High frequency trading and dark pools
Posted on 09 November 2015 by
Andrew Tyrie MP, the chairman of the Treasury select committee who is leading attempts to reform banking, is one of the latest high profile figures to warn of the risks posed by high frequency trading (“HFT”) in equity markets.
High-frequency traders are able to take advantage of miniscule price differentials between markets which result from delays in transmission. They employ sophisticated computer programs that can spot anomalies, and act faster than the relevant exchanges to turn a profit, trading in a matter of micro seconds.
Mr Tyrie is perhaps right to worry, with HFT being blamed for the “flash crash” of 2010, where 10% of the value of US stock markets was lost in 36 minutes, and the more recent extreme fall on 24 August 2015. HFT firms have also been accused of contributing to a 28% spike in the Swiss franc in January of this year and a collapse in US government bond yields in five minutes in October 2014.
Dangerous as these HFT activities may be to the markets in a macro sense, there is another more immediate concern for individual investors, particularly those participating in markets known as ‘dark pools’.
Dark pools are private forums for trading securities and are not accessible by the general investing public. They are called dark pools because of their complete lack of transparency and regulation. Such murky waters have become prime hunting ground for more predatory HFT firms; conduct such as suggested in US proceedings in NY Attorney General v Barclays. In this case, wrongdoing was alleged to have been perpetrated by the dark pool operator (“Barclays”) in the following circumstances;
- i. Barclays actively sought to attract HFT traders to its dark pool by affording them advantages over other market participants (“Participants”), contrary to its claim to Participants that special safeguards had been effected to protect them from predatory HFT.
- ii. Barclays provided misleading marketing materials to prospective Participants, claiming for example that a “liquidity profiling” service would be provided to analyse each interaction in the dark pool in an attempt to reduce the level of predatory trading.
- iii. Barclays disclosed sensitive and detailed information to HFT firms in order to encourage and increase their involvement in its dark pool, including trade information belonging to other investors.
This behaviour could potentially lead to damage for individual Participants, who will be concerned to obtain redress in relation to the same. In this respect, a civil suit has been brought in the US by pension funds and other investors against Barclays and seven exchanges including Intercontinental Exchange Inc's New York Stock Exchange, Nasdaq, BATS Global Markets and CHX Holdings Inc's Chicago Stock Exchange, accusing them of favouring HFTs, and costing less-favoured investors billions of dollars. While this claim was recently dismissed by a US District Judge in Manhattan (who held that under US federal law, the exchanges were afforded an "absolute immunity" from the plaintiffs' main claims due to their status as self-regulatory organisations and also that the plaintiffs did not reasonably rely on Barclay’s representations about the safety of its dark pools) if such a claim were to be brought here, the outcome may be very different given the vastly different legal framework. The success of a similar claim in this jurisdiction will of course also depend on the specific facts of the case.
So what legal causes of action could be available to such a Participant under the laws of England and Wales?
Causes of action
Breach of confidence
The provision of information to HFT firms (as per circumstance iii above) could create liability for a dark pool operator in the form of a breach of confidence. Such a possibility arises where the operator provides sensitive data belonging to one Participant to HFT firms without the Participant’s consent. An example is where order information is shared with an outside vendor after such information had been received in confidence.
There is an argument as to whether the content of such information possesses the required quality of confidence prior to the execution of the trade. The case is bolstered where a Participant is expressly choosing to use a dark pool to ensure such a disclosure does not take place. Subsequently providing this information to an HFT firm, which uses it to gain an advantage over the Participant, may therefore lead to a breach of confidence, as a party who receives information in confidence must not use it to the prejudice of the person who disclosed it without consent.
The tort of fraudulent misrepresentation consists of the following elements:
- i. The defendant makes a false representation to the claimant;
- ii. The defendant knows that the representation is false, alternatively, he is reckless as to whether it is true or false;
- iii. The defendant intends that the claimant should act in reliance on it; and
- iv. The claimant does act in reliance on the representation and, in consequence, suffers loss.
It is certainly arguable that these elements could be made out in respect of the activities at points i and ii of the circumstances above. For example, where an operator includes deliberately misleading information in its marketing materials, which is intended to, and does, induce a Participant to trade on its exchange. Should that Participant suffer loss as a result (for example as a result of falling victim to predatory trading, which has not been restricted as there is in fact no “liquidity profiling” service to do so) then it may have a claim against the Operator in fraudulent misrepresentation.
An action for negligent misrepresentation arises from the Misrepresentation Act 1967 (section 2(1)). Should the higher evidential threshold required to prove fraudulent misrepresentation not be reached, a claim could be grounded in negligent misrepresentation in respect of the representations made in circumstances i and ii from the above. A negligent misrepresentation can occur where a statement is made by one contracting party (e.g., an Operator) to another (e.g., a Participant) carelessly or without reasonable grounds for believing its truth.
In the context of dark pool fraud, a claim for negligent misstatement may be brought where the Operator owes a duty of care to a Participant and carelessly makes a false statement to the Participant, on which that Participant relies and, as a result of which, the Participant suffers loss. This could arise in relation to circumstances i and ii from the above.
Such a claim may arise whether or not a contractual relationship exists between the parties. However, as there will generally be a contractual relationship between an Operator and a Participant, it is more likely that a claim would be brought for negligent misrepresentation (as the claimant need not establish a duty of care).
Furthermore, as Participants are usually experienced institutional investors, they may come across problems establishing causation following a negligent misstatement: it may be hard to argue that a sophisticated investor relied to any significant degree on marketing materials without placing more weight on its wider knowledge of the situation.
Indeed, this is one of the arguments Barclays ran in a motion to dismiss the NY AG’s prosecution against it in the US: it pointedly rejected the allegation that investors had been given an incorrect impression about the amount of high-frequency trading in the Barclays LX dark pool “by glossy marketing brochures or quotes from magazine articles”.
It should be noted that these arguments could also apply against a claimant in the context of negligent/fraudulent misrepresentation, in respect of the reliance placed by the claimant on the representation. As discussed above, this was the Achilles’ heel of the civil suit brought in the US (albeit in the context of different causes of action, formulated under US law).
Unlawful means conspiracy
This economic tort requires an agreement between two parties to injure another and a concerted action pursuant to this agreement (active or passive). It does not require proof that the predominant purpose of the conspirators was to injure the claimant; it is enough that it was one of the purposes. In fact, the tort will be constituted where: (1) a conspiracy is aimed or directed at another entity; and (2) it can be reasonably foreseen that the conspiracy may injure that entity. Specifically, the tort can be made out where the injury inflicted is a means to an end, e.g., as a by-product of the Defendant’s commercial gain.
The defining feature of this tort is the requirement that the conspirators use unlawful means to pursue their goal.
A wide approach appears to be adopted when considering what will constitute unlawful means, including acts prohibited by both the criminal or civil law, as long as there is a causal link between the act which is unlawful and the damage inflicted on the claimant (rather than there just being unlawfulness somewhere in the story). It is not necessary to show that the unlawful means are actionable by the claimant in a claim for unlawful means conspiracy.
The scope of this tort lends itself to commercial fraud in the context of dark pools, where some form of unlawful action in this wider sense is quite likely.
Considering circumstance iii, where there is some agreement between the operator and a HFT firm to act in a way that gives the HFT firm a commercial advantage within the pool (for example providing them with informational advantages) and where by doing so another Participant is injured (as would be the case where they are victims of excessive predatory trading facilitated by the advantages bestowed upon the HFT firms), it could be considered at least reasonably foreseeable that the other Participant may be injured.
The second limb of the test, i.e. whether ‘unlawful means’ were employed, could be triggered by for example the commission of a breach of confidence, as discussed above, or in some form of insider trading in contravention of section 118(3) FSMA 2000.
There are also potential criminal wrongdoings associated with the behaviour found at circumstance iii (for example criminal insider trading) which could provide a platform for an unlawful means conspiracy claim.
Section 118 FSMA (Market abuse)
Unlike in respect of many other provisions of FSMA 2000, contravention of section 118 of the Act does not provide a cause of action for a victim of market abuse. This was affirmed in Hall v Cable and Wireless Plc.
Although a Participant will therefore not find a cause of action open to them in this respect, remedy may nonetheless be available as a result of the FCA’s powers to order the payment of compensation to victims of market abuse (amongst other things) under section 384 FSMA 2000.
Despite Martin Wheatley, former head of the FCA, appearing to play down the dangers posed by high frequency trading in his June 2014 speech at the Global Exchange and Brokerage Conference, New York, it seems almost inconceivable that the type of behaviour alleged to have taken place in NY Attorney General v Barclays has not found its way to this side of the Atlantic, particularly in light of the ever growing popularity of dark pools and HFT trading in the UK. Accordingly, investors in dark pools that consider they may have suffered loss at the hands of HFT firms would be well advised to investigate further the possibility of a claim against an Operator based on one or more of the causes of action suggested above.