Cancelation of High Frequency Trades: Clearly Erroneous or just a Mistake?

Author:by Andrew D. Getsinger

This paper focuses on an often overlooked and obscure element of the current marketplace: erroneous transactions. Historically, before the markets’ heavy reliance on automated systems, erroneous transactions were only rescindable if both parties agreed to rescind — a mutual mistake approach. Today, however, Exchanges have incorporated a dispute process to trade rescission, where members petition... (see full summary)

  1. INTRODUCTION During the last one-hundred years, technology has steadily diminished the role of humans in securities trading. More than one-hundred years ago, market crashes had anthropocentric explanations; trading patterns were describable in humanistic terms.(1) Indeed, skittish trading during the 1907 Panic was attributable to an earthquake, a scandal, and the election of President Roosevelt.2 At all stages, humans interacted. Recently, however, a new and amorphous trading strategy, that displaces human involvement in order executions, has emerged; it is high frequency trading ("HFT").3 While the markets are still susceptible to people-driven panics, the Exchanges (e.g. the New York Stock Exchange or the NASDAQ) have had to grapple with not just "fat-finger mistakes,"4 but also with computer glitches. Computer errors happen and will continue to happen;5 the only question is how to respond to such glitches, even if they are the result of a failure to follow industry best practices as well as of the implementation of trading software.

    This paper analyzes the Clearly Erroneous Execution ("CEE") Rule, which is one of the key tools used by the Exchanges to address computer-glitch trades. It begins with an overview of high frequency trading and identifies the common characteristics of HFT firms. It then analyzes the legal framework surrounding HFT. Furthermore, this paper traces the development of the CEE Rule, focusing on its legal underpinnings. Additionally, situations when the CEE Rule was used will be analyzed, focusing on the erroneous trading of Knight Capital Group, Inc. on August 1, 2012. Finally, this paper proposes that the CEE Rule, which applies only to trades that meet certain numerical thresholds, should be modified to allow for rescission of transactions, where one firm will be unjustly enriched by the algorithmic-trading errors of another.

    Bocconi Legal Papers (, rivista giuridica edita dagli studenti della Bocconi School of Law 3 II. ALGORITHMIC AND HIGH FREQUENCY TRADING High frequency trading is a subset of algorithmic trading.(6) Algorithmic trading is "computerized trading controlled by algorithms."7 Put another way, algorithmic traders' "computers directly interface with trading platforms, placing orders without immediate human intervention."8 An algorithmic trader's computers monitor the market, and when an advantageous trading possibility arises, they send back an instruction to place an order within milliseconds.9 The benefit to the investor is that trades are executed at a better price. A better price is secured for investors, because algorithmic trading minimizes the market impact of large orders by slicing the order into smaller parts and selling those parts across markets over an extended period of time.10 HFT firms, unlike algorithmic traders, rely on the best hardware and software to turn themselves into "the fastest sports car" in the marketplace.(11) The edge in the HFT firm's trading strategy lies in its ability to outmaneuver the slow moving market participants, and to be the first to the best deals.12 High frequency trading, like a chess-game, is event-driven; HFT responds to (and is informed by) market queues, just as the chess player reacts to (and learns from) his opponent's moves, using the necessary speed and deliberateness.13 HFT strategies are heavily reliant on cancelations to profitably effect executions: the TABB group notes that 98% of all orders are now canceled14 and the U.S. Securities and Exchange Commission ("SEC") has observed that most orders are subjected to cancelation.15 While lacking a clear definition, HFT firms share common characteristics. High frequency traders are proprietary firms(16) that use the fastest software and hardware for generating and executing orders, and that utilize co-location services.17 Bocconi Legal Papers (, rivista giuridica edita dagli studenti della Bocconi School of Law 4 These firms establish and then liquidate their position at incredibly rapid speeds,(18) with a characteristically high order-to-execution ratio, and their "end-of-the-day position" is flat.(19) HFT is largely a type of trading-strategy where the trader maintains a position very briefly and rarely overnight.

  2. THE LEGAL FRAMEWORK GOVERNING AUTOMATED TRADING The proverbial door for lucrative high frequency trading was opened wide in 2005, when the SEC promulgated Regulation NMS,(20) but the groundwork for HFT was laid thirty-years before. In 1975, Congress enacted Section 11A of the Securities Exchange Act of 1934 ("1934 Act"), which recognized the securities market as an "important national asset"21 and demanded that the SEC create a national market system ("NMS").22 Section 11A recognizes the importance of the securities markets, and emphasizes that new technology will enable a more efficient market system.23 Congress believed that "linking" the markets through "communication and data processing" centers (e.g. the Internet) would foster "efficiency, enhance competition," and increase information availability.(24) Congress mandated the SEC to achieve five goals: efficient transactions, fair competition, widely available information, best order execution, and the execution of orders without a dealer.25 In 2005, acting in furtherance of the congressional mandate in Section 11A, the SEC promulgated Regulation NMS. The SEC proposed Regulation NMS to "modernize and strengthen" the equities market's regulatory structure, by establishing the Order Protection Rule, the Access Rule,(26) the Sub-Penny Rule,27 Bocconi Legal Papers (, rivista giuridica edita dagli studenti della Bocconi School of Law 5 and the Market Data Rules.(28) In part Reg. NMS passed because the transactional costs in U.S. equity markets was exorbitant, estimated at $120 billion per year, or a 1% surcharge per year on the $12 trillion U.S. equity market.29 Accordingly, one of Reg. NMS's primary goals is "promot[ing] market depth and liquidity" by "encourag[ing] vigorous competition among orders."30 Among the rules established by Regulation NMS, the Order Protection Rule (Rule 611) has provided the greatest boon for HFT firms. The Order Protection Rule calls for trade-protection against the execution of orders at inferior prices.(31) As the SEC noted, the Order Protection Rule protects "only automated quotations,"(32) that is, quotations that are "displayed and immediately accessible" through automatic execution.(33) Requiring order execution to occur automatically at the best available quote, Rule 611 opened the door to a market where traders' ability to get the best price was determined not by their reputation or their reliability, but by their latency (the speed at which data is transmitted).34 In other words the fastest trader could secure, in the moment of the transmission, the best priced trades.

    According to the SEC, after Reg. NMS passed in 2005, a dramatic shift in the market occurred. In 2005, the number of the executed orders, compared to the placed orders in NYSE listed stock symbols, was 79.1%; in 2009, only 25.1% of all orders placed were executed.(35) In 2005, the average execution speed was 10.1 seconds; in 2009, it was 0.7 seconds.36 The NYSE's daily trades skyrocketed from 2.9 million in 2005 to 22.1 million during the first ten months of 2009.37 The SEC estimates that more than 50% of the equities trading-volume comes from HFT firms.(38) As high-frequency trading activity increased, so too did the frequency of bizarre and inexplicable market crashes.39 Adjusting to the rise of high-frequency Bocconi Legal Papers (, rivista giuridica edita dagli studenti della Bocconi School of Law 6 traders, the exchanges have responded to the increasing number of "computer glitches" by vesting themselves with the authority to break erroneous trades between their members.

  3. THE DEVELOPMENT AND USE OF TRADE CANCELATIONS BY THE EXCHANGES Historically, stock trading was governed by contract law. In the late-19th and early-20th centuries, the buyer was presumed to have had a reasonable opportunity to inspect the vendor's stock.(40) Both buyer and seller were assumed to have knowledge of the stock's market and commercial value.41 Exchanges recognized that all "offers made and accepted shall be binding,"42 but maintained a dispute resolution mechanism for their members.43 These rules reflected a trading system, where brokers dealt with each other face-to-face, and where automated trading was science fiction.

    1. Contract Law Principles that could govern the Mistaken Automatic Trading of Stock One need to look no further than at the common law to understand how a mistaken transaction between the parties could have been handled, had the exchanges not vested themselves with a nullification power.(44) The Restatement of Contracts defines a "mistake" as "a belief that is not in accord with the facts," that is, as an erroneous belief about the then-existing facts.45 A unilateral mistake is one that occurs as to a basic assumption of the agreement, which has a material effect on the agreed performances. A contract is rescindable if the one who made the unilateral mistake does not bear the risk46 and either enforcement would be unconscionable, or the other party knew of the mistake.47 . BATS attributed the massive price-drop to a software issue, rendering open orders in the symbol range A-BFZZZ inaccessible. It should be noted, however, that the European Central Bank has recently published a working paper, which concludes that HFTs mitigate transitory volatility in trading. Jonathan Brogaard et al., High Frequency Trading and Price Discovery 7 (European Central Bank, Working Paper No. 1602, 2013), available at "Transitory volatility" is the "variance in excess of that generated by information flow." Charles Cao & Hyuk...

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