By Samuel Branum*
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. While regulatory bodies struggle to keep up with technology, HFT is moving ahead at lightning fast speeds where milliseconds—and even nanoseconds—matter. 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. 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.
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 and various other mini-flash crashes, 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.
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” 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). 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. 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.
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.
It is important to realize, though, that HFT is not a homogenous form of trading. The debate is usually oversimplified into whether HFT, as a whole, is good or bad for investors. 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. 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.
Traditionally, specialists trading on the floor of exchanges were the main providers of liquidity. As market makers, they would stand ready and willing to buy and sell shares whenever they received orders. Today, though, due to the advancement in technology, HFT traders are the principal liquidity providers for the markets. 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. Generally, this strategy is beneficial to investors, as HFT firms employing this strategy are essentially assuming the role traditionally filled by human market makers. 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. 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. Related to this criticism is that HFT traders increase volatility in the markets.
Another common HFT strategy is statistical arbitrage, which generates profits by taking advantage of price discrepancies between correlated stocks. For example, the price of an exchange-traded fund (ETF) may be lower or higher than the underlying basket of stocks. 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. The HFT trader can then turn around and sell or buy the same ETF or stocks at a profit. This form of arbitrage is considered to be beneficial as it equilibrates prices between markets and so improves price efficiency.
Another form of arbitrage, latency arbitrage, is perhaps the most controversial of all and is considered to have little to no social utility. Some describe the strategy as predatory. It was criticized in Michael Lewis’s Flash Boys and has been the basis for litigation. 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. 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. 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. 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. 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. 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. These strategies may be harder to detect, though, when employed by HFT firms, given the sophistication of some of their algorithms These prohibited strategies have no real economic benefit and do not contribute to price discovery or market liquidity.
III. Current Rule 15b9-1
The SEC relies on self-regulatory organizations (SROs) to oversee the securities market. These SROs include the national securities exchanges, registered securities associations, and registered clearing agencies. The national securities exchanges include those commonly thought of such as the New York Stock Exchange and NADSAQ. The national securities associations regulate the off-exchange market; currently, the only registered securities association (“Association”) is FINRA. Clearing agencies settle trades, hold securities certificates, and maintain ownership records. Over the years, the SEC has become increasingly reliant on SROs to regulate the securities market.
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. 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.
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. 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. 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”). 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. 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. 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. 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. 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. The SEC estimates that about 125 broker-dealers are exempt from Association membership under Rule 15b9-1. Together, these broker-dealers represent about 48% of the orders sent directly to the off-exchange market in 2014.
Consequently, FINRA has no jurisdiction over these broker-dealers and so is unable to directly enforce compliance with federal securities laws and rules. 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. 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.
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. 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. 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.
This requirement, though, would then be subject to two, more targeted exemptions. Both exemptions are directed at broker-dealers that operate exclusively on the physical floor of a national securities exchange. 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. 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. 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. 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.
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. These firms would then be subject to FINRA’s rules. With these broker-dealers as members, FINRA would have a more complete picture of off-exchange trading activity. 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. Additionally, current members of FINRA would benefit, as there would be a level playing field in terms of regulation among market participants.
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. 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. Therefore, as the SEC recognizes, “The secondary markets exist for investors and public companies, and their interests must be paramount.” 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. Where the interests of short-term traders conflict with long-term investors, the interests of investors should take precedence. 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 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. The SEC then oversees FINRA. Research shows that enhanced surveillance of the market increases investor confidence. 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. 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. 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. The SEC, then, must work on implementing the comprehensive audit trail (CAT) plan as soon as possible. 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.
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, 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. 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.
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. 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.
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.
 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.
 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.
 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
 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.
 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.
 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.
 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.
 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.
 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.
 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.”).
 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.).
 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).
 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.”).
 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-.
 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.