The traditional definition of insider trading involves the buying and selling of a security while in possession of material, non-public information about that security. A simplified example of this is the following: the CEO of Company A learns from the CEO of Company B, prior to its public announcement, that Company B will be acquired by Company C. Knowing that the share price of Company B will likely rise following the public announcement of its acquisition by Company C, the CEO of Company A buys shares of Company B with the intent to resell the shares for a profit after the acquisition announcement. Insider trading is illegal because it provides an unfair advantage to investors who trade securities based on market-moving information that other investors do not have access to. Insider trading also causes a distortion in market prices since insider trading makes it increasingly difficult for markets to reflect all available information.
Recently, there is a new kind of conduct being scrutinized by the SEC, CFTC, and FBI that is now known as “Insider Trading 2.0.” However, this kind of conduct does not precisely fall into the traditional definition of insider trading described above, and is therefore not currently prohibited by law. Insider Trading 2.0 involves the use of high frequency trading (HFT) to execute trades based on non-public information that investors obtain access to within fractions of a second of such non-public information becoming publicly available. For example, until it agreed to discontinue this practice, Thompson Reuters used to sell investors access to the University of Michigan”s economic surveys, considered to be market-moving information, five minutes before these surveys were publicly disseminated. For a larger fee, customers could even obtain access to these surveys two seconds before those who paid for the five minute early access. Customers who paid for the earliest access to these surveys would trade extensively using HFT within the two second window before the market began to reflect the information in the surveys as they became available to the five minute early access customers and then eventually to the whole public. While this trading practice often involves a lawful sale of information (unlike traditional insider trading, which typically involves a misappropriation of non-public information that is in breach of the insider”s fiduciary duties), it has been condemned by New York Attorney General Eric Schneiderman as an unfair trading practice that distorts the market. New York Attorney General Eric Schneiderman”s remarks on Insider Trading 2.0 have been influential enough to make certain companies take action. Both Two Sigma Investments and BlackRock have agreed to end issuing and collecting certain surveys designed to gather stock information from analysts, which reflected non-public information regarding the analysts” sentiments pertaining to forecasted earnings estimates and other financial information. Similarly, and as alluded to above, Thompson Reuters agreed to suspend its early release of the surveys it receives from the University of Michigan.
There are other HFT practices in addition to the kind described above that have also raised concerns. For example, there is a concern about “latency arbitrage”, which occurs where investors use HFT to step head of other investors in order to have their trades executed first. This practice results in the investors who were cut in line having to buy/sell at a higher/lower price due to the HFT activity that occurs while their orders were still pending. By contrast, the investor using HFT to commit latency arbitrage ultimately profits by buying or selling once the pending orders of other investors are executed and prices adjust. This kind of market manipulation is very similar to front running, which is where brokers trade ahead of their clients” orders. Front running is prohibited under FINRA Rule 5320, however the Rule does not apply to HFT firms that are not acting on behalf of a client and are only trading for its own accounts.
Another HFT practice being investigated is known as “layering” or “spoofing,” in which a trader sends out an extensive amount of orders to create a faade of trading activity in a security in order to stimulate other investors to buy or sell, only for the trader to cancel the orders and profit from trades based on the artificially inflated or depressed prices. Similarly, traders using HFT have tried to gather information about the flow of stock orders by “pinging” different markets with multiple orders to determine whether any will be filled, and using that information to gauge the direction of a stock (most of the orders placed for pinging are canceled). There are concerns over the extent to which these practices constitute an unfair manipulation of the market.
Ultimately, the concerns over HFT practices are manifold. First, the HFT practices described above compromise the competitiveness of the market and distort market prices. Second, by diminishing the competitiveness of the market, investor confidence declines since there is an increasing perception that the market is rigged for HFT firms. Third, HFT practices have the potential to cause substantial market volatility. For example, the term “flash crash” was born on May 6, 2010, when during an already turbulent day for the market, the Dow Jones lost about 600 points in five minutes following a flurry of high frequency trading activity that caused the market to spiral out of control.
While many HFT practices dubbed Insider Trading 2.0 are not yet illegal, the use of HFT is being investigated by the SEC, CFTC, and FBI. Fund managers using HFT practices should be aware of the current scrutiny being placed on such practices and should seek advice on whether such practices may constitute an unlawful manipulation of the market.