Ted Kaufman - United States Senator for Delaware

‘Flash crash’ renews debate on market abuse

Source: Financial Times

By Jean Eaglesham

September 13, 2010

Spoofing, layering and front-running. These strategies for market manipulation may be long-established – but the May 6 “flash crash” has given a fresh sense of urgency to US regulators’ efforts to crack down on the abuse.

An inquiry into the crash has yet to pinpoint any definitive cause. But the regulators’ review has focused attention on the substantial growth in high-frequency trading and its use of computerised trading programmes – algorithms – to profit from fractional price differentials.

A review by the Securities and Exchange Commission, started before May 6, highlights two types of “directional strategies” used by traders that the regulator says “may present serious problems in today’s market structure”.

The first is order anticipation – trading to profit from the expected trading of others; for example, by using sophisticated software to try to detect large buyers or sellers in the market.

“Momentum ignition”, the second strategy under scrutiny, means trying to kick-start rapid price movement by – for example – initiating a series of rapid-fire buy or sell orders that are then cancelled. The techniques used to achieve this range from legitimate trading to illegal (but hard to detect) scams, such as false rumours. Other market abuse includes “spoofing” and “layering”, by which non-bona fide orders are used to drive a share price up or down.

The SEC release invites comment on “whether additional regulatory tools are needed to address illegal practices” as well as the issue of whether high-speed trading tools allow proprietary trading firms to use order anticipation strategies more widely these days.

Some US commentators want the regulator to act more rapidly, issuing guidance before rule changes to identify illegal trading strategies. They cite approvingly the example of Britain’s Financial Services Authority. Stating last autumn that some market participants might not be sure that spoofing or layering was wrong, an FSA spokesman said: “This is to clarify that it is.”

Ted KAUFMAN, Democratic senator from Delaware, called in March on regulators to “better define manipulative activity and provide clear guidance for traders to follow, just as Britain’s regulators have done”. Emphasising the importance of the formal rulemaking process, he said US watchdogs “must get back in the business of providing guidance to market participants on acceptable trading practices and strategies”.

The industry would also be likely to welcome such guidelines. Market participants say their concern is that the furore about the flash crash conflates legitimate trading strategies used by high-frequency firms with incidences of abuse. They cited regulatory focus on “quote stuffing” – placing a high volume of orders that are then cancelled almost at once. Many high-frequency firms use quote stuffing legitimately, rather than to manipulate prices, say industry figures.

Enforcement action the Financial Industry Regulatory Association is expected to announce on Monday – fining a trading firm and 11 of its staff for layering – will put a spotlight on the more dubious end of the market.

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