Are You Afraid of the Dark? How the New York Attorney General Is Shedding Light on Dark Pools and High Frequency Trading

By Marciello, Jordan M. | Suffolk University Law Review, Winter 2016 | Go to article overview

Are You Afraid of the Dark? How the New York Attorney General Is Shedding Light on Dark Pools and High Frequency Trading


Marciello, Jordan M., Suffolk University Law Review


"And then there is maybe the greatest cost of all: Once very smart people are paid huge sums of money to exploit the flaws in the financial system, they have the spectacularly destructive incentive to screw the system up further, or to remain silent as they watch it being screwed up by others." (1)

I. INTRODUCTION

Similar to nearly every industry in the world, technology forever changed Wall Street. (2) Electronic trading effectively started to replace human buyers and sellers in the early 1990s, but few could anticipate the speeds at which high-frequency trades occur today. (3) Savvy quants--mathematicians who use quantitative techniques to make market predictions--began to dominate the finance world in the early 2000s through the use and development of complex trading strategies and algorithms. (4) These changes altered the trading landscape as more venues, known as pools, became available to participants in the U.S. equity market, such as the dark pool alternative trading system (ATS). (5)

Dark pools became attractive to investors because, unlike trading in "lit" pools, such as New York Stock Exchange (NYSE) or National Association of Securities Dealers Automated Quotation (NASDAQ), trading that occurs in dark pools does not reveal buyer or seller identities, and transactions are not initially displayed to the public. (6) This structure is ideal for investors looking to make large trades because it cloaks investors' actions from competitors, minimizing price movements and predatory trading. (7) The obscurity of these pools, in conjunction with the sophisticated minds behind these trades, ultimately led to widespread manipulation and legal front-running. (8)

Until June 2015, there had been little legal action against the firms taking advantage of investors through high-frequency trading (HFT). (9) The New York Attorney General (NY AG), Eric Schneiderman, brought the first big case under a little-known state law from the 1920s, the Martin Act, which grants the NY AG the power to regulate and investigate securities fraud. (10) In efforts to boost investor confidence and ensure the markets work for the entire general public, Schneiderman hopes to stifle the fundamentally unfair situations that HFT has created at the expense of the rest of the market. (11)

This Note aims to provide a useful overview of the development of the U.S. stock market and show how lawsuits, such as the one against Barclays, will shape the U.S. stock market's future. (12) Part II of this Note will present a detailed assessment of HFT, relevant SEC regulations, and a history of the Martin Act. (13) Part III will discuss the current case against Barclays and how regulators should proceed in handling contemporary dark pool and HFT crises affecting the U.S. stock market and, in turn, its investors. (14) This Note advocates for an approach that seeks a balance between a free market economy and clear regulations, so as to avoid further market exploitation. (15)

II. HISTORY

A. From Buttonwood Trees to Pushing Buttons

In mid-May of 1792, twenty-four brokers stood under a buttonwood tree on Wall Street and signed an agreement that would start the trade of securities and create what is known today as the NYSE. (16) Although trading still conjures up an image of a frantic exchange floor, crowded with men yelling in expensive suits, that picture is no longer accurate. (17) Virtually no traders have worked on the floor since 2007, a trend that began after the 1987 stock market crash. (18) When the market fell by 22.61% on Black Monday, October 19, 1987, brokers deliberately did not answer their phones, making it impossible for small investors to sell stocks; this response, or lack thereof, triggered the gradual switch to computers. (19)

At the time of the Black Monday crash, nearly all trades went through middlemen, known as market makers. (20) This system forced ordinary Americans to utilize these brokers if they wanted to trade on the major exchanges; thus their services came at a hefty fee. …

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