High Frequency Trading has become a dominant trading system in the financial market, especially throughout equity markets. However it is important to note that the HFT itself does not cause trader misconduct. But rather it is on the traders’ use of HFT or traditional trading that impacts stability and fairness in the market. There are 5 general categories of trader misconduct that occurred in 2014-2018.
1. Price Manipulation – Algorithmic trading: Spoofing
Spoofing occurs when traders place a larger order in the futures market with intention to cancel the order before execution after a smaller order is placed in the same direction of the trader. In regards to automated spoofing, a case on Japan Government Bond Futures, in which the trader who was in Singapore used an algorithm as a tool to engage in spoofing. The Singapore trader was imposed a monetary penalty of JPY330,000 in 2014 by the Securities and Exchange Surveillance Commission (SESC) based on market manipulation under the regulations of ‘Financial Instruments and Exchange Act’ (FIEA), the main statute that governs securities law in Japan.
Through algorithm trading, it is clear that it enabled the trader to execute trades within a shorter period of time than manually. The trader was able to place a spoofing order and cancel the order within 300 milliseconds. It enables the trader to place sell orders once reached above a certain level, which causes unfair losses to the spoofed investors. Therefore it is clear that spoofing as a tactic is purely deceptive, as the information released is ambiguous and adds no good information to other traders and the trading strategy adopted for spoofing does not hold good intentions as the true intent for spoofing is to induce other traders to trade in the direction desired by the trader.
2. Reference price manipulation – Libor manipulation
Libor is an international benchmark for currency trading and FX trading, Libor rates had been calculated for ten major currencies across different periods (overnight, monthly, quarterly figures of the reference price). The Libor rate represents the average interest rate at which major banks (panel banks) are prepared to lend to each other, on an unsecured basis through the interbank market. On 2016, Tom Hayes, a former UBS and Citigroup trader was the first person to be convicted on manipulating the Libor rates and had to pay USD$1.2 million as monetary penalty and will serve an 11-year prison sentence.
3. Improper Order handling – Front Running
Front running is a form of market manipulation, it occurs when traders use confidential information and conduct deals in advance. The HSBC case of two former employees, Mark Johnson and Stuart Scott, both of whom held positions as global head of foreign-exchange trading and former head of European currency trading. Therefore these traders should be aware of their duty of trust and ability to execute trades in clients’ best interest however they have been convicted of front running a US$3.5 billion trade. This highlights that front running benefits the traders themselves at expense of their clients.
4. Wash trades:
Wash trade is a process in which a trader buys or sells securities for the purpose and intent to feed misleading information to the market, without changing beneficial ownership. Although taking both sides of a trade may help to minimize financial risk, it can also create false information to markets as it presents higher volume which can be used to manipulate prices, therefore this wash trades is prohibited under the US law. In regards to wash trade, a case where the SFC banned Wong Chun, former licensed representative, a dealer from Ping An of China Securities for misleading trades in the Sino-Tech through wash trades between his personal account and two other investors, which enabled him to make a personal profit of $2 million. The SFC has banned Wong Chun to enter back in the industry for eight years.
5. Insider information:
Insider information is to use non-public information about a firm by insiders for personal profit. Traders at investment banks hold access to these valuable confidential information, however if traders utilize these information relating to potential merger negotiations and use it for their own benefit. Insider trading is a category for trader misconduct as traders violate their duty to the company. A recent case of insider trading was charged to Woojae Jung, former vice-president at Goldman Sachs Group inc, as he traded on market moving information and had made $130,000 through illegally using the non-public information of which were companies that were clients of Goldman Sachs Group Inc.
Regulatory efforts and corporate works: Combat the act of trader misconduct
As highlighted above, trader misconduct from excessive risk taking can in effect, diminish the trust in the capital markers and prevent it from functioning properly. There have been constant regulatory efforts and corporate cooperation in place to prevent trader misconduct from occurring, however it is evident that trader misconduct has occurred regardless of nation or jurisdictional boundaries. Regulators have adjusted their approach from process and ‘rules’, towards an approach that emphasizes the interaction between culture, behavior, governance and conduct. For the bank side, new methodologies for managing trader misconduct have been placed, focused on enhanced internal controls and compliance functions.
Manipulation techniques such as spoofing have evolved from traditional markets into automated trading. Although highlighted under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, spoofing is prohibited due to its deceptive tactic, of order display manipulation. However it is difficult to detect misconduct for HFT abuses, due to its speed and large volume. Therefore to detect trader misconduct of spoofing through HFT, it may require regulators and professionals to go through that specific computer code that operates the algorithm, as this will provide better evidence towards the traders’ intent. Furthermore it could be a consideration that placing small fees for all cancelled trades once reached a certain limit, will enable to minimize the profits gained from spoofing. Whilst enabling the certain limit, to not disadvantage legitimate traders.
The European Commission has placed two regulations in 2011 and has been enacted in France, Italy and Germany. The two new regulations were known as ‘maximum order-to-trade ration’ and a ‘minimum resting time’ for displayed orders. These regulations are focused on preventing the unethical behavior that can be conducted by HFT. The benefits of these regulations are that they are quantifiable and will prevent any unethical practices before misinformation is formed and taken by other traders.
Financial regulators have begun to place reforms towards improving accountability and controls. The Financial Stability Board (FSB) launched a misconduct action plan in 2015, focused to tackle ways to mitigate trader misconduct a place preventative measures. Regulators have placed reforms to major financial benchmark arrangements to minimize trader misconduct. This highlights that regulators have taken a more preventive approach to mitigate the risk of trader misconduct. Rather than a one-time monetary penalty and sanctions, which can be effective for short term. The reforms help to minimize the occurrence of trader misconduct, as it tackles the source of where the bad behavior began. Furthermore for the bank side, they have implemented technology to maintain systems that are designed to detect spoofing, for example at Deutsche Bank, the bank had placed electronic surveillance system focused on detecting trading patterns for possible spoofing by its traders. Although this system had detected hundred of possible spoofing by its traders, Deutsche Bank had failed to conduct the correction actions necessary and had not performed its supervisory duties diligently.
Since 2016, Bank of England (BOE) and Financial Conduct Authority (FCA) launched the Senior Managers Regime (SMR), which senior managers of bank must be approved by the regulators. This is to ensure senior management of firms is suitable to perform their responsibilities and will not misbehave. The SMR helps to place a pinpoint to the problem in regards to the occurrence trader misconduct. Senior managers for the bank will have to provide a ‘statement of responsibilities’ that outlines the specific areas where they hold personal accountability. Therefore if trader misconduct arises in those areas, it will be the senior manger that will be held responsible, unless the senior manager can prove action was taken to prevent the trader misconduct from arising.
Based on the trader misconduct cases stated above, at times managers were aware of the traders exceeding risk limit and the mechanism that were used to disguise the excess risk that were taken. Traders felt it was cultural imperative to generate profits of last quarter or more, which meant the bank desired to take more risk, as yield became harder. Therefore traders were pressured to generate returns, as it had been the ‘culture’ of the industry. The Securities and Futures Commission (SFC) of Hong Kong has implemented the ‘Manager-In-Charge’ regime since 2017, to clarify the accountability held unto senior management. Thus these requirements help to promote more effective company culture, as it will be imperative for senior managers to ensure their employees act in line with the regulations and conduct trades that promote fairness in the market.