Patent Transaction and Patent Financing in China: The Difficulties and Opportunities for Third-Party Service Providers

By: Runhua Wang*

I. Introduction

The Chinese government has strongly encouraged patent application and patent protection in the past decade.[1]  As a result, China contributed 89% of the worldwide growth in patent applications in 2014, whereas the United States contributed 6%.[2]  Statistics from the World Intellectual Property Organization (WIPO) show that China has received the most patent applications since 2012 and that Chinese domestic patent applicants are filing more applications than applicants from any other country.[3]  This Paper introduces how third parties, referring to various types of patent service providers, are involved in the increasing patent market of China.

The WIPO statistics show that only a fraction of Chinese patents were filed abroad and that most of the patents only enrolled one foreign country, which indicates that the patents filed by China’s domestic applicants do not have a very wide geographical coverage.[4]  This may also imply that the average quality of Chinese patents is still low.[5]

Empirical evidence confirms this inference of low quality;[6] still, some scholars believe there is a trend of Chinese patent applicants improving the quality of the patents.[7]  This Paper discusses the difficulties, such as moral hazard, created by the different quality of patents in innovation commercialization, especially in patent transactions and patent financing, and how Chinese patent law exacerbates the difficulties.  The goal of this Paper is to encourage third parties to rethink their service for overcoming these difficulties.

Section II introduces the main categories of patent services provided in China.  Section III discusses the problems of the patent service and the paradox of promoting patent transaction and patent financing by policies and patent law.  Section IV suggests the opportunities for patent service providers in China.

II. Background: Service Map of the China Patent Market

Most patent applicants are represented by a registered patent agent when they apply for patents.[8]  Patent agents facilitate patent applicants by drafting patent applications and dealing with patent prosecution, such as conducting a prior-art search, drafting and filing patent applications, and answering examiners’ questions.[9]  As the number of patent applications increases in China, the demand for patent procurement also increases.[10]

The State Intellectual Property Office of the People’s Republic of China (SIPO) received 6.06 million (utility) patent applications from domestic applicants in 2016.[11]  The statistics by the All-China Patent Agents Association (ACPAA) show that China had 1,457 patent agencies and 14,795 patent agents in 2016.[12]  One patent agent deals with an average of eight new patent applications every month, which is much higher than the rates in the United States, Japan, and Korea,[13] which suggests an insufficient supply of patent procurement in China.[14]

At the same time that the number of patent agents has been increasing in China, the average level of their education has also been increasing.  In 2013, 29% of Chinese patent agents held a master’s degree and 3% of them held a Ph.D. degree.[15]  In the first-tier cities of China, such as Beijing, Shanghai, and Guangzhou, most patent agents held a master’s degree.[16]  Peking University Law School even established a graduate training program for patent agents.[17]

After patents are granted, they can be deployed to secure financing as intangible assets.[18]  For example, patentees can invest their patents for firm shares.[19]  Statistics by SIPO show that 34.3% of patents produced by universities are assigned to firms as investments in 2013.[20]

It is also common to use patents as collateral for loans in China.  Loans of 25.4 billion RMB were collateralized by patents in 2013 and increased to 48.9 billion RMB in 2014.[21]  Moreover, China’s patent market also provides patent insurance in more than fifty cities.[22]  Even though some international insurance carriers, such as AIG, IPISC, and Willis, have developed some mature patent insurance policies, the patent insurance policies provided in China do not exactly follow those carriers since patents are “jurisdiction-specific.”[23]  Two major types of patent insurance provided in the Chinese market are patent-infringement liability insurance for firms, as potential patent infringers, and patent-enforcement issuance for patentees.[24]  However, patent insurance has not been completely accepted by the market: the insurance coverage accumulated only 0.27 billion RMB between 2012 and mid-2015.[25]

Innovators expect monopoly rewards for their innovation.[26]  However, some scholars argue that innovators cannot be directly rewarded or compensated enough because their trade secrets related to the patents are more likely to be explored by their rivals through reverse engineering when they disclose the technology of the patents.[27] More scholars believe that innovators have strong perspectives on commercializing and improving their innovation after the monopoly rights exist.[28]  In addition to selling the patented products and generating revenue, licensing patents for expanding commercialization of products or co-inventing is also a critical measure that patentees use.[29]  Meanwhile, firms can license universities, public research institutes, or other firms for joint-R&D to share risks and profits, rather than independently develop technology.[30]  The statistics by SIPO show that smaller firms are more likely to license or transfer patents.[31]

There are patent agencies, such as CHOFN, and specialized patent transaction platforms that supervise patentees to transfer or license patents.  Gaohangip is the largest intellectual property transaction platform, which is like Amazon, where patentees can put their patents up for sale.  Patentees or Gaohangip lists the patents along with their prices, which are available to be searched by interested licensees for potential patent transactions.  Gaohangip functions as an agent and provides legal services for the patent transfer.

However, the statistics by SIPO show that in 2015 only 8.2% of patents were licensed by patentees and 5.2% patents were transferred,[32] suggesting an insufficiency in the business of patent transaction and patent transfers, as discussed in Section III.

III. Analysis

A. Difficulties for Patent Transaction

Out of the total firm patent owners surveyed, 62.1% believe that the major restriction of their profitability is that they cannot effectively prevent others from imitating the patents.[33]  On one hand, regardless of the arguments over the strength of patent protection in China, this relates to the low quality Chinese patents that are less competitive.  On the other hand, this concern suggests a mixed culture of copycat and innovation in China,[34] in which the competition increases as the follow-on innovation and downstream innovation raises in the market.  In this increasingly competitive market, moral hazard of patent transactions arises and grows too big to ignore because those licensed patents and any potential patents from the patentees are more likely to be circumvented.[35]

As a result, when the innovation ability of the licensees is high, patentees are less likely to transfer their valuable technology to avoid increased competition.[36]  Patentees may agree to transfer core technology only if the license includes a grant-back clause so that patentees are allowed to freely use further inventions by the licensees.[37]  However, given the low transaction rate, the moral hazard issues are not successfully mitigated in practice.

As a result, only 9.4% of the surveyed firms license patents or buy patents from domestic or foreign inventors.[38]  Out of the total number of firms surveyed, 19% invest R&D mainly in digesting the existing technology, while 54% invest R&D mainly in technology transformation.[39]  Even though firms are interested in purchasing technology instead of investing in learning, in this moral hazard scenario, licensing patents per se are not enough to learn core technologies from the patentee.  This is also a challenge for third parties to successfully bridge the parties in patent transactions when both sides do not have strong incentives to make a deal given the high cost of moral hazard.

While it is convenient to purchase and sell patents through an agency or a platform like Gaohangip, the agency or platform usually does not facilitate licensing.  Those agencies and platforms usually only facilitate drafting legal documents after parties enter into a patent transaction; they do not help with bargaining for the agreement.  Bridging the parties of patent transactions through those platforms with basic legal services effectively decreases the searching costs, but they cannot fill the moral hazard gap in patent transactions.

B. Difficulties for Patent Financing

Patent validity in China is stable: SIPO only received 3,724 invalidity petitions including utility patents, utility models, and design patents.[40]  With regard to litigation, the district courts in Shanghai decided 526 patent cases between 2002 and 2015.[41]  Only 15.97% of plaintiffs argued patent invalidity, while only 2.85% of third parties argued patent invalidity.[42]  Even though 20.7% of the plaintiffs in Beijing argued patent invalidity, for 487 patent cases between 2004 and 2015, only 2.04% patents were invalidated by courts.[43]

Nevertheless, this low invalidity rate does not provide patent owners strong incentives to purchase patent insurance.  They try to avoid litigation when they claim the insurance and when they do not have strong confidence in their patents’ validity.[44]

Therefore, the low patent invalidity rate does not mean a high quality of patents in China.  Indeed, lenders still hesitate to adopt patents per se as collateral.  Bank lenders usually ask for a loan guarantee in addition to patent collateral,[45] and they even prefer a combination of patent collateral, insurance, and guarantees to minimize risks.[46]  A loan guarantor in this circumstance is usually provided by the government or a government-funded mutual fund or incubator.[47]

Due to the high and complex thresholds, patent owners still have material difficulties in securing finance through loans.  The survey by SIPO shows that 45.3% of the firms that own patents rights complained about cash flow problems that can lead to a failure to finance patent commercialization.[48]  This could also be a result of the inevitable high cost of moral hazard in the loan market for patents.  Weak patent enforcement[49] in this litigation-averse society[50] exacerbates moral hazard issues.  These issues cannot even be mitigated by an emerging market of patent valuation in China, in which lenders can estimate patent value through economic analysis by patent valuation institutes.[51]

C. Paradoxes in Promoting Patent Transaction and Financing by Policies and Patent Law

1. Policies that Promote Patent Transaction and Patent Financing

In order to encourage patent applications and minimize the transaction costs in patent transactions and patent financing,[52] both the central government of China and the local governments have adopted various favorable policies for patent applicants, patent holders, and patent service providers, [53] such as the patent transaction platform—Shanghai United Assets and Equity Exchange.

Patent issuance in China was initiated by SIPO and the People’s Insurance Company of China (PICC).[54]  Meanwhile, local governments subsidize patent insurance to encourage the innovation firms to purchase the insurance.[55]  For patent collateralization, local governments actively provide interest subsidies or guaranties to facilitate innovative firms to acquire loans.[56]

The government also actively intervenes in patent applications and patent management by firms.  SIPO supervises local governments’ training for firms on patent management and patent strategies.[57]  Local governments provide subsidies and grants to fund firms to apply for patents and establish a patent management department.[58]  Many local governments also subsidize patent agents to improve the quality of patent applications.[59]

Most of the policies are enacted through economic instruments to decrease the transaction costs in patent applications, patent transactions, and patent financing.  However, even though the government can subsidize the application cost with SIPO, those current economic instruments cannot fully offset the cost of moral hazard that arises from the issues like low patent quality, weak patent enforcement, and the copycat culture.  Indeed, Chinese patent law is designed to prohibit patent transaction and patent financing to some degree.

2. Increased Cost in Patent Transaction and Financing by Patent Law

I am the first to argue that there are two main articles in Chinese patent law that could impede innovation commercialization, including patent transaction and financing.  First, Article 24 limits the scope of publication before the effective filing date of a claimed invention: the six-month grace period for novelty is only for the inventions that are disclosed in the exhibitions hosted or approved by the Chinese government, published at a specified academic or technological conference, or divulged by a person without consent by the applicant.

The exceptions of lack of novelty in 35 U.S.C. 102(b) regulating the one-year grace period does not restrict the manner of publications, including patentees’ sales and uses before the filing date, so inventors can test their market and consumers at an early stage.[60]  Moreover, Japan even has an Extensive Experimental Use Doctrine, which is not limited by a grace period, which helps with the understanding of the advanced technology and assisting with faster investing decisions.[61]

By contrast, Article 24 does not only provide a shorter term for inventors understanding the advancement of technology, but also does not provide a chance for inventors to test the market and consumers.  Therefore, it is not surprising to observe deficiencies in innovation commercialization in China.  Some patents may not have commercial value at all, but the law does not allow patentees to understand the practice before they file the applications.

Second, Article 69(2) defines broad prior user rights.  While western scholars often argue that trade secret owners should have relatively narrow prior user rights to promote innovation,[62] prior user rights are relatively broad in China.  “Prior” means the time prior to the patent filing date rather than the publication date or the beginning of the grace period as under U.S. patent law.[63]  The scope of “user” is also vague, which could suggest a person who has manufactured identical products, utilized identical methods, or is fully prepared to do so.  Article 69(2) does not mention a person who conducts an arm’s length sale or other arm’s length commercial transfer or uses with respect to the technology, which confuses many judges and legal scholars in China.[64]  Accordingly, Chinese patentees, most of whom are follow-on inventors rather than initial inventors, may be unwilling to enforce their patents since they do not know whether the infringers are excluded from patent infringement for prior user rights that may also threaten their patent validity for lack of novelty.[65]

Overall, these two articles include an underlying notion that patents should be filed at an early stage.  As the government provides many subsidies and grants to encourage patent applications, it is not surprising to observe a dramatic increase of patent applications and a strengthening mechanism of patent agencies in the recent years in China.  However, the law may also raise the cost of patent commercialization, patent transaction, and patent financing.  In this patent regime, it is hard to accurately estimate the patent value, so lenders cannot completely rely on patent valuation reports to adopt patents per se as collateral.  Firms also hesitate to license patents or conduct joint-R&D with potential licensees.

VI. Recommendation: Opportunities for Third Parties

The most solid business of patent service in China is patent procurement, which assists inventors in drafting and applying for patents.  Both the market demand and the government support are great in this area.  Even though the government heavily funds patent commercialization, patent transaction, and patent financing, the limited technology value, the culture of copycat and litigation-aversion, the strength of patent protection, and the design of some articles in patent law are the main barriers to conquer.  These barriers increase the cost of moral hazard in patent transactions and financing when the government instructs inventors to file more patents, and manage and commercialize their patents through subsidies and grants.  While there are agencies or platforms bridging patentees and potential buyers or licensees, the decrease in the transaction costs does not effectively eliminate the high cost of moral hazard when bargaining for an agreement.

Also, this cost cannot be reduced when the government directly or indirectly provides guaranties for patent loans.  These guaranties from third parties are used as substitutes for patent collateral rather than as supplementary to the patents.  Loans are offered for those guarantees or other financing packages in the name of patents, which shifts the risk burdens to those third parties.  Even though there are institutions evaluating patents’ economic value and even though SIPO provides patent evaluation reports for patents’ validity, lenders who ask for financing packages in addition to patent collateral do not completely rely on these reports.  Then, we cannot conclude that these reports are enough to eliminate the risks for those third parties.

V. Conclusion

Even though China has emerged as the country with the largest number of patent applications, there are material difficulties for Chinese patentees to commercialize, transfer, license, or finance their patents.  As the business of patent procurement and other supplementary service of patents grows, the market demands more third parties to fill in the gap effectively reducing the moral hazard to promote patent transaction and patent financing, such as promoting joint-R&D, facilitating inventors to improve patent quality, educating patentees to license their patents at an early stage, establishing reliable patent quality evaluation mechanisms, efficiently managing patent licenses, or monitoring the follow-on activities of licensees or patentee lenders.


* Post-Doctoral Research Associate & J.S.D., University of Illinois College of Law.  I thank professor Thomas S. Ulen and Professor Jay P. Kesan for cultivating the ideas of this Paper, Carlos Delvasto Perdomo for his suggestions, and Zishu Wang and Samuel Branum for the editing.

[1] Shiwu Shiqi Woguo Zhishi Chanquan Shiye Da Fazhan (十五时期我国知识产权事业大发展) [The Career Development of Intellectual Property in the Tenth Five-Year Economic Plan] (July. 19, 2006), http://www.sipo.gov.cn/ztzl/qtzt/sywgh/hgyzw/201310/t20131029_872884.html.

[2] WIPO, World Intellectual Property Indicators 23 (2014).

[3] Id. at 7–8.

[4] Id. at 14–15.

[5] Dietmar Harhoff et al., Citations, Family Size, Opposition and the Value of Patent Rights, 32 Res. Pol’y 1343, 1343 (2003) (“Patents . . . representing large international patent families are particularly valuable.”).

[6] Song Hefa & Li Zhenxing, Patent Quality and the Measuring Indicator System: Comparison Among China Provinces and Key Countries (IPSC Paper, 2014), https://www.law.berkeley.edu/files/Song_Hefa_IPSC_paper_2014.pdf.

[7] Michael Li, Patent Quality in China, IPWatchdog (Mar. 27, 2014), http://www.ipwatchdog.com/2014/03/27/patent-quality-in-china/id=48720/.

[8] Zhuanli Fa (专利法) [Patent Law] (promulgated by the Standing Comm. Nat’l People’s Cong., Mar. 12, 1984, effective April 1, 1985), art 19, (China).

[9] Herbert F. Schwartz, Patent Law and Practice 7–21 (2nd ed. 1996).

[10] Wang Suyuan (王素远), Zhuanli Daili Shichang Xuqiu Fenxi Shangpian (专利代理市场需求分析上篇) [The First Half Analyses of the Market Demand in the Market of Patent Agencies], 的博客 [IPRdaily] (Dec. 28, 2016), http://blog.sina.com.cn/s/blog_e0f474c10102wy1i.html.

[11] SIPO, http://www.sipo.gov.cn/tjxx/tjyb/2016/201701/P020170124439120249793.pdf (last visited Mar. 3, 2017).

[12] Li Shulian (李淑蓮), Nianxin 15 Wan Renminbi Zhaobudaoren! Dalu Zhuanli Dailiren Quekou Da? (年薪15萬人民幣招不到人! 大陸專利代理人缺口大? ) [0.15 Million RMB Revenue But Failed in Recruitment! The Mainland China Has a Big Gap in Patent Agents?], Beimei Zhiquan Bao (北美智權報) [North Am. Intell. Prop. News] (Nov. 2, 2016), http://www.naipo.com/Portals/1/web_tw/Knowledge_Center/mainland/IPNC_161102_0801.htm.

[13] Id.; see also Qingsheng, infra, note 16.

[14] See Shulian, supra note 12.

[15] SIPO, Zhongguo Zhuanli Daili Hangye Nianbao (中国专利代理行业年报) [The Annual Report of the Industry of Patent Agency in China] 10 (2014).

[16] Miao Qingsheng (苗青盛), Sikao: Ruhe Chengwei Yige Youxiu De Zhuanli Dailiren (思考:如何成为一个优秀的专利代理人) [Thinking: How to Become a Great Patent Agent], Zhiren Wang (Apr. 22, 2015, 10:25 PM), http://www.wipren.com/html/2015/redian_0422/231.html.

[17] Zhuanli Daili Zhuanye Fangxiang (专利代理专业方向) [The Major Direction of Patent Agency] (2015), http://www.law.pku.edu.cn/docs/2015-04/20150427171829618046.pdf.

[18] See Richard Hall, A Framework Linking Intangible Resources and Capabilities to Sustainable Advantage, 14 Strategic Mgmt. J. 607 (1993).

[19] Huang Pulin (黄璞琳), Gudong Nengfou Yi Zhuce Shangbiao Huo Zhuanli Shiyongquan Chuzi (股东能否以注册商标或专利使用权出资?) [Can Shareholders Use Registered Trademarks or Patent Rights to Invest in the Firm], Zhongguo Gongshang Bao (中国工商报) [China Industry & Com. News] (Aug. 24, 2015), http://www.saic.gov.cn/gsld/gztt/xxb/201508/t20150824_160956.html.

[20] SIPO, Zhuanli Tongji Jianbao (专利统计简报) [Patent Statistic Bulletin] 2 (2014), http://www.sipo.gov.cn/tjxx/zltjjb/201509/P020150911515451537791.pdf.

[21] Dingjian (丁坚), Zhongguo ZhongxiaoQiye Zhishi Chanquan Zhiya Rongzi Chengwei Yizhong Qushi (中国中小企业知识产权质押融资成为一种趋势) [A Trend of Intellectual Property Collateral by Small and Medium Sized Enterprises in China] (July 5, 2015), http://www.chinacpv.com/index.php/Home/Xinwendongtai/show/lx/gsxw/id/34.

[22] Jili Chu, Recent Developments in Patent Insurance in China (Jan. 26, 2017), http://en.naipo.com/Portals/0/web_en/Knowledge_Center/Feature/IPNE_170126_0702.htm.

[23] Id.

[24] Wang Yu (王宇), Zhuanli Baoxian: Zhuqi Chuangxi Chuangye Baohu Weiqiang (专利保险:筑起创新创业保护围墙) [Patent Insurance: Structuring the Walls for Protecting Innovation and Entrepreneurship], Zhishi Chanquan Bao (知识产权报)[Intell. Prop. News] (Dec. 2, 2015), http://www.sipo.gov.cn/ztzl/qtzt/zscqzldzcywzcx/fxjd/201609/t20160901_1289578.html.

[25] Id.

[26] See Edmund W. Kitch, The Nature and Function of the Patent System, 20 J.L. & Econ. 265 (1977).

[27] Fritz Machlup & Edith Penrose, The Patent Controversy in the Nineteenth Century, 10 J. Econ. History 1 (1950).

[28] Mark A. Lemley, Ex Ante Versus Ex Post Justifications for Intellectual Property, 71 U. Chi. L. Rev. 129 (2004); see also Steven N. S. Cheung, Property Rights and Invention, in 8 Research in Law and Economics: The Economics of Patents and Copyrights 5, 18 (John P. Palmer & Richard O. Zerbe, Jr. eds., 1986).

[29] Shubha Ghosh, Richard S. Gruner & Jay P. Kesan, Transactional Intellectual Property: From Startups to Public Companies 3 (3rd ed. 2015).

[30] See Klaus Kultti, Tuomas Takalo & Juuso Toikka, Cross-Licensing and Collusive Behaviour, 23 Homo Oeconomicus 181 (2006), http://economics.mit.edu/files/5914.

[31] SIPO, Zhongguo Zhuanli Diaocha Shuju Baogao (中国专利调查数据报告) [China Patent Data Research] 14 (2016), http://www.sipo.gov.cn/tjxx/yjcg/201607/P020160701584633098492.pdf.

[32] Id. at 13.

[33] Id. at 16.

[34] Alexandra Harney, China’s Copycat Culture, N.Y. Times (Oct. 31, 2011, 11:37 PM), https://latitude.blogs.nytimes.com/2011/10/31/chinas-copycat-culture; see also Peter Guy, China Never Really Stopped Being a Copycat, and That’s Why Its Tech Companies Aren’t Changing the World, S. China Morning Post: Mind the Gap (Apr. 10, 2016, 10:00AM), http://www.scmp.com/business/article/1934779/china-never-really-stopped-being-copycat-and-thats-why-its-tech-companies.

[35] See Jay Pil Choi, Technology Transfer with Moral Hazard (Discussion Paper Series No. 745, 1994–95).

[36] See id.

[37] See id.

[38] See Kultti, Takalo & Toikka, supra note 30, at 6.

[39] Id.

[40] Tuwen Zhibo: 2015 Nian Faming Zhuanli Shenqing Shouquan Ji Qita Youguan Qingkuang Xinwen Fabu Hui (图文直播:2015年发明专利申请授权及其他有关情况新闻发布会) [Live of Pictures and Words: Press Conference About 2015 Invention Patent Application, Issuance, and Other Issues], SIPO (Jan. 14, 2016, 10:00 AM), http://www.sipo.gov.cn/twzb/2015ndzygztjsj/.

[41] Gao Rongying (高荣英), Shanghaishi Zhuanli Qinquan Anjian Dashuju Fenxi Baogao (上海市专利侵权案件大数据分析报告) [Big Data Analysis of Shanghai Patent Infringement Cases] (2015), http://inews.ifeng.com/yidian/45985691/news.shtml?ch=ref_zbs_ydzx_news.

[42] Id.

[43] Gao Rongying (高荣英), Beijingshi Zhuanli Qinquan Anjian Shuju Fenxi Baogao Dashuju (北京市专利侵权案件数据分析报告大数据) [Big Data Analysis of Beijing Patent Infringement Cases] (2016), http://www.rensheng2.com/1120000/1110837.shtml.

[44] Donghui Juan (董慧娟), Zhongguo Zhuanli Zhixing Baoxian De Zuixin Jinzhan Zhanghai Ji Duice (中国专利执行保险的最新进展、障碍及对策) [The Latest Progress, Obstacles, and Solutions for Enforcing Patent Insurance in China], in 7 Zhongguo Keji Luntan (中国科技论坛) [China Tech. Forum] 88, 91–92, (2015).

[45] Guanyu Shangye Yinhang Zhishi Chanquan Zhiya Daikuan Yewu De Zhidao Yijian (关于商业银行知识产权质押贷款业务的指导意见) [Instruction Opinions on Loans with Intellectual Property Collaterals in Commercial Banks] (promulgated by China Banking Regulatory Comm’n, SIPO, St. Admin. for Industry & Commerce, Jan. 21, 2013) 2013 (China).

[46] Zhuanli Diya Daikuan De Qingdao Moshi (专利抵押贷款的青岛模式) [The Qingdao Model of Patent Collateral for a Loan], http://www.haodai.com/zixun/97995.html (last visited Mar. 4, 2017).

[47] Zhongguancun Guojia Zizhu Chuangxin Shifanqu Qiye Danbao Rongzi FuchiZijin Guanli Banfa (中关村国家自主创新示范区企业担保融资扶持资金管理办法) [Admission Methods of Zhongguan-Cun Since Park] (promulgated by Zhongguan-Cun Admin., effective Oct. 1, 2011) 2011 (China).

[48] See Kultti, Takalo & Toikka, supra note 30, at 16.

[49] See Ying Zhan, Problems of Enforcement of Patent Law in China and its Ongoing Fourth Amendment, 19 J. Intell. Prop. Rights 266 (2014).

[50] See Bee Chen Goh, Remedies in Chinese Dispute Resolution, 13 Bond L.Rev. 1, 17 (2001); see also Guo-Ming Chen & William J. Starosta, Chinese Conflict Management and Resolution: Overview and Implications (Intercultural Commc’n Studies VII: 1 1997–98), http://digitalcommons.uri.edu/cgi/viewcontent.cgi?article=1015&context=com_facpubs; Cecilia Lai-Wan Chan, The Cultural Dilemmas in Dispute Resolution: The Chinese Experience (Presentation at the Conference of Enforcing Equal Opportunities in Hong Kong: An Evaluation of Conciliation and Other Enforcement Powers of the EOC, 2003), http://www.law.hku.hk/hrportal/wp-content/uploads/file/14062003a-CeciliaChan.pdf.

[51] Liu Chunjie (刘春杰), Wang Fei (王菲) & Sun Haiyan (孙海燕), Zhuanli Jiazhi Pinggu Yanjiu Jinzhan (专利价值评估研究进展) [The Research Progress of Patent Valuation], 国知动态 [Guozhi Patent News] (2016), http://www.patentwarning.com.cn/content/details41_535.html.

[52] Shiyiwu Shiqi Zhishi Chanquan Shiye Fazhan De Zongti Silu Mubiao He Zhidao Yuanze (“十一五”时期知识产权事业发展的总体思路、目标和指导原则) [The Overall Design, Goal, and Instructive Principles of the Development of Intellectual Property During the Eleventh Five-Year Economic Plan] (2006), http://www.sipo.gov.cn/ztzl/qtzt/sywgh/hgyzw/201310/t20131029_872883.html.

[53] 2016 Nian Quanguo Zhuanli Shiye Fazhan Zhanlue Tuijin Jihua (2016年全国专利事业发展战略推进计划) [The 2016 Plan of Strategically Promoting the Development of State’s Patent Development] (2016), http://www.sipo.gov.cn/gk/fzgh/201605/t20160516_1269421.html; see also Huang Yuanhui (黄远辉), Fuwu Shuangchuang Quanmian Dazao Zhishi Chanquan Yunying Shenzhen Moshi (服务双创,全面打造知识产权运营深圳模式) [Serving Innovation and Entrepreneurship, Completely Design the Shenzhen Model of Intellectual Property Deployment], http://www.sipo.gov.cn/ztzl/ndcs/zgzlznew/yypy/201611/t20161128_1303850.html (last visited Mar. 4, 2017).

[54] See Yu supra note 24.

[55] Chengdushi Keji Yu Zhuanli Baoxian Butie Zijin Guanli Zanxing Banfa (成都市科技与专利保险补贴资金管理暂行办法) [Temporary Methods of Administrating the Subsidies for Technology and Patent Insurance in Chengdu] (promulgated by Chengdu Municipal Finance Bureau & Chengdu Technology Bureau & Chengdu Intellectual Property Office, effective July 1, 2012) June 26, 2012 (China).

[56] Xie Kaifei (谢开飞) & Xu Wenbin (徐文彬), Fujian Zhuanliquan Zhiya Rongzi Tupo 32 Yi (福建专利权质押融资突破32亿) [The Loans with Patent Collateral in Fujian Exceed 3.2 Billion RMB], Keji Ribao (科技日报) [Tech. Daily], Feb. 6, 2017, at 7, http://digitalpaper.stdaily.com/http_www.kjrb.com/kjrb/html/2017-02/06/content_361336.htm?div=-1.  Another example is the establishment of Zhongguan-Cun Credit Promotion Association.

[57] Su Pin (苏品), Zhonguancun Zhuanli Daohang Gaoji Shiwu Xilie Peixun Zhi Zhuanli Bujue Chuji Shizhanban Chenggong Juban (中关村专利导航高级实务系列培训之专利布局初级实战班成功举办) [Zhongguan-Cun Patent Navigation and High Level Practice Training on Patent Geography Was Successfully Held] (2014), http://www.sipo.gov.cn/ztzl/ywzt/zldhsdgc/gjzldhcyfzsyq/201409/t20140915_1010102.html.

[58] See Shanghai Shi Zhishi Chanquan Ju (上海市知识产权局) [Shanghai Intellectual Property Office], Shanghai Shi Zhuanli Zizhu Banfa (上海市专利资助办法) [The Methods of the Shanghai Patent Subsidies] (July 1, 2012) (China).

[59] Id.

[60] See Mark A. Lemley, Ready for Patenting, 96 B.U. L. Rev. 1171 (2016).

[61] Kevin Iles, A Comparative Analysis of the Impact of Experimental Use Exemptions in Patent Law on Incentives to Innovate, 4 Nw. J. Tech. & Intell. Prop. 61 (2005); see also Jennifer A. Johnson, The Experimental Use Exception in Japan: A Model for U.S. Patent Law?, 12 Pac. Rim L. & Pol’y J. 499, 512 (2003); John A. Tessensohn, Reversal of Fortune—Pharmaceutical Experimental Use and Patent Infringement in Japan, 4 J. Int’l Legal Stud. 1, 25 (1998).

[62] David H. Hollander, Jr., The First Inventor Defense: A Limited Prior User Right Finds Its Way Into US Patent Law, 30 Aipla Q.J. 37 (2002); see also Gary L. Griswold, Prior User Rights—A Necessary Part of A First-to-File System, 26 J. Marshall L. Rev. 567 (1993); Ning Lizhi & Li Guoqing, A Problem into American Prior User Rights System, 27 J. Nanjing U. Sci. & Tech.1 (2014).

[63] 35 U.S.C. 273(a)(2) (2012).

[64] Wei Xiaoyun (韦晓云), Zhuanli Qinquan Zhong Xianyong Kangbianquan Wenti Yanjiu (专利侵权中先用权抗辩问题研究) [A Study of Prior User Rights Argument in Patent Infringement], 12 Renmin Sifa (人民司法) [People Judicature] 52 (2003).

[65] He Huaiwen (何怀文), Jingwai Zaixian Zhuanli Shenqing Qike Zhunyong Dichu Shenqing Kangbian (境外在先专利申请岂可准用抵触申请抗辩) [Prior Use in Foreign Countries Cannot Argue for Prior User Rights], 109 Zhongguo Zhishi Chanquan (中国知识产权) [China Intell. Prop. Rights] (2016), http://www.cnipr.com/yysw/qqyd/201604/t20160408_196114.htm.

Full Tilting at Windmills: How Daily Fantasy Sports Can Overcome Their Legal Hurdles

By Amartya Bagchi*

I. Introduction

Approximately 205 million Americans watched at least one NFL game during the 2015 season according to the league’s own viewership numbers,[1] and many of them likely noticed the seemingly endless stream of commercials for DraftKings and FanDuel.[2]  Research has shown there are fewer than eleven minutes of actual football action in a televised game.[3]  It is highly likely, then, that in the past few years, viewers have seen a disproportionate number of these commercials, extolling the virtues of daily fantasy football as a game that requires a “different set of skills”[4] to earn “immediate cash payouts” minus the “season-long commitments” of seasonal fantasy football.[5]

Daily fantasy football has grown very quickly in the last few years,[6] with daily fantasy sports (DFS) service DraftKings notably striking a partnership with ESPN.[7] Even tech giant Yahoo jumped into the DFS waters in 2015, launching its own proprietary service.[8]

With hundreds of millions of dollars invested in these companies[9] and virtually no regulatory oversight,[10] it should come as no surprise that in October of 2015, DFS websites found themselves at the center of a legal controversy that could radically alter or outright eliminate this fast-growing industry.[11]  In 2016, ESPN ended its partnership with DraftKings.[12]  However, despite NFL viewers getting a respite from these commercials in the 2016–17 season, the industry has continued to steadily grow.[13]  As a result, the complexities surrounding the legality of DFS have only grown. This Article aims to explain those complexities and articulate why DFS is not a form of gambling and should be allowed in the United States.

II. Background

It is quite likely that if you are a fan of American football, you know someone who participates in some form of fantasy football: nearly seventy-five million Americans are likely to participate in some form of fantasy football in the upcoming 2016 season.[14]  Many of these leagues and participants partake in the traditional season-long fantasy format: each fantasy owner selects players from various NFL teams during a pre-season draft, and owners accumulate fantasy points based on the statistics their players put up.[15]  As injuries or poor performances change the landscape of the NFL, so too does it change the active fantasy owner’s roster composition: owners frequently pick up and drop players who end up hurt or underperforming as the season goes along.[16]

Daily Fantasy Sports websites differ from the traditional and well-known season-long model of fantasy football in a number of very important ways,[17] and an understanding of these differences is central to understanding the legal controversy surrounding DFS services. First, and perhaps most importantly, there is no draft or set pool of players from which fantasy owners choose.[18]  Rather, the most common format is a salary cap league[19]: DFS websites attach a “price tag” to a player depending on the player’s season-long performance, matchup, and other factors, and a DFS owner must attempt to build a competitive team within the confines of a prescribed salary cap.[20]  Many owners end up selecting the same set of elite players at each position based on that player’s opposition matchup and value in a given week.[21]  Putting a number of high priced players in a lineup often results in owners having to select less talented, fringe NFL players based solely on matchups or gut feelings.[22]  Between head-to-head and tournament style competitions, profitability is a central tenet of the game for many DFS participants.[23]  While there are a number of nuanced differences between DFS and season-long strategies,[24] ultimately DFS should be familiar to most fantasy football players.

The crux of the legal trouble for the DFS industry stems from the play of a DraftKings employee, Ethan Haskell, who released ownership percentages of players before a tournament’s lineups had locked. [25]  What Haskell failed to disclose, however, is that he continued to play DFS on rival site FanDuel.[26]  At the heart of this controversy is the important role that ownership percentage information plays in tournament style play.[27]  Knowing that most participants in a tournament are putting a particular player into their lineup allows an owner with access to this information to build a contrarian lineup.[28]  In other words, the DFS owner with the insider information is able to exploit market inefficiencies that regular players simply do not have access to.[29]  This is particularly relevant in terms of fringe lineup players, where a contrarian player having a good day can result in shooting up tournament rankings.[30]

III. Legal Challenges

When experts began exploring the impact of Haskell’s use of inside information in his DFS entries, an even more troubling pattern emerged: a small number of DFS participants won the majority of money.[31]  Were the odds stacked against new participants? A month after Ethan Haskell’s publication of DraftKings ownership data in week three of the 2015 NFL season, New York Attorney General Eric Schneiderman ordered DraftKings and FanDuel to stop accepting money from New York residents, as their games constituted illegal gambling under New York state law.[32]  Schneiderman, a noted consumer rights advocate, stated that DraftKings and FanDuel clearly intended to fleece participants by “seriously misleading” the average person into believing he had a shot at winning money.[33]  Both companies have since filed lawsuits in New York courts.[34]

Central to the legal questions surrounding the DFS industry is whether federal or state gambling laws apply. The federal Unlawful Internet Gambling Enforcement Act (UIGEA), for instance, is a point of contention specifically because the Act lists “fantasy sports” as an exception.[35]  The UIGEA explicitly states that so long as the prizes are established and known in advance of the game or contest, the value is not determined by the number of participants or fees collected, and the winning outcomes reflect the skill of participants and the accumulated statistics of drafted players, the contest meets the requirements to be exempted as a “fantasy sport.”[36]

States are still free to make their own laws regarding fantasy sports participation.[37]  However, as the authors of the bill intended to carve out an exception for season-long fantasy and “never conceived” of DFS games,[38] there is still some dispute as to whether the UIGEA even applies to these types of games.[39]  In fact, the evidence at hand in 2006 seemingly indicates that Congress had the unregulated, online poker industry in mind,[40] not fantasy sports, and certainly not DFS.

Furthermore, so long as they are not preempted by federal law, states are allowed to make determinations on specific types of gambling under the Tenth Amendment.[41]  Typically, prima facie cases of illegal gambling under state law can be proven when the activity in question satisfies three elements: consideration, reward, and chance.[42]  DFS services are likely to prevail in this dispute, so long as they successfully argue that their contests constitute games of skill rather than chance. While many states subscribe to the majority view that the “dominant element” test is best suited to determine whether a game or contest is one of skill or chance, a number of states have adopted other methods of determination.[43]  Depending on what kind of research the DFS companies will be able to produce, this may not be a significant issue at all. For instance, Seth Young, the COO of DFS service Star Fantasy Leagues, took a look at the people who were winning consistently in his company’s contests.[44]  The simulation performed by Young showed that skilled participants (who set their lineups based on previous player performance) consistently dominated unskilled participants (who set lineups primarily by attempting to use up as much salary cap space as possible given the entire player pool).[45]  The numbers were lopsided: participants who used the skilled participant algorithm in setting their rosters won 69.1% of games.[46]

IV. Recommendation and Conclusion

Given the likelihood that DFS companies will be able to prove that they are skills of chance, or in the case of federal law, that they are excepted from the current iteration of the UIGEA, these companies should be allowed to continue to operate. What states should consider instead of outright bans are strict regulations that limit who can play, how they can play, and how financial information is handled by DFS services.[47]

First, implementing a player verification system would very easily allow states and services alike to monitor who is using these DFS services.[48]  By requiring some sort of identification—be it a social security or state driver’s license number—services will be able to turn away users who are too young, or registered employees of the company itself or its competitors, thus solving the issue of information inequality between users and employees. Second, it is important for these DFS services to implement responsible gaming features that will put them in good standing within the framework of the UIGEA.[49]  Finally, financial transparency and regulation will be the most important building blocks in making DFS as supervised and trustworthy as casinos.[50]  Both DFS providers and financial institutions will be responsible for monitoring for fraud, money laundering, and procedural inconsistencies in segregation of funds.[51]  The segregation of funds—between dollars dedicated to operating costs and those used strictly to pay out participants accounts—will be highly scrutinized by internal and external financial audits.[52]

By adopting changes that protect consumers, DFS companies will be able to better convince state legislatures and states attorneys that the business is on the up and up. Secondarily, they will be able to reduce their own liability. Thus, a regulated DFS industry is simply good business for all involved parties, and it will spell the difference between a burgeoning gaming industry that will continue to grow and one that will be legislated away as part of a puritanical assault on what is ostensibly gambling.

 


* Amartya “Orko” Bagchi is a 3L at the University of Illinois College of Law. I’d like to thank my wonderful girlfriend Alexa and my parents who have supported me every step of the way, and David Johnson and Tim Hightower who helped me secure my only fantasy football titles.

[1] Michael David Smith, 34 of America’s 35 Most-Watched Fall TV Shows Were NFL Games, NBC Sports: Pro Football Talk (Jan. 8, 2014, 3:52 PM http://profootballtalk.nbcsports.com/2014/01/08/34-of-americas-35-most-watched-fall-tv-shows-were-nfl-games/.

[2] Steven Perlberg, Are DraftKings and FanDuel Bombarding Fans With Too Many Ads?, Wall St. J. (Sept. 16, 2015, 6:00 AM), http://blogs.wsj.com/cmo/2015/09/16/are-draftkings-and-fanduel-bombarding-fans-with-too-many-ads/.

[3] David Biderman, 11 Minutes of Action, Wall St. J. (Jan. 15, 2010 12:01 AM), http://www.wsj.com/articles/SB10001424052748704281204575002852055561406.

[4] DraftKings TV, DraftKings—Welcome to the Big Time, YouTube (Aug. 28, 2015), https://www.youtube.com/watch?v=bfCm6PJuL5I.

[5] FanDuel, 2015 FanDuel Fantasy Football Preseason Commercial (Version Two), YouTube (Aug. 11, 2015), https://www.youtube.com/watch?v=-lVS87mhZQo.

[6] Jonathan Moreland, The Growth of Daily Fantasy Sports, Visualized, RotoGrinders https://rotogrinders.com/pages/growth-of-daily-fantasy-sports-719070 (last visited Feb. 12, 2017).

[7] Todd Spangler, ESPN Teams with DraftKings as Exclusive Daily Fantasy-Sports Partner, Variety (June 24, 2015, 6:58 AM), http://variety.com/2015/digital/news/espn-draftkings-daily-fantasy-sports-1201527028/.

[8] Daily Fantasy Featured Contests, Yahoo! Sports Daily Fantasy, https://sports.yahoo.com/dailyfantasy (last visited Feb. 12, 2017).

[9] FanDuel, Crunchbase, https://www.crunchbase.com/organization/fanduel (last visited Feb. 12, 2017).

[10] Ira Boudway & Joshua Brustein, How Will the Government Change the Game for Daily Fantasy Sports?, Bloomberg: Tech. (Oct. 15, 2015, 2:39 PM) http://www.bloomberg.com/news/articles/2015-10-15/how-will-the-government-change-the-game-for-daily-fantasy-sports-.

[11] John Culhane, The DraftKings Crash, Slate (Oct. 13, 2015, 4:47 PM), http://www.slate.com/articles/sports/sports_nut/2015/10/the_insider_trading_scandals_could_bring_down_draftkings_and_fanduel.html.

[12] ESPN Accepts DraftKings’ Request to Ends Its Exclusive Advertising Partnership Early, SportsBusiness Daily (Feb. 10, 2016), http://www.sportsbusinessdaily.com/Daily/Issues/2016/02/10/Marketing-and-Sponsorship/ESPN-DraftKings.aspx.

[13] Dustin Gouker, Is Daily Fantasy Sports Dying or Flourishing? The Truth Is Somewhere in the Middle, LegalSportsReport.com (Oct. 27, 2016, 11:25 AM), http://www.legalsportsreport.com/11918/daily-fantasy-sports-industry-outlook/.

[14] Gregory Bresiger, Nearly 75M People Will Play Fantasy Football This Year, N.Y. Post (Sept. 5, 2015, 4:59 PM), http://nypost.com/2015/09/05/nearly-75m-people-will-play-fantasy-football-this-year/.

[15] What Is Fantasy Football?, NFL.com, http://www.nfl.com/fantasyfootball/help/whatis (last visited Feb. 12, 2017).

[16] Id.

[17] Jonathan Bales, GrindersU UnderGraduate: Differences Between Daily and Season Long, RotoGrinders, https://rotogrinders.com/pages/grindersu-undergraduate-differences-between-daily-and-season-long-160174 (last visited Feb. 12, 2017).

[18] Daily Fantasy Sports Explained, Sports Betting Online, https://www.sportsbettingonline.net/daily-fantasy-sports/ (last visited Feb. 12, 2017).

[19] Id.

[20] Id.

[21] Bales, supra note 16.

[22] Id.

[23] Peter Jennings, Profitability in Daily Fantasy, RotoGrinders, https://rotogrinders.com/lessons/profitability-in-daily-fantasy-174279 (last visited Feb. 12, 2017).

[24] Bales, supra note 16.

[25] NFL Forum: DraftKings Ownership Leak, RotoGrinders, https://rotogrinders.com/threads/draftkings-ownership-leak-850584?page=1#reply-850635 (last visited Feb. 12, 2017).

[26] Id.

[27] Id.

[28] Id.

[29] Culhane, supra note 11.

[30] Alex Weldon, DKLeak Scandal: Why Ownership Percentages Are So Important, PartTimePoker.com (Oct. 7, 2015), http://www.parttimepoker.com/dkleak-scandal-why-are-ownership-percentages-so-important.

[31] Id.

[32] Walt Bogdanich et al., Attorney General Tells DraftKings and FanDuel to Stop Taking Entries in New York, N.Y. Times (Nov. 10, 2015), http://www.nytimes.com/2015/11/11/sports/football/draftkings-fanduel-new-york-attorney-general-tells-fantasy-sites-to-stop-taking-bets-in-new-york.html.

[33] Id.

[34] Darren Rovell, DraftKings, FanDuel Sue New York Attorney General Eric Schneiderman, ESPN (Nov. 13, 2015), http://espn.go.com/chalk/story/_/id/14119916/draftkings-fanduel-sue-new-york-attorney-general-eric-schneiderman.

[35] 31 U.S.C. § 5362(1)(E)(ix) (2012).

[36] Id.

[37] Anthony N. Cabot & Louis V. Csoka, Fantasy Sports: One Form of Mainstream Wagering in the United States, 40 J. Marshall L. Rev. 1195, 1201 (2007) (“The exemption in UIGEA for fantasy sports does not mean that fantasy sports are lawful, only that fantasy sports are not criminalized under UIGEA. In other words, conducting a fantasy contest for money still might violate other state or Federal laws.”).

[38] Dustin Gouker, UIGEA Author: “No One Ever Conceived” that Law Would Allow Daily Fantasy Sports, LegalSportsReport.com, http://www.legalsportsreport.com/1369/uigea-author-did-not-intend-daily-fantasy-sports-carveout/ (last visited Feb. 12, 2017).

[39] David Purdum, DraftKings CEO Acknowledged Some UIGEA Noncompliance in May Conference Call, ABC News (Nov. 19, 2015, 4:55 PM), http://abcnews.go.com/Sports/draftkings-ceo-acknowledged-uigea-noncompliance-conference-call/story?id=35313282 (“Jason acknowledged that Golf and NASCAR do not comply with the letter of the UIGEA, but argued that UIGEA was written when daily fantasy didn’t exist.”).

[40] Chuck Humphrey, Unlawful Internet Gambling Enforcement Act of 2006: Internet Gambling Funding Ban, Gambling-Law-US.com (Oct. 13, 2006), http://www.gambling-law-us.com/Federal-Laws/internet-gambling-ban.htm.

[41] Tim Lynch, Gambling Regulation Belongs to the States, Cato Inst. (July 23, 1998), http://www.cato.org/publications/commentary/gambling-regulation-belongs-states.

[42] Geis v. Cont’l Oil Co., 511 P.2d 725, 727 (Utah 1973) (“[T]he statutory elements of a lottery are: (1) Prize; (2) chance; (3) any valuable consideration.”); Valentin v. La Prensa, 427 N.Y.S.2d 185, 186 (Civ. Ct. 1980) (“[T]here are three elements necessary to constitute a lottery: (1) consideration, (2) chance, and (3) a prize.”).

[43] See generally D. A. Norris, Annotation, What Are Games of Chance, Games of Skill, and Mixed Games of Chance and Skill, 135 A.L.R. 104 (1941) (providing illustrations of the various tests used to determine whether an action is a game of chance across the United States).

[44] Id.

[45] Id.

[46] Id.

[47]Seth Young, Fantasy Sports Regulation: An Inclusive Way Forward, LegalSportsReport.com (Mar. 25, 2016 5:00 AM), http://www.legalsportsreport.com/9246/fantasy-sports-regulation-framework/.

[48] Id.

[49] David O. Stewart, Online Gambling Five Years After UIGEA 16 (2011).

[50] Seth Young, I Believe Daily Fantasy Sports Is a Game of Skill, and Here’s the Proof, LegalSportsReport.com (Apr. 6, 2015, 8:36 AM) http://www.legalsportsreport.com/820/view-why-dfs-is-a-game-of-skill/.

[51] Id.

[52] Id.

 

 

SEC to Increase Oversight of High Frequency Trading Firms Under a Proposed Amendment to Rule 15b9-1

By Samuel Branum*

I. Introduction

As the result of ever faster and more powerful computers, high frequency trading (HFT) has become a significant presence in the market, with some estimates showing that HFT accounts for 73% of the total daily trading volume in the U.S. securities markets.[1]  While regulatory bodies struggle to keep up with technology, HFT is moving ahead at lightning fast speeds where milliseconds—and even nanoseconds—matter.[2]  Humans may program the HFT machines, but the machines collect the data, analyze it, detect patterns in the market, interact with other traders, and buy and sell shares of stock.[3]  With some HFT firms having more than 100 teraflops of power and being able to process more than 100 trillion calculations per second, competitive trading in stocks is no longer available to human traders, or even those using less-sophisticated computers.[4]

As reflected in pop culture films, such as The Terminator and Battlestar Galactica, the fear of machines taking over the world (or universe) is deeply rooted in our national psyche. In the securities market, HFT computers and algorithms have taken over the function of providing liquidity to investors, which many see as a benefit. The “Flash Crash” of May 6, 2010[5] and various other mini-flash crashes,[6]  however, have stoked investors’ concerns that technology going berserk is a real threat to the securities markets. Perhaps it may be a long time before HFT computers take over the world, but their existence for now, whether justified or not, has eroded investor confidence in the markets.[7]

In addition to the cautiousness underlying the use of autonomous technology, people also become angry, and rightfully so, when they feel that the markets are set up to benefit a select few at the expense of others, and that HFT traders can game the system to their advantage. Again, regardless of whether there is any truth to this, these perceptions erode investor confidence.

This combination of “fear of the machines” and “fear of a rigged market”[8]  is a powerful combination that will continue to erode investor confidence unless steps are taken to address these fears. This can be done by either: (1) showing that the markets are not, in fact, rigged by HFT; or (2) showing that steps are being taken to mitigate any harmful effects of HFT through effective regulation. Or, through a combination of the two.

One step that the Securities and Exchange Commission (SEC) is taking to address HFT is to require proprietary trading firms that trade in the off-exchange market, which includes many HFT firms, to register with the Financial Industry Regulatory Authority (FINRA).[9]  As of now, these firms are exempt from registration because of Rule 15b9-1 (“Rule”), a rule originally intended to exempt a targeted class of floor brokers.[10]  Since these proprietary trading firms are using the Rule in a way it was not intended, the SEC has proposed an amendment to the Rule that would effectively eliminate the exemption for these firms, thus making them subject to FINRA oversight.[11]

II. Overview of High Frequency Trading

The SEC has yet to give HFT a precise definition. It is broadly identified, though, as a trading strategy employed by proprietary trading firms that uses computer algorithms to rapidly enter and exit positions in very short time frames, and that generate a large number of daily trades.[12]

It is important to realize, though, that HFT is not a homogenous form of trading.[13]  The debate is usually oversimplified into whether HFT, as a whole, is good or bad for investors.[14]  It is not HFT, however, but the particular strategies that HFT firms employ that can be either beneficial or harmful to the market and investors.[15]  Some of these strategies include liquidity provision (market making), statistical arbitrage, latency arbitrage, and certain already illegal strategies, including momentum ignition strategies such as spoofing, layering, and quote stuffing.[16]

Traditionally, specialists trading on the floor of exchanges were the main providers of liquidity.[17]  As market makers, they would stand ready and willing to buy and sell shares whenever they received orders.[18]  Today, though, due to the advancement in technology, HFT traders are the principal liquidity providers for the markets.[19]  This liquidity provision (market making) strategy constitutes the “lion’s share” of HFT activity, with estimates ranging from 65%–71% of total HFT trading volume.[20]  Generally, this strategy is beneficial to investors, as HFT firms employing this strategy are essentially assuming the role traditionally filled by human market makers.[21]  Nonetheless, a common criticism concerning this strategy is that HFT traders provide phantom liquidity, supplying it when it is abundant and withdrawing it when it is needed.[22]  Moreover, because they are able to withdraw liquidity at lightning fast speeds, they can exacerbate flash crashes, even if they are not the cause of flash crashes.[23]  Related to this criticism is that HFT traders increase volatility in the markets.[24]

Another common HFT strategy is statistical arbitrage, which generates profits by taking advantage of price discrepancies between correlated stocks.[25]  For example, the price of an exchange-traded fund (ETF) may be lower or higher than the underlying basket of stocks.[26]  An HFT trader will then either buy or sell the ETF or underlying stocks when one is cheaper or more expensive in relation to the other, anticipating that the prices will eventually converge.[27]  The HFT trader can then turn around and sell or buy the same ETF or stocks at a profit.[28]  This form of arbitrage is considered to be beneficial as it equilibrates prices between markets and so improves price efficiency.[29]

Another form of arbitrage, latency arbitrage, is perhaps the most controversial of all and is considered to have little to no social utility.[30]  Some describe the strategy as predatory.[31]  It was criticized in Michael Lewis’s Flash Boys and has been the basis for litigation.[32]  In this form of arbitrage, the HFT trader uses its access to the direct feeds of an exchange, through its co-located servers, to profit from timing discrepancies.[33]  Since it takes time for the Securities Information Processor (SIP) to process information from the trading centers before it appears on the consolidated feed, the HFT trader (i.e., the HFT algorithm) can act on price changes in quotes before other traders are even aware of them.[34]  However, some argue that this strategy cannot prey on others’ orders because by the time the HFT trader sees the order, the order is already in the queue.[35]  So, while the HFT trader can see the order before it is made available on the consolidated feed, it cannot see the order before it happens.[36]  Thus, it cannot prey on the order; instead, it only has a competitive advantage in being able to respond quickly to changes—a competitive advantage available to anyone willing to pay for it.[37]  Other strategies include those that are already illegal and that traders have been using for decades to manipulate the market, such as spoofing, layering, and quote stuffing.[38]  These strategies may be harder to detect, though, when employed by HFT firms, given the sophistication of some of their algorithms[39]  These prohibited strategies have no real economic benefit and do not contribute to price discovery or market liquidity.[40]

III. Current Rule 15b9-1

The SEC relies on self-regulatory organizations (SROs) to oversee the securities market.[41]  These SROs include the national securities exchanges, registered securities associations, and registered clearing agencies.[42]  The national securities exchanges include those commonly thought of such as the New York Stock Exchange and NADSAQ.[43]  The national securities associations regulate the off-exchange market;[44]  currently, the only registered securities association (“Association”) is FINRA.[45]  Clearing agencies settle trades, hold securities certificates, and maintain ownership records.[46]  Over the years, the SEC has become increasingly reliant on SROs to regulate the securities market.[47]

FINRA is the regulatory agency currently in the best position to regulate broker-dealers who trade on the off-exchange markets. Each exchange (as an SRO) can only effectively monitor and regulate the transactions of its member broker-dealers that are transacted on their own exchange.[48]  In order to effectively regulate off-exchange transactions, then, Section 15(b)(8) of the Securities and Exchange Act (“Act”) requires all broker-dealers to become a member of an Association (currently only FINRA), unless it effects transactions solely on an exchange of which it is a member.[49]

Nonetheless, some broker-dealers who effect transactions off-exchange are not required to become a member of, and so are not regulated by, FINRA. Under Section 15(b)(9) of the Act, Congress authorized the SEC to exempt any broker-dealer from becoming a member of an Association if the exemption would be consistent with the public interest and the protection of investors.[50]  Pursuant to this authority, the SEC adopted Rule 15b9-1, which exempts broker-dealers from having to become a member of an Association if it is a member of a national securities exchange and carries no customer accounts.[51]  Additionally, the broker-dealer must not have an annual gross income of more than $1,000 that is derived from securities transactions effected off the exchange of which it is a member (“de minimis allowance”).[52]  Importantly, though, there are two exemptions: income derived from transactions for the dealer’s own account or through another broker-dealer do not count toward the de minimis allowance.[53]  Consequently, so long as a broker-dealer trades off-exchange for its own account, it is not required to become a member of FINRA.

Originally, the purpose of the de minimis allowance was to accommodate broker-dealers trading on the floor of an exchange.[54]  It allowed them to share in occasional commissions related to off-exchange transactions and to hedge their risks through off-exchange trades without triggering the requirement to become a member of an Association.[55]  Today, though, many proprietary trading firms, including many that engage in HFT strategies, are relying on the Rule to avoid having to become a member of FINRA, even though they transact a substantial volume of trading off-exchange.[56]  Due to the changes in the structure of the market and the increased use of technology in trading securities, these proprietary trading firms are substantially involved in today’s markets.[57]  The SEC estimates that about 125 broker-dealers are exempt from Association membership under Rule 15b9-1.[58]  Together, these broker-dealers represent about 48% of the orders sent directly to the off-exchange market in 2014.[59]

Consequently, FINRA has no jurisdiction over these broker-dealers and so is unable to directly enforce compliance with federal securities laws and rules.[60]  FINRA is also unable to adequately monitor these firms’ use of HFT strategies, and as a result, it is much more difficult for FINRA to detect manipulative behavior by these firms or the systemic risk posed by HFT.[61]  These firms are members of the exchanges they trade on, but the exchanges are not in a position to regulate off-exchange activity as typically they only have access to the data for trades transacted on their own exchange.[62]

IV. Proposed Amendment to Rule 15b9-1

Since proprietary trading firms are using the exemption in a manner it was not intended, the SEC has proposed an amendment to Rule 15b9-1 to better align the Rule with its original purpose, which was to accommodate the limited off-exchange activities of broker-dealers with a floor-based business.[63]  The proposed amendment keeps the current requirements that a broker-dealer must be a member of a national securities exchange and carry no customer accounts to be exempt from Association (i.e., FINRA) membership.[64]  The proposed amendment, however, would eliminate the de minimis allowance in its entirety, including the two exemptions to the allowance. In its place would be a requirement that broker-dealers must effect transactions solely on the exchange of which it is a member to be exempt from Association membership.[65]

This requirement, though, would then be subject to two, more targeted exemptions.[66]  Both exemptions are directed at broker-dealers that operate exclusively on the physical floor of a national securities exchange.[67]  The first exemption would allow broker-dealers to effect transactions off-exchange so long as the transactions are done solely for the purpose of hedging the risks of their floor-based activities.[68]  This targeted exemption better addresses the type of activity the Rule was originally designed to permit without triggering the need for a broker-dealer to become a member of an Association.[69]  The second exemption would allow broker-dealers to route orders off-exchange to prevent the trade-through of a protected quote on another trading center.[70]  As current regulations require trading centers to protect the best bid and offer and to prevent trade-throughs, this exemption allows broker-dealers to comply with regulatory requirements without it triggering the need for them to become a member of an Association.[71]

If the SEC adopts the proposed amendment, many of the estimated 125 broker-dealers currently exempt from Association membership would be required to become a member of FINRA, as they would not fit within the new limited exemptions.[72]  These firms would then be subject to FINRA’s rules.[73]  With these broker-dealers as members, FINRA would have a more complete picture of off-exchange trading activity.[74]  As the SEC relies on FINRA for information about off-exchange trading activity, the SEC would also be in a better position to regulate the securities market.[75]  Additionally, current members of FINRA would benefit, as there would be a level playing field in terms of regulation among market participants.[76]

V. Recommendations

In assessing any new regulations related to propriety trading firms and high frequency trading, it is important to keep in mind the reason why a well-functioning secondary market is important in the first place: it assures investors who purchase new securities in the primary market that they will be able to sell them easily whenever they choose.[77]  This assurance makes investors more willing to purchase securities in the primary market, which in turn, strengthens the economy by giving businesses access to capital in order to expand their operations, invest in research and development, and hire additional employees.[78]  Therefore, as the SEC recognizes, “The secondary markets exist for investors and public companies, and their interests must be paramount.”[79]  The regulatory framework of the securities market, then, must be evaluated by asking what is in the best interest of investors and whether it facilitates the formation of capital for businesses.[80] Where the interests of short-term traders conflict with long-term investors, the interests of investors should take precedence.[81]  The proposed amendment to Rule 15b9-1 is a good place to start. In order for HFT to be properly regulated, HFT firms trading off-exchange must be under the supervision of FINRA. Exchanges cannot be effective regulators of the off-exchange market because of limited access to cross-exchange trades[82]  FINRA is the regulatory body charged with direct oversight of the off-exchange market, and it has specialized trading rules specifically focused on the potential abuses of HFT.[83]  The SEC then oversees FINRA.[84] Research shows that enhanced surveillance of the market increases investor confidence.[85]  Therefore, by just knowing that propriety HFT firms will be under the supervision of FINRA, investors will be more confident that HFT is being properly regulated. Of course, FINRA must also implement substantive regulations addressing HFT, but it has already been making progress on this front by regulating its members’ use of HFT algorithms.[86]  It will need to continue tailoring specialized regulations for HFT, though, in order to reduce market manipulation and address any volatility that HFT adds to the market.

In order for FINRA, the SEC, and the exchanges to properly regulate HFT, however, they must also have access to comprehensive and precise data concerning how HFT affects ordinary investors and the securities markets. Currently, there is not a comprehensive audit trail that is easily available that can provide regulators with sufficiently accurate information to fully analyze HFT.[87]  As a result, it really is not known to what extent HFT firms are engaging in manipulative or predatory strategies or to what extent HFT adds unacceptable volatility to the market or contributes to flash crashes.[88]  The SEC, then, must work on implementing the comprehensive audit trail (CAT) plan as soon as possible.[89]  The CAT will give regulators the data they need to model and reconstruct trading activity in order to study the effects of HFT and to investigate traders who manipulate the market using sophisticated computer algorithms.[90]

Once regulators have a better understanding of the effects of HFT strategies, they should put in place regulations that restore investor confidence. In drafting new regulations for HFT, though, regulators must keep in mind that HFT is not a homogenous group of trading strategies. With around 65%–71% of HFT trading volume consisting of liquidity providing trading strategies,[91] regulations should be specifically tailored to combat predatory practices instead of being painted with a broad brush. Proposed taxes for order cancellations is one example of a regulation that is too broad to address the harmful effects of HFT.[92]  Taxing order cancellations might make predatory HFT less profitable, but it would also make beneficial HFT, such as market making, less profitable as well. This would only increase investors’ costs and reduce liquidity in the markets, having a negative effect on the overall economy.[93]

Setting aside market-making strategies, which are beneficial, and manipulative strategies, which are already illegal, what remains are mostly criticisms concerning latency arbitrage. This form of arbitrage merely takes advantage of timing discrepancies through the use of co-located servers and direct feeds to the exchanges and is generally seen as consuming resources, increasing costs, and decreasing market efficiency.[94]  Additionally, there is the criticism that the HFT “arms race” to speeds approaching the speed of light has no social value and, in fact, wastes societal resources that could be better utilized elsewhere. To address both the concerns over latency arbitrage and the HFT arms race, the SEC should seriously think about implementing frequent batch auctions across trading centers.[95]

As an initial step, however, proprietary HFT firms trading on the off-exchange markets must be under FINRA oversight. Therefore, the SEC should begin by adopting the proposed amendment to Rule 15b9-1.

 


*Samuel Branum. University of Illinois College of Law, J.D. candidate, Class of 2017

[1] Tom Bailey, Flash and Burn: High Frequency Traders Menace Financial Markets, World Fin. (July 3, 2015), http://www.worldfinance.com/banking/flash-and-burn-high-frequency-traders-menace-financial-markets.

[2] On a “Rigged” Wall Street, Milliseconds Make All the Difference, NPR (Apr. 1, 2014, 1:28 PM), http://www.npr.org/2014/04/01/297686724/on-a-rigged-wall-street-milliseconds-make-all-the-difference.

[3] Bradley Hope, How Computers Trawl a Sea of Data for Stock Picks, Wall St. J. (Apr. 1, 2015, 10:30 PM), http://www.wsj.com/articles/how-computers-trawl-a-sea-of-data-for-stock-picks-1427941801.

[4] Id.

[5] Matt Egan, Flash Crash: Could It Happen Again?, CNN Money (May 6, 2014, 3:58 PM), http://money.cnn.com/2014/05/06/investing/flash-crash-anniversary.

[6] Todd C. Frankel, Mini Flash Crash? Trading Anomalies on Manic Monday Hit Small Investors, Wash. Post (Aug. 26, 2015), https://www.washingtonpost.com/business/economy/mini-flash-crash-trading-anomalies-on-manic-monday-hit-small-investors/2015/08/26/6bdc57b0-4c22-11e5-bfb9-9736d04fc8e4_story.html.

[7] Gary Shorter & Rena S. Miller, Cong. Research Serv., High-Frequency Trading: Background, Concerns, and Regulatory Developments 27 (June 19, 2014).

[8] See Michael Lewis, Flash Boys: A Wall Street Revolt 40 (2014) (“[T]he markets are rigged.”).

[9] Exemption for Certain Exchange Members, Exchange Act Release No. 74,581, 80 Fed. Reg. 18,036, 18,036 (proposed Apr. 2, 2015) (to be codified at 17 C.F.R. pt. 240).

[10] Id.

[11] Id.

[12] Concept Release Concerning Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594, 3606 (Jan. 21, 2010). The SEC describes HFT as having the following characteristics: (1) “professional traders acting in a proprietary capacity that engage in strategies that generate a large number of trades on a daily basis”; (2) “the use of extraordinarily high-speed and sophisticated computer programs for generating, routing, and executing orders”; (3) “use of co-location services and individual data feeds offered by exchanges and others to minimize network and other types of latencies”; (4) “very short time-frames for establishing and liquidating positions”; (5) “the submission of numerous orders that are cancelled shortly after submission”; and (6) “ending the trading day in as close to a flat position as possible.” Id

[13] Andrew J. Keller, Robocops: Regulating High Frequency Trading After the Flash Crash of 2010, 73 Ohio St. L.J. 1457, 1477 (2012).

[14] Id.

[15] Id.

[16] Steven R. McNamara, The Law and Ethics of High-Frequency Trading, 17 Minn. J.L. Sci. & Tech. 71, 114–16 (2016).

[17] Stanislav Dolgopolov, Regulating Merchants of Liquidity: Market Making from Crowded Floors to High-Frequency Trading, 18 J. Bus. L. 651, 653–54 (2016). Liquidity is the immediate availability of shares that can be bought or sold at a fair price. Rishi K Narang, Inside the Black Box: A Simple Guide to Quantitative and High-Frequency Trading 247 (2d ed. 2013). Liquidity is related to the depth of the order book (the number of shares available to be bought or sold at a certain price) and the bid-ask spread (the difference in price between the national best bid and the national best offer). Id. at 224.

[18] Market Maker, SEC, https://www.sec.gov/answers/mktmaker.htm (last visited Jan. 15, 2017).

[19] Richard Finger, High Frequency Trading: Is It a Dark Force Against Ordinary Human Traders and Investors?, Forbes (Sept. 30, 2013, 8:41 AM), http://www.forbes.com/sites/richardfinger/2013/09/30/high-frequency-trading-is-it-a-dark-force-against-ordinary-human-traders-and-investors/#709c5e0c51a6.

[20] Björn Hagströmern & Lars Nordén, The Diversity of High-Frequency Traders, 16 J. Fin. Markets 741, 756 (2013).

[21] Staff of the Division of Trading and Markets, SEC, Equity Market Structure Literature Review Part II: High Frequency Trading 9 (Mar. 18, 2014) [hereinafter HFT Literature Review], https://www.sec.gov/marketstructure/research/hft_lit_review_march_2014.pdf.

[22] Shorter & Miller, supra note 7, at 19.

[23] HFT Literature Review, supra note 21, at 33.

[24] Id. at 23–28.

[25] George J. Miao, High Frequency and Dynamic Pairs Trading Based on Statistical Arbitrage Using a Two-Stage Correlation and Cointegration Approach, 6 Int’l J. Econs. & Fin. 96, 96–97 (2014).

[26] Concept Release Concerning Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594, 3608 (Jan. 21, 2010).

[27] Id.

[28] Id.

[29] Merritt B. Fox et al., The New Stock Market: Sense and Nonsense, 65 Duke L.J. 191, 241 (2015).

[30] Id. at 238–42.

[31] Sal Arnuk & Joseph Saluzzi, Themis Trading LLC, Latency Arbitrage: The Real Power Behind Predatory High Frequency Trading (Dec. 4, 2009), https://pdfs.semanticscholar.org/0f6d/8a58f1ec09fc107e7df18f786b55605c5af5.pdf.

[32] Fox et al., supra note 29, at 238.

[33] Id. at 239.

[34] Id.

[35] Narang, supra note 17, at 285.

[36] Id.

[37] Id.

[38] Charles R. Korsmo, High-Frequency Trading: A Regulatory Strategy, 48 U. Rich. L. Rev. 523, 548 (2014).

[39] Id. “Spoofing” is placing a bid or offer for shares just to manipulate other traders into raising or lowering their bid or offer. McNamara, supra note 16, at 114. “Layering” is similar to spoofing except that bids or offers are entered in successively higher (or lower) increments to simulate a pattern in the market. Id. at 115–16. “Quote stuffing” is the rapid-fire placing of bids or offers to overwhelm the capacity of exchange servers and slow them down in order to gain an advantage over other traders. Id. at 116.

[40] François-Serge Lhabitant & Greg N. Gregoriou, High-Frequency Trading: Past, Present, and Future, in The Handbook of High Frequency Trading 155, 161–62 (Greg N. Gregoriou ed., 2015).

[41] Boston Consulting Group, Inc., U.S. Securities and Exchange Commission Organizational Study and Reform 20 (Mar. 10, 2011).

[42] 15 U.S.C. 78c(a)(26) (2012).

[43] Exchanges, SEC, https://www.sec.gov/divisions/marketreg/mrexchanges.shtml (last visited Jan. 15, 2017).

[44] Exemption for Certain Exchange Members, Exchange Act Release No. 74,581, 80 Fed. Reg. 18,036, 18,039 (proposed Apr. 2, 2015) (to be codified at 17 C.F.R. pt. 240).

[45] Self-Regulatory Organization Rulemaking, SEC, https://www.sec.gov/rules/sro.shtml (last visited Jan. 15, 2017).

[46] Clearing Agencies, SEC, https://www.sec.gov/divisions/marketreg/mrclearing.shtml (last visited Jan. 15, 2017).

[47] Boston Consulting Group, Inc., supra note 41, at 25.

[48] Concept Release Concerning Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594, 3599 (Jan. 21, 2010).

[49] 15 U.S.C. § 78o(b)(8) (2012).

[50] Id. § 78o(b)(9).

[51] Exemption for Certain Exchange Members, Exchange Act Release No. 74,581, 80 Fed. Reg. 18,036, 18,037 (proposed Apr. 2, 2015) (to be codified at 17 C.F.R. pt. 240).

[52] Id.

[53] Id.

[54] Id.

[55] Id.

[56] Id.

[57] Id.

[58] Id. at 18,042.

[59] Id.

[60] Id. at 18,043.

[61] Id.

[62] Id. 

[63] Id. at 18,038, 18,043.

[64] Id. at 18,070.

[65] Id. at 18,046.

[66] Id.

[67] Id. at 18,046, 18,049.

[68] Id. at 18,046.

[69] Id. at 18,047.

[70] Id. at 18,049.

[71] Id.

[72] Exemption for Certain Exchange Members, Exchange Act Release No. 74,581, 80 Fed. Reg. 18,036, 18,042 (proposed Apr. 2, 2015) (to be codified at 17 C.F.R. pt. 240).

[73] 15 U.S.C. § 78o-3(b) (2012).

[74] Exemption for Certain Exchange Members, 80 Fed. Reg. at 18,059.

[75] Id.

[76] Id.

[77] Charles P. Jones, Investments: Analysis and Management 82 (11th ed. 2009).

[78] Id.

[79] Mary Jo White, Chairwoman, SEC, Speech at the Sandler O’Neill & Partners, L.P. Global Exchange and Brokerage Conference: Enhancing Our Equity Market Structure (June 5, 2014), https://www.sec.gov/News/Speech/Detail/Speech/1370542004312.

[80] Id.

[81] See Regulation NMS, Exchange Act Release No. 51,808, 70 Fed. Reg. 37,496, 37,603 (June 29, 2005) (to be codified at 17 C.F.R. pts. 200, 201, 230, 240, 242, 249, 270) (“[T]he interests of long-term investors and short-term traders in fair and efficient markets coincide most of the time. In those few contexts where the interests of long-term investors directly conflict with short-term trading strategies, we believe that, in implementing regulatory structure reform, the Commission has both the authority and the responsibility to further the interests of long-term investors, and that the record provides substantial support for the Commission’s determination to further their interests.”).

[82] High Frequency Trading’s Impact on the Economy: Hearing Before the Subcomm. on Securities, Insurance, and Investment of the S. Comm. on Banking, Housing, and Urban Affairs, 113th Cong. 9 (June 18, 2014) (statement of Andrew M. Brooks, Vice President and Head of U.S. Equity Trading, T. Rowe Price Assoc., Inc.).

[83] Exemption for Certain Exchange Members, Exchange Act Release No. 74,581, 80 Fed. Reg. 18,036, 18,038 (proposed Apr. 2, 2015) (to be codified at 17 C.F.R. pt. 240).

[84] Id.

[85] Limited Liability Company Agreement of CAT NMS, LLC, app. C, at 56 (Dec. 23, 2015 amend.).

[86] See, e.g., FINRA Regulatory Notice 15-09, Equity Trading Initiatives: Supervision and Control Practices for Algorithmic Trading Strategies, at 2 (Mar. 2015), https://www.finra.org/sites/default/files/notice_doc_file_ref/Notice_Regulatory_15-09.pdf (requiring its member firms to have reasonable supervision mechanisms in place for monitoring the use of algorithmic trading).

[87] Consolidated Audit Trail, Exchange Act Release No. 67,457, 77 Fed. Reg. 45,722, 45,729–30 (to be codified at 17 C.F.R. pt. 242) (“[S]taff at the Commission working on the analysis of the May 6, 2010 ‘Flash-Crash’ found it was not possible to use the data from existing audit trails to accurately or comprehensively reconstruct exchange and ATS equity limit order books for NMS securities as required to fully analyze the events of that day.”).

[88] Id.

[89] Consolidated Audit Trail (CAT) Resource Center, SIFMA, http://www.sifma.org/issues/legal,-compliance-and-administration/consolidated-audit-trail-(cat)/overview/ (last visited Jan. 15, 2017).

[90] Id.

[91] Hagströmern & Nordén, supra note 20, at 756.

[92] Matt Levine, Why Do High-Frequency Traders Cancel So Many Orders?, Bloomberg View (Oct. 8, 2015, 6:06 PM), https://www.bloomberg.com/view/articles/2015-10-08/why-do-high-frequency-traders-cancel-so-many-orders-.

[93] Douglas J. Elliott, Brookings Inst., Market Liquidity: A Primer (June 2015), http://www.brookings.edu/~/media/research/files/papers/2015/06/market-liquidity/market-liquidity.pdf.

[94] Fox et al., supra note 29, at 242.

[95] See generally Budish et al., The High-Frequency Trading Arms Race: Frequent Batch Auctions as a Market Design Response, 130 Q. J. Econ. 1547 (2015); see also Sviatoslav Rosov, Are Frequent Batch Auctions a Solution to HFT Latency Arbitrage?, CFA Inst. (Nov. 10, 2014), https://blogs.cfainstitute.org/marketintegrity/2014/11/10/are-frequent-batch-auctions-a-solution-to-hft-latency-arbitrage/. Currently, exchanges operate in continuous time, so that even if a trader is one nanosecond faster than another trader, that trader will have his orders prioritized over the other trader. Rosov, supra. The fastest traders are placed at the top of the book and can snipe stale quotes, or cancel their quotes before they are sniped by others. Id. This sets up the incentive for HFT traders to continuously seek out the fastest transmission speeds. Id. In a batch auction, though, instead of processing orders as they come in, auctions are held at discrete intervals, such as every 100 milliseconds. Id. Thus, so long as HFT traders get their orders in within the 100-millisecond window, they will all be processed at the same time. Id. As a result, there is no longer an advantage for being a nanosecond faster, and the HFT arms race will be over. Id. In this sense, frequent batch auctions are analogous to Rule 612 of Regulation NMS, which sets the minimum quoting increment of shares at a penny. If there were no minimum quoting increment, a trader could prioritize his or her order simply by entering a bid or offer that is $.001 (or even $0.000001) higher or lower than the quoted price. This is similar to a HFT trader jumping to the top of the book by being a nanosecond faster. If miniscule differences in price should not prioritize a trader’s order, neither should miniscule differences in time.