On Monday, September 13th the Financial Industry Regulatory Authority (FINRA) announced sanctions against Trillium Brokerage Services, LLC and several of its employees totaling $2.26 million in total fines. (News Release) Trillium has been fined $1 million with another $1.26 million levied against nine traders, the Director of Trading and the Chief Compliance Officer.Everyone is mis-interpreting this case as a blow to HFT, it's not
The interesting piece of this sanction is how it has been portrayed by FINRA and some prominent bloggers out there, particularly Zero Hedge, as a fine against a particular HFT strategy. FINRA's news release states that the fine is for the use of "an illicit high frequency trading strategy and related supervisory failures". But, upon reviewing the facts of the case, these were not high frequency traders.
Perhaps the crux of the problem is the lack of a standardized definition for what HFT entails. At the very least, any definition of HFT should include the concept of automated strategies. HFT strategies are programmed ahead of time and executed by blackboxes, or computers. This case does not involve HFT but typically very astute financial bloggers are mistaking it as the first major blow to HFT. Well, for better or likely worse, it's not.
Trillium traders were manual, proprietary traders gaming stocks by layering the bid or offer with orders they never wanted to have filled so they could garner fills on orders on the other side of the book. The traders were creating the appearance of buying or selling interest for price improvement on their orders.
Let's create a hypothetical example: say a trader wants to have 500 shares filled on the bid at $10.05. Using the strategy in question, he puts in his limit order bid for 500 shares at $10.05. Then he begins offering relatively large orders on the offer to induce other market players to hit his bid at $10.05. Say the inside offer is $10.07, this trader comes in at $10.09 showing the market his intention to sell 10,000 shares. The other colluding traders join the offer by offering stock at $10.10, $10.11 and so on to create the appearance of significant selling pressure.
Traders outside this ring watching the stock immediately react by hitting $10.05 to exit their positions or to enter a short in the stock. The Trillium trader in question receives his fill for 500 shares and then cancels his 10,000 share offer. Subsequently, he repeats the entire process on the other side of the book to attempt to exit his position at higher prices.
Nowhere in any of this process was there computerized trading employed. On the contrary, the manual trader is actually trying to game HFT! As the action states these traders engaged in this strategy "to take advantage of trading, including algorithmic trading by other firms". High frequency traders (computers) are nearly always the first to react to changes in the order book. Many other traders react as well, worried that the 10,000 share offer will push the price down. Yet, in this case, and in the case of what happens over and over all day long in stocks across the board, the offer is "fake" -- there is no intention to have it filled by the trader entering it.
FINRA charges that Trillium traders used this strategy 46,000 times over time, likely over weeks and weeks, not in a few hours as Barry Ritholtz incorrectly assumes (Note: I heart Rithotz but he's wrong here). Also, his solution would not solve this problem, namely mandating that all bids and offers last for 2 seconds. While this would raise the level of risk to the manipulating trader, it would not wholly stop this practice from happening.
Yet, some HFT do this all day long, just differently
Now, I am not saying that there aren't high frequency traders out there manipulating the tape. There most certainly are. What I would say though, is that it is much, much harder to prove. What makes this case easy to prove is two things: 1) it involves a colluding group of nine different traders, and 2) their orders were "often in substantial size relative to a stock's overall legitimate pending order volume".
A high frequency trading system is one entity and uses very small orders. The manipulation is to profit from very small spreads and, when manipulative, involves quote stuffing, not large quotations. The only way to battle this problem within the HFT arena, as Sean Hendelman and I have been arguing, is to tax order cancellations (or messaging traffic as Senator Kaufman argues, a very similar concept). As I'm finishing up this article I've just been IMed Felix Salmon's post today and he's exactly right.
Brandon R. Rowley
"Chance favors the prepared mind."
*DISCLOSURE: Nothing relevant.