- Heleen Boonen
High Frequency Trading, Electronic Frontrunning and Structural Insider Trading Under the EU Market A
High Frequency Trading and How It Relates to Insider Trading
High Frequency Trading (HFT) has gained a foothold in financial markets and has been making front-page news since the events of May 6, 2010, now commonly referred to as the Flash Crash. Significant changes in the macro and microstructure of European financial markets following the implementation of the Markets in Financial Instruments Directive (MiFID) I and technological progress in trading processes have resulted in the rapid growth of HFT on European trading platforms. HFT has become one of the most important trading techniques in the stock market, as well as the subject of one of the most fierce regulatory discussions in the financial sector. The term “high frequency trading” is used more generally to describe the activity of professional traders acting in a proprietary capacity and engaging in short-term trading strategies through the use of high-speed computer algorithms that automatically generate and execute trading decisions. High frequency traders thereby generate a large number of trades on a daily basis, often in terms of seconds and milliseconds, and its trading strategies are traditionally characterized by a high order-to-trade ratio.
A lot of the more general regulatory discussions have focused on the systemic risks that have emerged since the growth of HFT. Largely left untouched, however, is the relationship between HFT strategies and insider trading. As a result of co-location facilities, expert networks and private data feeds, high frequency traders enjoy significant informational advantages when implementing their trading strategies. The question that will be addressed in this article is whether these advantages could potentially violate the prohibition on insider trading under the EU Market Abuse Regulation.
This issue can easily be explained in the context of the commonly-known HFT strategy of electronic frontrunning. Electronic frontrunning is an order anticipation strategy by which a high frequency trader, prior to any other market participant, becomes aware of a transaction taking place on one trading venue and derives from that information that potentially similar orders are being placed and are en route to other trading venues. As a result of this speed advantage, the high frequency trader uses this information to execute beneficial trades.
Consider the following example (see figure below). Institutional investor A decides to buy shares of XYZ and sends out two different market buy orders to both Euronext Amsterdam and the London Stock Exchange. As the matching engine of the latter is located further away from the computers of A than the former, the market buy order will arrive slightly earlier, in this hypothetical 10 microseconds, at Euronext Amsterdam. As the market buy order of A matches with outstanding sell orders of the high frequency trader, the latter derives from this information that plausibly similar orders are en route to the other major European trading platforms. Subsequently, in the 10-microsecond time frame, it is able to adjust its outstanding sell limit order on the London Stock Exchange to a slightly higher price.
The institutional investor ultimately pays more, namely €0.02 per share, than when the high frequency trader had not used its informational advantage. Although it is clear that such a technique could fall under the prohibition of market manipulation, more interesting is the query whether the high frequency trader, by using its speed advantage, could find itself in the same position as an insider trader. Therefore, the critical question at issue is whether the ability of certain traders to receive faster access to certain information that is accessible to everyone that has the necessary resources, may come within the field of insider trading.
Insider trading under the EU Market Abuse Regulation
Under the EU Market Abuse Regulation (MAR), inside information is defined as “information of a precise nature, which has not been made public, relating, directly or indirectly, to one or more issuers or to one or more financial instruments, and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments” (Article 7(1)(a) MAR). Insider dealing takes place when a person that possesses this sort of information, consequently decides to cancel or amend an order concerning a financial instrument to which the information relates where the order was placed before the person concerned possessed this inside information (Article 8(1) MAR).
Taking into account the definition of insider trading under European legislation, it is fair to say that electronic frontrunning could potentially entail all the essential elements that make a trading strategy illegal under Article 8(1) MAR juncto Article 14 MAR. Firstly, high frequency traders use certain information to amend their outstanding orders. Learning that certain orders at a specific price for XYZ, as part of a large order by A, are en route to different trading venues, lets the high frequency trader decide to adjust the price of its outstanding limit sell orders on these trading venues. Through its great speed advantage, it manages to effectively trade prior to the ‘normal’ or low-frequency investor. Secondly, this information is directly related to financial instruments, namely the ones that are being bought or sold by the institutional investor. Finally, if the fact that an institutional investor is buying a specific kind of shares on a large scale were to be made public, it would be likely to have a significant effect on the prices of these financial instruments.
The critical question is whether the information at issue is actually ‘non-public information’. Surely, everyone in possession of the means and sophisticated computer programs fast enough to detect that an order of an institutional investor is placed on Euronext Amsterdam and that similar orders are likely en route to the London Stock Exchange, could use this information to his or her advantage. Therefore, according to some, electronic frontrunning should not be confused with the illegal traditional frontrunning, where a broker trades an equity in his personal account based on advanced knowledge of pending orders from its firm or its clients.
Under EU insider trading laws, the main factor to consider when deciding whether information is public or not, is ‘availability’. Information would only be held public and available where it would have penetrated the market and the market thereupon would have had the opportunity to absorb and evaluate the information that had been made public.
According to F. G. H. Kristen, a professor at Utrecht University School of Law, a thorough analysis of the establishment of the initial Directive 89/592 results in the consideration that the concept of ‘public’ relates to the moment the investing public was able to pick up on the information, to be understood as all investors in general and in abstract terms and therefore current, as well as potential investors. The investing public, however, only needs to be able to learn about the information, or have the possibility to learn of it. Irrelevant is whether the investing public actually did possess this knowledge at a certain moment in time. For the condition of availability or accessibility to be fulfilled, it is therefore likewise not necessary that the whole, although the majority, of the investing public is being or can be informed. The medium with which the information is provided to the investing public does not have to provide for universal coverage and as such, general availability is not required. F. G. H. Kristen finds this reasoning also applicable to the Market Abuse Directive 2003/6/EC. As the definition of market abuse, from a theoretical point of view, has not been amended in the current Market Abuse Regulation, this interpretation also deems to be used today. More importantly, the CESR had already established that publicly available information can also consist of information made available on a commercial basis, for example through electronic information services an investor needs to subscribe to. As a final argument, Kristen makes clear that as a consequence of the interpretation of ‘inside information’ of the Directive, the information cannot only be considered as public after a certain period of knowledge or absorption that deems to be reasonable for consulting, observing or processing the information that has been made available to the investing public.
It is therefore important that with electronic frontrunning or any other HFT-strategy that uses co-location to enjoy preferential access to order information, the orders are necessarily already present in the market before the high frequency trader is able to detect them. The high frequency trader only identifies the orders of other market participants after they actually have appeared in the market. As a consequence, high frequency traders are not technically conducting illegal activity because they are not relying on inside information. Notwithstanding the systemic informational advantages that high frequency traders enjoy by virtue of co-location facilities and private data feeds, these practices do not fall under the prohibition of insider trading.
Coherence between doctrine and policy?
Although information available to high frequency traders seems to be ‘public’ in the legal sense of the word, functionally it is not. Non-public information has a completely different meaning in a low frequency context than in a high frequency one. The use of co-location and private data feeds in financial markets results in damages that substantially resemble those of conventional, corporate insider trading. The latter’s prohibition was introduced to protect investors of consistently losing from better-informed investors to enhance trust in financial markets and guarantee equal opportunities to investors to fair investor returns. The usage of structural advantages to receive and trade on quasi-public information prior to other low-frequency investors, has therefore already been labeled as ‘structural insider trading’.
Where the law permits insider trading in one context, but sanctions it in the other, there seems to be a lack of coherence between doctrine and policy which undermines the EU laws’ supposedly “catch all protection” against insider traders. The means to gain access to particular “public” information is however institutionalized, governed by transparent means, and accessible to everyone able to afford them. Moreover, unequal access to information between investors is almost an inherent characteristic of traditional markets.
This leaves us with a few very important questions. Does the concept of insider trading in an HFT world need to be reconsidered? Is securities regulation today still about ensuring an unconditional level playing field when receiving and trading on market information? In case MAR should only be applicable to core corporate insider trading, it is recommended to adjust the doctrine to reflect its limited scope. If the EU legislator decides that the consequences of structural insider trading are however sufficiently detrimental to our market integrity in order to revaluate the current legislative framework, frequent batch actions could be considered as a market design response.
Heleen Boonen serves as a graduate editor of the NYU Journal of Law & Business. She is an LLM candidate at NYU School of Law where she focuses on corporate law and finance. Heleen is a Fulbright and B.A.E.F. grantee from Belgium. Prior to attending NYU she finished her Masters of Law at Ghent University summa cum laude where she was also a member of the University’s Honours programme. During law school, Heleen worked amongst others as a research assistant at Ghent University for the Department of Economic Law and as a summer associate at Linklaters Brussels.