Major exchanges face accusations of entry into Faustian bargain with HFT firms

Maria Nikolova

The exchanges are said to have attracted HFT firms by providing them with special products and services that allowed them to position their trades to the detriment of other market participants.

The case against a number of leading stock exchanges, including BATS Global Markets, Inc., Chicago Stock Exchange, Inc., Direct Edge ECN, LLC, The NASDAQ Stock Market LLC, NASDAQ OMX, continues at the New York Southern District Court. The dispute hovers around high-frequency trading and whether the exchanges did (or did not) create a two-tiered system that favoured HFT firms at the expense of the plaintiffs.

The plaintiffs in the case – City of Providence, Rhode Island, Plumbers and Pipefitters National Pension Fund, Employees’ Retirement System of the Government of the Virgin Islands, and State- Boston Retirement System on Friday submitted a Memorandum of Law in Opposition to the exchanges’ renewed Motion to Dismiss the allegations against them.

The complaint alleges that the exchanges provided HFT firms with an array of products and services, including proprietary data feeds, co-location services, and complex order types, which the HFT firms used in combination to systematically manipulate the public securities markets and take advantage of non-HFT market participants. These products and services, used in concert, allegedly allowed HFT firms to divert billions of dollars in trading proceeds from the plaintiffs (and the Class).

Let’s recall that, in March 2018, the United States Court of Appeals for the Second Circuit disagreed with a ruling of the New York Southern District Court in favor of BATS Global Markets, Inc., the Chicago Stock Exchange Inc., the Nasdaq Stock Market, LLC, and the New York Stock Exchange LLC (NYSE). On March 20, 2018, the judgment of the District Court was vacated and the case was remanded for further proceedings consistent with the Opinion of the Court of Appeals. The USCA concluded that the defendant exchanges are not entitled to absolute immunity.

The exchanges are trying to defend themselves, whereas the plaintiffs have once again reiterated their allegations against the defendants.

The defendants are the US largest stock exchanges, upon which the vast majority of equity trades occur. According to the plaintiffs’ complaint, the defendants created products and services for HFT firms that allowed those firms to obtain and react to market data more quickly, using unexplained and in some cases unknown order types. According to the plaintiffs, thanks to these products and services, HFT firms did what the defendants knew they would do – create the appearance of liquidity with “spam” orders, front-run legitimate orders, queue-jump to take advantage of a profitable trade and/or to steal “market” rebates and cancel out of toxic trades before they occurred, all to the benefit of defendants and to the detriment of the plaintiffs.

According to the plaintiffs, the exchanges “have entered into a Faustian bargain with HFT firms, which provide the defendants with the increased trading volume, or “order flow,” that they require to generate higher profits”.

As HFT firms have grown in size, the financial incentives provided by their order flow proved too great for the defendants to resist, the plaintiffs say. In sum, the defendants attracted HFT firms by providing them with special products and services that, in combination, allowed them to position their trades to the detriment of the plaintiffs and the class.

The exchanges are said to have benefitted greatly, collecting large sums in fees from HFT firms for these products and services. The plaintiffs quote estimates showing the defendants’ annual revenue from co-location fees is at $1.8 billion.

As the complaint alleges, the defendants knew that catering to HFT firms with complex (and oftentimes selectively or incompletely disclosed) order types would result in increased trading volume and increased transaction fees. The complaint also states that the defendants knew the “guaranteed economics” provided to HFT firms by such order types would come at the expense of the plaintiffs and the class, yet the exchanges are accused of actively concealing the functionality (and sometimes even the existence) of their complex order types and how these order types were used in conjunction with co-location services and proprietary date feeds to disadvantage the investing public.

The plaintiffs also respond to the defendants’ assertions that permitting the plaintiffs’ claim would create conflicts with the Exchange Act’s regulatory structure and the SEC’s regulatory authority. Put otherwise, according to the exchanges, the lawsuit would conflict with Congress’s intent that the SEC make the rules regarding the national markets. But the plaintiffs note the Second Circuit’s ruling which already addressed this contention, agreeing the plaintiffs’ claims are not a challenge to the SEC’s general authority or an attack on the structure of the national securities market. Instead, they are properly characterized as allegations of securities fraud against the exchanges that belong to that ordinary set of suits in equity. In other words, the plaintiffs’ allegations do not conflict with the SEC’s general authority or the structure of the national securities market.

The case is captioned In Re: Barclays Liquidity Cross and High Frequency Trading Litigation (1:14-md-02589).

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