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.

Getting Ahead of the Digital Divide: How State Laws Ensuring Equal and Adequate Access to Education Technology Across School Districts Will Benefit Both Students and Legislatures

By Mark Goldich*

I. Introduction

Although not explicitly guaranteed by the Constitution, public education is upheld under the law as a crucial government service that must be provided equally to all children in the United States.[1]  The Supreme Court has declared public education essential to providing citizens the tools to enjoy and participate in America’s economy.[2]  Technological development in classrooms, meanwhile, has proven crucial in improving teaching and learning to keep pace as the economy modernizes.[3]  Due to the inequitable distribution of vital technology resources across school districts, students in poorer neighborhoods nationwide do not enjoy the benefits of classroom technology to their significant disadvantage.[4]

As states provide for education through their own constitutions and statutes, they are exposed to lawsuits by aggrieved parents and school districts seeking more equitable and robust distribution of education resources. Part II of this Note will review the importance of technology in classrooms, briefly examine a handful of state constitutions providing for public education, and introduce several lawsuits challenging statewide distribution of education funds and resources. Part III will examine the implications of state-level education litigation, and review several recently enacted laws that specifically enhance technology in classrooms. Part IV will recommend that states address the education technology gap head-on by crafting laws ensuring its equitable and adequate dispensation across school districts. Such laws will better serve students, and prevent costly litigation.

II. Background

School systems across America are in a period of transition. Over the past several years, classrooms have shifted from predominantly print-based to digital learning environments.[5]  Access to education technology allows students to connect to learning opportunities worldwide,[6] develop valuable research skills at an early age,[7] and access online courses and supplemental materials to complement their in-school experience.[8]  Results show that access to such technology can boost test scores, while increasing student engagement in project-based learning in classrooms.[9]

Classroom technology also helps prepare students for the modern workforce. Many jobs require at least some use and knowledge of computer technology; students who exit school without adequate training enter the workforce at a marked disadvantage.[10]  By equipping schools with adequate technology, districts better prepare students to compete economically.[11]

As the national education community has awakened to the benefits of classroom technology,[12] some states have accordingly provided such resources to students.[13]  With increasing regularity, school districts are experimenting with online learning programs, and helping schools implement digital curriculum.[14]  In 2002, for example, Maine became the first state to adopt a one-to-one laptop program, providing each student in Maine access to a laptop in the classroom.[15]  Students across America increasingly enjoy access to online classes that supplementing traditional courses, offer dual or advanced credits, or replace traditional high school courses altogether.[16]  In 2008, Florida enacted the first statewide legislation requiring districts to offer full- and part-time virtual course options.[17] Currently, five states (Alabama, Arkansas, Florida, Michigan, and Virginia) have laws requiring students to complete at least one online course in high school.[18]  Such measures reflect the growing understanding that education technology is prudent in the pursuit of producing prepared pupils.

Despite some growth in education technology nationwide, an alarming gap in access to such resources persists between the nation’s wealthy and poor school districts.[19]  This “digital divide” leaves many students from poorer school districts at a severe disadvantage.[20]  The Chicagoland area offers a poignant example of the disparity. In 2012, DuSable High School, located in a poorer neighborhood on the south side of Chicago, offered only twenty-four instructional computers for nearly a thousand students.[21] Many are thus without basic skills, such as the ability to save files to a flash drive, or set margins in Microsoft Word.[22]  In contrast, nearby Deerfield Public Schools District 109, located in a richer neighborhood, currently provides approximately 2,000 computer workstations for its 3,100 students, affording them the chance to develop valuable research and critical thinking skills at an early age.[23]  That students in low-income school districts also often lack access to technology at home only compounds the problem.[24]  Recent studies show only 62% of people in households making less than $30,000 a year use the Internet, compared to 90% in those making $50,000–$74,999.[25] Teachers in low-income neighborhoods note greater difficulty using education technology than their peers in wealthier schools.[26]  Many teachers in low-income schools cite their students’ inadequate access to technology at home as a “major challenge” in attempting to use it in the classroom.[27]

The extent of the digital divide is hard to justify, and flows directly from funding disparities between districts in many states.[28] State and local governments in twenty-three states spend less per student in their poorest school districts than they do in their wealthiest counterparts.[29] On average, states and municipalities nationwide spend 15% less on students in the poorest school districts than they do in the most affluent.[30]  Former Education Secretary Arne Duncan lamented as to the findings: “we have, in many places, school systems that are separate and unequal. Money by itself is never the only answer, but giving kids who start out already behind in life, giving them less resources is unconscionable, and it’s far too common.”[31]

Such large disparities in funding and resource distribution often give rise to state-level litigation, wherein aggrieved students, parents, and districts challenge state funding methods under state constitutional provisions. The state constitution of Kansas, for example, provides, “the legislature shall make suitable provision for finance of the educational interests of the state.”[32]  The Kansas Supreme Court clarified the provision requires the state to guarantee equitable and adequate distribution of school funds and resources statewide.[33]  Since 2012, the state has been mired in litigation—Gannon v. State of Kansas—over its funding formula. In Gannon, a collection of districts, parents, and students argue the current formula does not meet the Kansas Supreme Court’s equity and adequacy requirements.[34]  The court has repeatedly scolded state legislators for attempting to shirk their constitutional mandate, maintaining, “school districts must have reasonably equal access to substantially similar educational opportunity through similar tax effort.”[35]  The court also clarified, “regardless of the source or amount of funding, total spending is not the touchstone for adequacy.”[36]  In so holding, the court required the state to provide school districts with adequate support and resources in addition to a mere dollar amount.

In New York, according to its highest court, the state constitution guarantees “a sound basic education” to all students.[37]  Like the Kansas court in Gannon, the New York court made clear this requirement cannot be met with funding alone: “A sound basic education is gauged by the resources afforded students and by their performance, not by the amount of funds provided to schools.”[38]  In Campaign for Fiscal Equity v. State of New York, the court noted:

For at least a decade it has been the position of [State Education Department] that instructional technology—computers, related hardware such as printers and modems, and appropriate software—is an essential resource for students . . . . Defendants correctly point out that in the last three years there has been an infusion of funds devoted to increasing schools’ use of instructional technology. However, these funds have failed to remedy New York City public schools’ technological deficit. Moreover, it is unclear whether funding for technological improvements in New York City public schools will continue.[39]

In Ohio, the Supreme Court summarized the state’s constitutional education mandate as follows:

The mission of education is to prepare students of all ages to meet, to the best of their abilities, the academic, social, civic, and employment needs of the twenty-first century, by providing high-quality programs that emphasize the lifelong skills necessary to continue learning, . . . use information and technology effectively, and enjoy productive employment.[40]

In DeRolph v. State of Ohio, the court held that the state’s school funding formula failed to pass constitutional muster,[41] lamenting:

None of the appellant school districts is financially able to keep up with the technological training needs of the students in the districts. The districts lack sufficient computers, computer labs, hands-on computer training, software, and related supplies to properly serve the students’ needs. In this regard, it does not appear likely that the children in the appellant school districts will be able to compete in the job market against those students with sufficient technological training.[42]

The courts in Kansas, New York, and Ohio suggest that providing adequate technological resources to its school districts is a minimum requirement states must meet to defeat education-funding challenges.

III. Analysis

Cases like those discussed above have often proven successful for plaintiffs, and warn of future battles for state legislatures.[43] Such cases often span years, and require states to expend valuable resources defending legislation. Gannon, for example, represents the culmination of years of political tug-of-war over school funding in Kansas.[44]

After the court found for the plaintiffs in 2012, the state legislature re-tooled the state’s per-pupil funding formula, adding approximately $130 million to its school budget to address inadequacy and inequity.[45]  The court approved the legislature’s remedies, but left the matter open to allow plaintiffs to raise future concerns if the state failed to uphold its promises.[46]  As it became clear that the state’s corrective measures would cost more than anticipated, the legislature scaled back on the additional aid it promised to poorer districts, passing a new, block-grant formula designed to shield the state from school funding increases.[47]  Not surprisingly, the Gannon plaintiffs immediately challenged the state’s maneuver.[48]  The ongoing litigation has been a significant thorn in lawmakers’ sides, as many expected the case to disappear with their initial appeasement promises.[49]  Disgruntled state representatives have lashed out, arguing courts should stay out of state budget determinations; some have threatened to alter the state’s judicial selection process in retaliation against the court’s “activism.”[50]  The Ohio Supreme Court’s decision in DeRolph precipitated similarly ugly political fallout in Ohio. Though the case began in 1991, the Ohio Supreme Court did not hand down a decision for the plaintiffs until March 1997.[51]  Since then, the Ohio Supreme Court has declared the state’s school funding formula unconstitutional three additional times.[52]

Long, bitter adequacy suits are costly to states in several ways. The most obvious costs are those imposed by courts, requiring states to spend greater sums on education. The initial Gannon decision led Kansas to announce a $130 million increase in annual education spending.[53]  The Ohio legislature, as a result of the DeRolph decisions, “spent billions on new schools, increased per-student aid 66 percent, and spent hundreds of millions in extra money for poor schools.”[54]  While such increases represent boons for poorer public school districts, they are jarring for state legislatures, as they require massive budget reallocation on the fly. Further, extended battles in state court are not cheap. The plaintiffs in DeRolph, for example, reported litigation costs of over $3.6 million annually prior to winning the case.[55]  At various points throughout the lengthy litigation, the court ordered the state to pay the coalition’s costs, on top of the approximately $2 million it spent on its own legal defense.[56]

Such lawsuits, culminating with the state’s highest court declaring the state’s youth under-served, also represent considerable embarrassments to state legislatures. Given public education’s position as “the most important function of state and local governments,”[57] one can only surmise the meticulous condemnation of a state’s public school system would not mark a proud moment for lawmakers. Although any state’s greatest incentive to equally provide its students with adequate education technology is to best prepare its young people; avoiding lengthy lawsuits, jarring fiscal mandates, and public embarrassment provide additional incentive for states to satisfying their constitutional duties.

Some states have shown early leadership in the fight to close the digital divide, passing statutes specifically aimed to equip schools with adequate education technology. For example, in 2014, North Carolina passed two new laws designed to transition classrooms from traditional textbooks to digital learning platforms.[58]  Similarly, the Georgia legislature recently passed the “Digital Classroom Act,” designed to provide digital textbooks and learning tools in classrooms across Georgia.[59]  The law provides a laptop, tablet, or other wireless electronic device to all students above the third grade who cannot provide their own for reading or accessing instructional material. [60]

In 2015, the Delaware Legislature established a task force devoted to making Delaware “the premier state for utilizing technology in pre- kindergarten to grade 12 education.”[61]  One of its primary mandates is to equalize access to education technology across districts statewide.[62]  While such provisions benefit students by ensuring access to essential learning tools; the state’s proactive, statutory approach to providing education technology signals its commitment to offering a modern and robust education equally to all students, and addresses an issue that has proven central to many state education lawsuits.[63]

IV. Recommendation

Given the importance of providing students access to education technology, states should follow the lead of North Carolina, Georgia, and Delaware, and address the digital divide head-on with legislation. Each of the recently passed provisions discussed above take different approaches to improving education technology within the respective states. As states implement new education technology plans and experiment with methods, others should watch closely, identify best practices, and scale up the most effective methods.

By passing laws ensuring equal and adequate access to education technology, states commit to providing students a rich and relevant education better suited for a technology-driven economy.[64]  States additionally benefit from avoiding ugly, lengthy, and expensive education-funding litigation.[65]  State courts have shown their willingness to interpret and strictly enforce the duties imposed by state constitutions, and poor or unequal provision of education technology is a major factor considered. Passing such legislation represents a positive, worthwhile investment in any state’s students, and lends credibility to any state arguing before its highest court that it is meeting its constitutional requirements.

V. Conclusion

Education technology is only becoming more essential and more ingrained in classrooms nationwide.[66]  To best serve students and legislatures alike, states should pass laws ensuring all students enjoy the benefits of a modern education; not just those from wealthier school districts. In perpetuating the digital divide, states breach their constitutional duties to provide equal and adequate public education to their citizens, inviting courts to hold state legislatures accountable. State lawmakers should show courage by investing in education technology, and help level the playing field between rich and poor districts.


*Mark Goldich, J.D. Candidate ’17, University of Illinois College of Law. Many thanks to MP, Geoff, Meredith, Ellen, and everyone who took the time to read this (yes: you).

[1] See Plyler v. Doe, 457 U.S. 202, 221 (1982) (“Public education is not a ‘right’ granted to individuals by the Constitution. . . . [E]ducation has a fundamental role in maintaining the fabric of our society. We cannot ignore the significant social costs borne by our Nation when select groups are denied the means to absorb the values and skills upon which our social order rests.”).

[2] See id. (“[E]ducation provides the basic tools by which individuals might lead economically productive lives to the benefit of us all.”).

[3] See Saomya Saxena, Using Technology in Education: Does It Improve Anything?, EdTechReview (Oct. 8, 2013), http://edtechreview.in/news/681-technology-in-education (discussing ways technology has improved education in recent years).

[4] See Nick Pandolfo, As Some School Plunge into Technology, Poor Schools Are Left Behind: Quickening Pace of Technology Widens the Digital Divide, Chi. Tribune (Jan. 25, 2012), http://articles.chicagotribune.com/2012-01-25/news/ct-x-digital-divide-0125-20120125_1_computers-consortium-for-school-networking-poor-schools/2 (highlighting the growing disparity in access to education technology between the nation’s wealthiest and poorest districts).

[5] Arne Duncan, U.S. Sec’y of Educ., The Digital Transformation in Education: Remarks at the State Educational Technology Directors Association Education Forum (Nov. 9, 2010), http://www.ed.gov/news/speeches/digital-transformation-education-us-secretary-education-arne-duncans-remarks-state-educational-technology-directors-association-education-forum. Some school districts, for example, have begun using digital tablets with educational software in classrooms to deliver curriculum in more innovative ways. See A Bold New Vision For Instruction Should Ignite the Move to 1:1, Off. Educ. Tech., U.S. Dep’t Educ., http://tech.ed.gov/stories/a-bold-vision-for-instruction-should-ignite-the-move-to-11/?back=%2Fstories%2Fstory_tag%2Fpersonalized-learning%2F (last visited Nov. 14, 2016) (describing a recent initiative in Virginia providing each student with tablet for in-class and at-home use).

[6] Duncan, supra note 5.

[7] Saxena, supra note 3.

[8] Pandolfo, supra note 4.

[9] Id.

[10] U.S. Dep’t of Educ., Getting America’s Students Ready for the 21st Century: Meeting the Technology Literacy Challenge 19 (1996), http://files.eric.ed.gov/fulltext/ED398899.pdf (explaining that employers are likely to prefer candidates with technological proficiency).

[11] Id.

[12] Pandolfo, supra note 4.

[13] Duncan, supra note 5.

[14] See Evergreen Educ. Grp., Keeping Pace With K-12 Digital Learning: An Annual Review of Policy and Practice 11, 12 (2015), http://www.kpk12.com/wp-content/uploads/Evergreen_KeepingPace_2015.pdf (describing nationwide increases in education technology).

[15] Katie Ash, State Laptop Program Progresses in Maine amid Tight Budgets, Educ. Wk. (Sept. 1, 2009), http://www.edweek.org/ew/articles/2009/09/02/02laptop.h29.html (last visited Nov. 14, 2016).

[16] See Evergreen Educ. Grp., supra note 14, at 14 (noting the nationwide proliferation of online courses).

[17] Fla. Stat. § 1002.45 (2008).

[18] Evergreen Educ. Grp., supra note 14, at 106.

[19] See Pandolfo, supra note 4 (highlighting the growing disparity in access to education technology between the nation’s wealthiest and poorest districts).

[20] See id. (describing the impacts the digital divide has on low-income school districts).

[21] Id.

[22] Id.

[23] Id.

[24] See Liz Soltan, Digital Divide: The Technology Gap Between the Rich and Poor, Digital Responsibility, http://www.digitalresponsibility.org/digital-divide-the-technology-gap-between-rich-and-poor/ (last visited Nov. 14, 2016) (discussing the correlation between lack of technology at school and lack of technology in homes in low-income school districts).

[25] Id.

[26] Id.

[27] Id.

[28] See Emma Brown, In 23 States, Richer School Districts Get More Local Funding than Poorer Districts, Wash. Post (Mar. 12, 2015), https://www.washingtonpost.com/news/local/wp/2015/03/12/in-23-states-richer-school-districts-get-more-local-funding-than-poorer-districts/ (discussing alarming funding gaps between the nation’s wealthiest and poorest school districts).

[29] Id.

[30] Id.

[31] Id.

[32] Kan. Const. art. VI, § 6.

[33] See Gannon v. State, 319 P.3d 1196, 1226 (Kan. 2014) (“[T]he ordinary understanding of the term ‘suitable’ encompasses minimum requirements of adequacy and equity.”).

[34] Id. at 1204; see also Kyle Palmer & Sam Zeff, Kansas to Court: Stay Out of School Funding, KCUR 89.3 (Nov. 24, 2015), http://kcur.org/post/kansas-court-stay-out-school-funding#stream/0 (describing the timeline of the ongoing Gannon litigation).

[35] Gannon, 319 P.3d 1196 at 1109.

[36] Id. at 1237.

[37] Campaign for Fiscal Equity v. State of New York, 719 N.Y.S.2d 475 (N.Y. Sup. Ct. 2001).

[38] Id. at 534.

[39] Id. at 513–14.

[40] DeRolph v. State, 677 N.E.2d 733, 740 (Ohio 1997).

[41] Id. at 781.

[42] Id. at 744.

[43] A 1997 survey of state-level litigation found that plaintiffs won 74% of all adequacy suits (suits where concerned parents, school districts, and interested parties contend some students are not receiving an education of the quality demanded by their state constitution) before state supreme courts. See Jessica Malman, Connecting Students to “the Net”: Guiding Principles from State Constitutions, 7 Geo. J. on Poverty L. & Pol’y 53, 103 (2000).

[44] See Sam Zeff, A Primer on the School Funding Case Before the Kansas Supreme Court, KCUR 89.3 (Nov. 5, 2015), http://kcur.org/post/primer-school-funding-case-kansas-supreme-court#stream/0 (“On Friday morning, the Kansas Supreme Court hears arguments in a school funding case that’s gone on for years and could lead to the Legislature being ordered to spend hundreds of millions of dollars more on public education.”).

[45] Gannon Explained, Mainstream Coalition (Mar. 10, 2014), http://www.mainstreamcoalition.org/gannon_explained.

[46] Id.

[47] John Eligon, Kansas Schools Fight Plays Out Against Backdrop of Debate on Judiciary, N.Y. Times (Mar. 22, 2015), http://www.nytimes.com/2015/03/23/us/kansas-schools-fight-plays-out-against-backdrop-of-debate-on-judiciary.html?_r=0.

[48] Id.

[49] Zeff, supra note 44.

[50] Id.

[51] Eric Albrecht, What Went On in the Supreme Court, Columbus Dispatch (March 24, 2007, 3:54 PM), http://www.dispatch.com/content/stories/local/2007/03/18/SUPREMES.ART_ART_03-18-07_A1_OK638N7.html.

[52] Sandra McKinley, The Journey to Adequacy: The DeRolph Saga, 30 J. Educ. Fin. 321, 321 (2005).

[53] Gannon Explained, supra note 45.

[54] Albrecht, supra note 51.

[55] See James Drew, Coalition Legal Fees $3.6M and Growing Ohio Taxpayers Foot Bills for Columbus Firm’s Work, Toledo Blade (June 17, 2001), http://www.toledoblade.com/State/2001/06/17/Coalition-legal-fees-3-6M-and-growing-Ohio-taxpayers-foot-bills-for-Columbus-firm-s-work.html (“The coalition challenging Ohio’s school-funding system has used $3.6 million in tax dollars to pay for legal fees over the last decade—and the meter keeps running.”).

[56] Id.

[57] Brown v. Bd. of Educ., 347 U.S. 483, 493 (1954).

[58] Id.

[59] 2015 Ga. Laws 171 (S.B. 89).

[60] Id.

[61] S.C.R. 22, 148th Gen. Assemb., Reg. Sess. (Del. 2015), http://legis.delaware.gov/BillDetail?LegislationId=23843.

[62] Id.

[63] Campaign for Fiscal Equity v. State of New York, 719 N.Y.S.2d 475, 513–14 (N.Y. Sup. Ct. 2001); DeRolph v. State, 677 N.E.2d 733, 740 (Ohio 1997); McDuffy v. Sec’y of Exec. Office of Educ., 615 N.E.2d 516, 553 (Mass. 1993).

[64] See Monica Herk, The Skills Gap and the Seven Skill Sets that Employers Want: Building the Ideal New Hire, Comm. For Econ. Dev. (June 11, 2015), https://www.ced.org/blog/entry/the-skills-gap-and-the-seven-skill-sets-that-employers-want-building-the-id (explaining the importance employers place on technological proficiency in seeking prospective hires).

[65] Associated Press, Kansas Officials Want School Funding on Hold, Wichita Eagle (June 29, 2015, 3:39 PM), http://www.kansas.com/news/politics-government/article25777900.html; Drew, supra note 55; Gannon Explained, supra note 45.

[66] See Evergreen Educ. Grp., supra note 14 (describing nationwide increases in education technology).

Segmenting Cyberwarfare to Aid in the Formation of Ethical Policy and Law

By Scott Van Hoy*

Introduction

Breaching computer infrastructure has become a relatively easy task for skilled hackers, making cybersecurity an increasingly hot topic. The importance of the information stored on computer systems and society’s overall reliance on computer systems is substantial, leading to concerns regarding how to manage the security of technology. If a hacker gains access to government networks, the resulting damage may cause greater disruption than physical damage to property or people. A skilled hacker can also alter computer systems in ways that result in physical damage to humans or machines. A cyberattack and the subsequent cyberdefense when used as part of a military strategy is referred to as cyberwarfare.

Cyberwarfare has become the all-encompassing term for cyberattacks. Cyberwar and conventional war are often discussed under the same ethical and legal frameworks, masking the type of cyberattack beneath the term. Addressing cyberwarfare as a general term for a high-tech war could result in ethical dilemma considering the legal frameworks of war would not adapt to the technology’s capabilities. In order to aid in ethical decision making during cyberconflict, cyberwarfare should be addressed as three different types of war: conventional cyberwarfare, infrastructural cyberwarfare, and information cyberwarfare. Only after policy and lawmakers acknowledge this segmentation can cyberwarfare be addressed ethically among the international community.

Background

Cyberwarfare has posed a unique set of challenges to military and government leaders over the last few decades, and continues to be an ongoing discussion worldwide. From cars to our electrical power grid, computers control the world around us. The capabilities to hack and recode technology create a new domain of warfare that has already been tested and proven in the international community.[1]

In 1982, a Soviet Trans-Siberian oil pipeline explosion was observed by a United States infrared satellite.[2]  This explosion was the most violent non-nuclear explosion ever observed by satellite, and was the equivalent of three kilotons of TNT.[3]  It is accepted that the explosion was caused by the United States’ Central Intelligence Agency (CIA).[4]  The CIA supposedly hacked into the pipeline’s control system and altered the pressure specifications for the pumps, values, and turbines.[5] The resulting high pressure caused the explosion.[6]  There were no human casualties recorded.[7]

In 2005 and 2007, Brazil experienced power outages in two of its largest cities.[8]  Over three million residents lost power for two days, and the cause was proven to be a result of hackers breaching Brazil’s energy infrastructure.[9]  Cyberweapons can be used without the victim ever knowing who committed the attack, and entire cities can be plunged into darkness without leaving a trace of who committed the attack, or why the attack was committed.[10]

When Iran’s uranium enrichment capability increased in the early 2000s, the United States developed a digital weapon to slow Iran’s production.[11] In 2009, the United States deployed Stuxnet, a program designed to increase the revolutions per minute of the centrifuges that enriched the uranium. Centrifuges began to fail, and in the first five months Iran’s centrifuge count was reduced from 4,592 to 3,936 due to Stuxnet.[12])

Then in 2015, the United States’ Office of Personnel Management (OPM) was hacked.[13]  The OPM attack compromised the personal information of 22.1 million government employees, including their social security numbers, performance evaluations, and names of friends and family.[14]  The Washington Post reported that U.S. officials believe this breach is potentially the most damaging “cyber heist” in U.S. government history.[15]  China has not been officially named as the OPM attacker; however, the common narrative among government officials is that China is conducting “traditional espionage” via cyber means against the United States.[16]

International Interpretations

There is a human element to cyberwarfare that is not as clear as the 1s and 0s of the cyber world. Some ethical and legal frameworks of conventional warfare that have been established and accepted may no longer be valid in the digital age. For example, the rightful application of just war theory is debatable when trying to determine if a cyberattack is considered an armed attack.[17]  One argument is that a cyberattack with no human casualties will never justify war because an armed attack results in, and could be defined by, physical harm or loss of life.[18]  Another argument is that a malicious attack, whether it physically harms a person or not, is considered an armed attack due to the unknown second and third order effects, thus justifying war.[19]

Debates such as the just war theory discussion could continue for decades only to result in uncertain ethical responses to cyberwarfare. So long as governments treat cyberwarfare and conventional warfare within the same legal and ethical frameworks, government officials will struggle to agree on an ethical way to manage new cybertechnologies. For example, the NATO Cooperative Cyber Defense Centre of Excellence (CCDCOE), which includes the United States, focuses on connecting humanitarian and international law to identify what actions are just in a cyberwar.[20] The CCDCOE defines a cyberattack as “a cyber operation, whether offensive or defensive, that is reasonably expected to cause injury or death to persons or damage or destruction to objects,”[21] and recognizes cyberwarfare as a cyberattack authorized by state actors.[22]  Combining the definitions, cyberwarfare is considered to be an extension of conventional war with loss of human life and infrastructure, placing cyberwar within the current just war theory and the law of armed conflict. However, the CCDCOE’s Tallinn Manual, the leading manual on the “international law applicable to cyber warfare,” states that the application of the law of armed conflict can be problematic due to the difficulty in identifying the originator, the intent, and the outcome of the attack.[23]

The Shanghai Cooperation Organisation (SCO) consists of six member states including Russia and China.[24] The SCO defines cyberwarfare as “the dissemination of information ‘harmful to the spiritual, moral, and cultural spheres of other states.’”[25] The SCO’s member states have concerns over the concept of uncontrolled information exchange,[26] an idea that when combined with their definition of cyberwar, may lead to unethical responses to cyberattacks. If a country were to hack into an SCO country’s television stations and modify service, this disruption would fall within the SCO’s definition of cyberwar. Since the SCO does not define the barriers between cyberwar and conventional war, a cybertelevision attack may justify war the same as if it were a kinetic attack.

Cyberwarfare Segmentation

The different interpretations of cyberwarfare in the international community will not likely be resolved in the near future due to the dissimilar opinions of the SCO, CCDCOE, and other supranational organizations. Each of the definitions lead to different outcomes and reactions to cyberwar, none of which will fall perfectly within current international law. In order to attempt to justify what is and is not ethical during a cyberwar, cyberwarfare should be broken down into three different categories of cyberwarfare, which can be referred to as the cyberwarfare segmentation model. The first category is conventional cyberwarfare, the second is infrastructural cyberwarfare, and the third is information cyberwarfare.

Conventional cyberwarfare best represents the CCDCOE’s definition of cyberwar, where cyberwarfare is an extension of conventional warfare.[27] Conventional cyberwarfare assumes that a cyberattack will result in the direct or indirect death or physical harm to humans.[28] When there is no longer physical harm to people, but instead physical infrastructure is damaged and widespread disruption occurs, the result is infrastructural cyberwar.[29] The Brazilian power outage, oil pipeline explosion, and the Stuxnet cases show the effectiveness of infrastructural cyberattacks. These same attacks also had the potential to initiate conventional cyberwar. For example, if the Siberian oil pipeline explosion killed the operator, or the power outage directly led to civilian deaths, then it would be an example of conventional cyberwar.[30]

Information cyberwarfare is the act of cyberespionage or information disruption.[31] When hackers gained access into the OPM database and captured the personal information of 22.1 million U.S. government employees, the hackers conducted an information cyberattack on the United States. No human lives were lost and there was no infrastructural damage or physical disruption; thus, only cyberespionage and information disruption occurred.

The lack of segmentation in international law results in both legal yet unethical responses, and illegal yet ethical responses to cyberwar. The United Nations Charter Article 51 declares that self-defense is the only justification for an armed attack, making preemptive strikes illegal.[32]  In addition, the International Committee of the Red Cross (ICRC) and the law of armed conflict declare that civilians are protected and must never be targeted.[33]  With the changing ethical landscape of just war, it is debated that information cyberwar can be used preemptively and target noncombatants if used responsibly to prevent conventional war, which according to the ICRC and the U.N. Charter is unlawful. In the Stuxnet case, the cyberattack on Iran could be considered an armed attack if the attack is not segmented and realized as an infrastructural cyberattack. Thus, by the U.N. Charter, Iran could have responded legally, but not ethically, with a kinetic attack. Without segmentation, the U.N. Charter also infers Stuxnet was an illegal armed attack against Iran, thus the United States was ethically, but not legally, conducting a preemptive strike.

The Shanghai Cooperation Organisation has a much broader definition of cyberwarfare and uses different ethical and legal frameworks for determining what is and is not legal war.[34]  Although the SCO cooperates with the international laws set forth by the United Nations,[35] its broad definition of cyberwarfare leaves room for a broad interpretation of legality, especially for the definition of “armed attack.”[36]  This open interpretation of the U.N. Charter could lead to a response that is legal yet unethical. If the SCO adopts the cyberwarfare segmentation model, it would lay a foundation for further discussion about how to create ethical policies and laws for how to respond to each type of cyberattack, rather than using one term to justify the legality of war.

Both the Stuxnet and SCO examples are derived from the open interpretation of international law set forth by the United Nations. The changing ethical landscape of war resulting from cyberwarfare is consequently changing the legal landscape of war, and the United Nations has not yet taken significant steps to adapt to this form of 21st century conflict. International law often attempts to relate cyberwarfare to conventional warfare, creating laws that may lead to unethical responses to cyberattacks. To ensure ethical laws are established to regulate cyberwarfare, the U.N.’s CCDCOE and the SCO should adopt the cyberwarfare segmentation model to help reevaluate the morality of current international law.

 


*Scott Van Hoy. University of Illinois, MS Technology Management, 2016.

[1] Chris Domas, The 1s and 0s Behind Cyber Warfare, TED (Oct. 2013), https://www.ted.com/talks/chris_domas_the_1s_and_0s_behind_cyber_warfare.

[2] Johann Rost & Robert L. Glass, The Dark Side of Software Engineering: Evil on Computing Projects 118 (2011).

[3] Id.

[4] Id.

[5] Id. at 119.

[6] Id.

[7] Id.

[8] Kevin Poulsen, Report: Cyber Attacks Caused Power Outages in Brazil (Nov. 7, 2009, 12:55 AM), www.wired.com/2009/11/brazil/.

[9] Id.

[10] Guy-Philippe Goldstein, How Cyberattacks Threaten Real-World Peace, TED (Jan. 2010), https://www.ted.com/talks/guy_philippe_goldstein_how_cyberattacks_threaten_real_world_peace.

[11] Kim Zetter, An Unprecedented Look at Stuxnet, the World’s First Digital Weapon, WIRED (Nov. 3, 2014, 6:30 AM), www.wired.com/2014/11/countdown-to-zero-day-stuxnet/.

[12] Id.

[13] Ellen Nakashima, Hacks of OPM Databases Compromised 22.1 Million People, Federal Authorities Say, Wash. Post (July 9, 2015), www.washingtonpost.com/news/federal-eye/wp/2015/07/09/hack-of-security-clearance-system-affected-21-5-million-people-federal-authorities-say/.

[14] Id.

[15] Id.

[16] Id.

[17] Michael N. Schmitt, “Attack” as a Term of Art in International Law: The Cyber Operations Context, 4th Int’l Conf. on Cyber Conflict 283, 290–93 (2012), https://ccdcoe.org/publications/2012proceedings/5_2_Schmitt_AttackAsATermOfArt.pdf.

[18] Id.

[19] Patrick Lin et al., Is it Possible to Wage a Just Cyberwar?, Atlantic (June 5, 2012), www.theatlantic.com/technology/archive/2012/06/is-it-possible-to-wage-a-just-cyberwar/258106/.

[20] About Us, NATO Cooperative Cyber Defence Centre of Excellence, https://ccdcoe.org/about-us.html (last visited Sept. 27, 2016).

[21] Michael N. Schmitt, Tallinn Manual on the International Law Applicable to Cyber Warfare 106 (2013).

[22] CCDCOE, Cyber Definitions, https://ccdcoe.org/cyber-definitions.html

[23] Schmitt, supra note 21, at 77.

[24] Shanghai Cooperation Organization (SCO), GlobalSecurity.org, http://www.globalsecurity.org/military/world/int/sco.htm (last visited Sept. 27, 2016).

[25] Activities, Shanghai Cooperation Org., http://www.infosco.eu/index.php/aboutsco/activities (last updated Jan. 23, 2013).

[26] Keir Giles, Russia’s Public Stance on Cyberspace Issues, 4th Int’l Conf. on Cyber Conflict 63, 65 (2012), https://ccdcoe.org/publications/2012proceedings/2_1_Giles_RussiasPublicStanceOnCyberInformationWarfare.pdf.

[27] Gal Beckerman, Is cyberwar really war?, The Boston Globe https://www.bostonglobe.com/ideas/2013/09/15/cyberwar-really-war/4lffEBgkf50GjqvmV1HlsO/story.html (last visited Sept. 28, 2016).

 

[28] Nuclear Futures Lab, Cyberwarfare: On Whose Authority?, http://nuclearfutures.princeton.edu/wws353-2015-blog-week09-2/ (last visited Sept. 28, 2016).

[29] Lee Rainie Et al, Cyber Attacks Likely to Increase, Pew Research Center, http://www.pewinternet.org/2014/10/29/cyber-attacks-likely-to-increase/ (last visited Sept. 28, 2016).

[30] Ellyne Phneah, Cyberwarfare Not Theoretical, Can Actually Kill, ZDNet (Nov. 17, 2011, 10:26 AM), www.zdnet.com/article/cyber-warfare-not-theoretical-can-actually-kill.

[31] Fred Schreier, On Cyberwarfare, https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=8&ved=0ahUKEwjjg-fAprLPAhXMy4MKHXidA2UQFghLMAc&url=http%3A%2F%2Fwww.dcaf.ch%2Fcontent%2Fdownload%2F67316%2F1025687%2Ffile%2FOnCyberwarfare-Schreier.pdf&usg=AFQjCNHSti4VD11zqhHbyC36ASV-0RLJ8g&sig2=ynFsHCTuEw0Ev6SaIDl41w (last visited Sept. 28, 2016).

[32] U.N. Charter ch. VII, art. 51, www.un.org/en/sections/un-charter/chapter-vii/.

[33] Protected Persons: Civilians, Int’l Committee of the Red Cross, https://www.icrc.org/en/war-and-law/protected-persons/civilians.

 

[34] Andrew Jones & Gerald Kovacich, Global Information Warfare: The New Digital Battlefield 33 (2015).

[35] United Nations, Cooperation Between UN, Shanghai Cooperation Organization Dynamically Expanding, in Shared Quest for Peace, Prosperity, Says Secretary-General, in Message, http://www.un.org/press/en/2010/sgsm12953.doc.htm (last visited Sept. 28, 2016).

[36] Schmitt, supra note 21.