Regulating High-Frequency Trading: Man V. Machine

By Gould, Alyse L. | The Journal of High Technology Law, January 2012 | Go to article overview

Regulating High-Frequency Trading: Man V. Machine


Gould, Alyse L., The Journal of High Technology Law


Cite as 12 J. High Tech. L. 273 (2011)

I. Introduction

Today's financial markets are light years away from those operating when the Securities Act of 1934 ("1934 Act") established the Securities and Exchange Commission ("SEC"). (1) The implementation of computers and advanced mathematics into trading has changed the way the United States and the world do business. (2) High-frequency trading and sophisticated algorithms are a product of the emergence of the internet and quantitative analysis in the 1990s, where speed and accuracy were necessary for best execution of orders. (3) Suddenly, a huge amount of shares could be traded quickly at a low cost. (4) Among the many benefits are high profits, low cost and accuracy in trade execution. (5) It is no surprise that today high-frequency trading techniques account for over fifty percent of trade volume. (6)

The SEC has had the difficult task of keeping up with the changing market conditions and tools. (7) The risks of many technologically advanced trading tools, including high-frequency trading, as of the beginning of 2010 had yet to be realized while others such as "flash orders" garnered proposed SEC regulation. (8) Given the perceived benefits and unrealized risks, high-frequency trading has been left largely unregulated. (9) The market events of May 6, 2010, popularly known as the "flash crash," caused stock prices to plummet falsely and then sharply rise. (10) While the market stabilized itself rapidly after the faulty algorithm of a single trader took its toll, the event caused many to cry out for regulation of high-frequency trading. (11) The SEC quickly implemented circuit breakers reminiscent of the "Black Monday" market crash of 1987 and erroneous-trade rules. (12) These measures were swiftly implemented and have yet to become permanent. (13)

Despite an earlier concept release in January 2010 on high-tech market tools, the SEC is now required by the Dodd-Frank Act to conduct research and propose legislation on high-frequency trading regulation. (14) The "flash crash" attributed to high-frequency trading practices caused market instability and dried up liquidity in a matter of minutes. (15) Regulation is required to prevent repeat occurrences based on algorithmic mistakes. (16) Part I discusses the evolution of the financial markets and provides an explanation of the benefits and risks of high-frequency trading. Part II provides background on the SEC's ability to regulate the financial markets and historical responses to advancing technology. Part III will explain specific legislation and regulations regarding high-frequency trading.

Part IV details the market events of May 6, 2010 and explains the cause of the "flash crash." Finally, Part V will examine whether the SEC's proposed regulations and implemented pilot regulation are an effective way to deal with high-frequency trading. The "flash crash" is reminiscent of the 1987 "Black Monday" crash and so are the SEC's responses. In order to create effective regulation the SEC needs to look ahead in creating responses instead of providing a quick fix, band-aid that will be ripped off in the near future. Regulations should be flexible in order to allow the positive effects of high-frequency trading to continue and provide room for new technologically advanced tools in the future.

II. From Trader to Computer: A Glance at How the World Trades

Trading floors and broker-dealer influence in the market is becoming obsolete. (17) Technology has knocked down barriers that once made the trading process slow and only possible through the use of a middleman. (18) These advances are, in large part, thanks to the invention of the Internet and direct connectivity from electronic communication networks ("ECNs"). (19) High-frequency trading has made it possible to replace human traders with sophisticated algorithms that can work under the direction of analysts and portfolio managers at a fraction of the cost. …

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