a nutshell, the regulators are letting the worst aspects of the technology shape their approach, rather than trying to limit them. Marc Lenglet, Conflicting Codes and Codings: How Algorithmic Trading is Reshaping Financial Regulation, 28 THEORY CULTURE & SOC’Y 44, 47–48 (2011).





PASQUALE.36.6.2 (Do Not Delete) 8/19/2015 9:48 AM 2015] LAW’S ACCELERATION OF FINANCE 2087 without proving that the primary goal of the financial system is to promote liquidity—that is, to assure that equities can be bought and sold in the fastest, most expeditious manner possible. This, too, is a problematic assumption, because sometimes a financial system can do far more to facilitate real productivity and economic stability when it puts some friction into exchange and encourages long-term investment.

There is no necessary relationship between the overall wisdom of capital allocation in a society and its enabling ever-decreasing time commitments to investment.7 Policymakers’ failure to recognize that finance is endogenous to law, and that liquidity is only one of many values in a financial system, has distorted legal scholarship on HFT. Leading scholars’ primary concern is whether regulators can keep up with the technology of the high-frequency traders.8 They should be examining how regulation itself incentivized the development of millisecond-level trading technology, and could in the future reduce (or even eliminate) its appeal. Moreover, the finance law scholarship program of fine-tuning the practices of extant public exchanges (and dark pools) misses a critical problem with equity trading: its short termism.9 Management teams and boards at publicly traded companies will become less likely to make important, long-term investments when stock prices are increasingly driven by short run trading dynamics.

Fortunately, an emerging approach to financial affairs, known as the “Legal Theory of Finance” (LTF), offers illumination here, and should guide future policy interventions.10 An interdisciplinary research team of social scientists and attorneys, led by Columbia Law Professor Katharina Pistor, has documented the ways in which law is constitutive of financial markets. Revitalizing the tradition of legal realism in finance, Pistor has demonstrated the critical role of law in creating and maintaining durable exchanges of equity and debt. Though law to some extent shapes all markets, in finance it is fundamental—the “products”

7 MARY MELLOR, THE FUTURE OF MONEY: FROM FINANCIAL CRISIS TO PUBLIC RESOURCE 5

(2010); ADAIR TURNER ET AL., THE FUTURE OF FINANCE: THE LSE REPORT 14 (2010).

8 Tara Bhupathi, Technology’s Latest Market Manipulator? High Frequency Trading: The Strategies, Tools, Risks, and Responses, 11 N.C. J.L. & TECH. 377 (2010); Charles R. Korsmo, HighFrequency Trading: A Regulatory Strategy, 48 U. RICH. L. REV. 523, 595 (2014) (“With novel technology... the harms involved and the best methods for avoiding them are unlikely to be fully understood with any great confidence. Without significant experience, it may not be possible to develop efficient and effective ex ante regulations.” (footnotes omitted)); Tom C.W. Lin, The New Investor, 60 UCLA L. REV. 678, 717 (2013) (“Law constantly plays tortoise to finance’s hare.”).

9 Lynne L. Dallas, Short-Termism, the Financial Crisis, and Corporate Governance, 37 IOWA J.

CORP. L. 265 (2012).

10 Katharina Pistor, A Legal Theory of Finance, 41 J. COMP. ECON. 315, 317 (2013).

PASQUALE.36.6.2 (Do Not Delete) 8/19/2015 9:48 AM

2088 CARDOZO LAW REVIEW [Vol. 36:2085

traded are very little more than legal recognitions of obligations to buy or sell, own or owe.11 The LTF changes the debate, which can now move beyond stale dichotomies like “law vs. technology,” or “state vs. market.” As Pistor shows, “financial markets are rule-bound systems” and “finance is essentially hybrid between state and markets, public and private.”12 The LTF also enables a more substantive dialogue about the purpose of finance, beyond merely increasing the speed, efficiency, and accuracy of trading. Once we acknowledge that public resources are the critical foundation of modern finance, we can begin to re-instill it with public purpose. Here, another branch of thought about finance—mainly arising out of the work of economists like Mary Mellor, Geoff Mulgan, Ann Pettifor, and Mariana Mazzucato—should inform American debate.13 Their substantive approach to finance, focusing on the most productive deployment of capital, is a necessary corrective to decades of procedural focus in U.S. law.14 This Article redefines the problem of HFT through the twin lenses of the LTF and substantive guidance of investment. The common mental picture of hapless, outmatched regulators contending with technical expertise beyond their comprehension is misleading. First, it was regulators who changed the rules and sparked the rapid growth of HFT technologies.15 Second, regulators’ lack of resources is not simply the natural state of affairs—rather, it is one intensively pursued by lobbyists who influence the relevant Congressional committees to cut appropriations, and to prevent agencies like the Securities Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) from keeping the billions of dollars they effectively earn by policing markets and imposing fines.16 The relevant regulators could 11 ROSCOE POUND, JURISPRUDENCE 163–64 (1959) (“In a commercial age wealth is largely made up of promises.”).

12 See Pistor, supra note 10, at 312 (discussing the four key components of the legal theory of finance).

13 See MELLOR, supra note 7; see also MARIANA MAZZUCATO, THE ENTREPRENEURIAL STATE:

DEBUNKING PUBLIC VS. PRIVATE SECTOR MYTHS (2014); GEOFF MULGAN, THE ART OF PUBLIC

STRATEGY: MOBILIZING POWER AND KNOWLEDGE FOR THE COMMON GOOD (2009); ANN

PETTIFOR, JUST MONEY: HOW SOCIETY CAN BREAK THE DESPOTIC POWER OF FINANCE (2014).

14 An excellent recent article has begun this process of translation. Robert C. Hockett & Saule T. Omarova, Public Actors in Private Markets: Toward a Developmental Finance State, 93 WASH.

L. REV. (forthcoming 2015).

15 One critical development was the implementation of aspects of Regulation NMS (National Market System). See, e.g., Dissemination of Quotations in NMS Securities, 17 C.F.R. § 242.602 (2013); Disclosure of Order Execution Information, 17 C.F.R. § 242.605 (on making order execution information available); Access to Quotations, 17 C.F.R. § 242.610; PATTERSON, supra note 1, at 49 (discussing Reg. NMS’s effects on trading venues’ monitoring of prices).

16 In other agencies of government, like the Centers for Medicare and Medicaid Services (CMS), law enforcers can keep some of the money they collect in fines, in part in order to invest in better ways of detecting and deterring fraud in the future. Frank A. Pasquale, Private Certifiers and Deputies in American Health Care, 92 N.C. L. REV. 1661, 1667 (2014).

PASQUALE.36.6.2 (Do Not Delete) 8/19/2015 9:48 AM 2015] LAW’S ACCELERATION OF FINANCE 2089 always go back and undo or alter the rules that make milliseconds matter in trading. Congress could empower regulators to do more to deter misuses of latency—i.e., the delays in transmission between certain orders and their execution. A tax as small as a tenth of a penny per trade could effectively end most HFT. Rather than taking the current rules and technological capabilities of law enforcement as the given baseline for discussions of HFT, we should instead view them as the prime targets of reform.

To make that case, Part I describes the rise of HFT, and the distortions, biases, and unfair advantages it creates in current markets.

Part II addresses the current law of trading, analyzing efforts by federal and state regulators (and private litigants) to challenge particularly manipulative or troubling application of technology by HFT firms and the exchanges and dark pools used by them. Part III discusses how to make current regulatory initiatives more effective. It also shows how policy that is more substantive in orientation than current approaches could promote both efficiency and fairness.17 Part IV concludes with reflections on how the LTF and substantive goals for financial regulation could reshape finance policy more generally.

I. THE ACCELERATION OF FINANCE

By the 1990s, pioneer automators were pushing stock and commodities trading away from physical exchanges and “out of the pits” in order to squeeze out middlemen and narrow the “bid-ask” spread in any given trade.18 The algorithmic tools deployed in all these scenarios did indeed reduce some inefficiencies, and knocked now-vestigial middlemen out of the industry. Yet they have also had many troubling consequences. Section A below describes the rise of HFT, and the nature of the trading it enables. Section B describes the problems that HFT creates, focusing on the ways in which the practice of high speed algorithmic trading engenders problems bigger than those it ostensibly solves.

17 For definitions of efficiency and fairness, see Chris William Sanchirico, Taxes Versus Legal Rules as Instruments for Equity: A More Equitable View, 29 J. LEGAL STUD. 797 (2000).



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