Contributeur :

Stéphane DANIEL

DJCE, Université Panthéon-Assas, 2011-2012

LLM, London School of Economics, 2012-2013

Superviseur :

Jonathan FISHER QC

Barrister, Devereux Chambers

LSE visiting Professor

1

New Technologies and Market Abuses: Outdated Legal Frameworks,

Short-Falling Reforms and New Proposals

ABSTRACT

The question addressed is whether the development of new technologies in financial markets,

namely high frequency trading and dark pools, has an impact on financial market abuses and

whether the US and EU legal frameworks enable competent authorities to prevent and punish

them. My findings are that market abuses are quantitatively increasing and qualitatively

evolving. However, despite on-going reforms, the enforcement models and the substantive

laws on market abuses are inadequate. Ultimately, I formulate proposals attempting to

remedy the identified legal deficiencies.

2

TABLE OF CONTENTS

Introduction ............................................................................................................................. 3

Part 1 – The Rise of New Technologies in Financial Markets ........................................... 5

I – A New Trading Technique: High Frequency Trading ............................................... 5

II – An Alternative Trading Venues to Traditional Exchanges: Dark Pools ................. 7

Part 2 – The Development of New Forms of Market Abuses ........................................... 10

I – The Empirical Nexus Between New Technologies and Market Abuses ................. 10

II - The New Possibilities for High Frequency Traders to Manipulate Market Price . 11

III - The New Possibilities for Traders to Practice Abusive Informed Trading .......... 14

Part 3 – The Challenges Faced by Regulators to Prevent and Punish New Forms of

Market Abuse ........................................................................................................................ 19

I - The Inadequacy of Enforcement Models with Modern Trading Environments .... 19

II - The Unequal Effort of the US and the EU to Improve Market Abuse Enforcement

Efficiency ............................................................................................................................ 20

III - Proposals to Improve Enforcement of Market Abuse Regulation in the EU ....... 23

Part 4 – The Incapacity of Market Abuse Substantive Laws to Encompass New Forms of

Market Abuses ....................................................................................................................... 25

I - The Regulatory Gaps of US and EU Laws on Market Abuses ................................. 25

a) Market Manipulation ................................................................................................... 25

b) Insider Dealing and Front Running ............................................................................. 26

II - The Shortfall of US and EU Substantive Law Reforms ......................................... 28

III - Proposals to Adapt the Substantive Laws on Market Abuses .............................. 31

Conclusion .............................................................................................................................. 33

Bibliography .......................................................................................................................... 35

3

Introduction

“Virtually gone are the days when nearly all securities were traded across the vast

floors of stock exchanges by men yelling and wearing bright checkered jackets in order to

stand out amongst the crowd.”1 Indeed, for the past decades, financial markets have

dramatically changed. The end of historical exchange monopoly, the fragmentation of venues,

the explosion of trading volume and the drop in trading cost have been accompanied by

innovations, essentially computer-based trading, where trading orders are sent and executed

automatically through superfast algorithmic devices without any human intervention.

That is why David Cliff recently explained that: “Human traders are an endangered

species.”2 Professor at the Bristol University, he invented the Zero Intelligence Plus trading

algorithm (ZIP), one of the first autonomous adaptive trading systems capable of learning

from its actions. In 2001, it has been demonstrated that ZIP programs were invariably beating

human traders by obtaining significantly larger gains3. This explains why machines, slowly

but surely, are replacing humans in financial markets4.

As a result, the rise of the electronic market structure is nowadays a burning issue high

in the global regulatory agenda5. Above all, the relationship between law and innovation is

questioned. More than any other fields, financial law and financial regulation are confronted

to cutting-edge and fast-evolving new practices challenging their foundations. It becomes

more and more difficult for law makers and regulators to keep pace with financial

developments. Therefore, this dissertation intends to analyse the potential disconnection

between the current market abuse regulation in the US and the EU and the fraudulent

behaviours potentially at work on today’s financial markets.

My question is then whether the development of new technologies in financial

markets, namely high frequency trading and dark pools, has an impact on financial market

abuses and whether the US and EU legal frameworks enable competent authorities to prevent

and punish them6. My findings are that market abuses are quantitatively increasing and

qualitatively evolving. However, despite on-going reforms, the enforcement models and the

substantive laws on market abuses are inadequate. Ultimately, I formulate proposals

attempting to remedy the identified legal deficiencies.

I will support this thesis through four different parts.

1 McGowan, Michael, ‘The Rise of Computerized High frequency Trading: Use and Controversy’, Duke Law

Technology Review, n°016, 2010 2 Cliff, David, ‘Robot Traders and Evolving Markets: 15 Years of Automated Adaptive Algorithmic Trading’,

Innovation and Algorithmic Trading Conference at University College London, 23 February 2011 3 Das, Rajarshi and others, ‘Agent-Human Interactions in the Continuous Double Auction’, The Proceedings of

the International Joint Conferences on Artificial Intelligence, August 2001 4 Braconnier, Deborah, ‘Algorithmic Trading to Replace Humans in the Stock Market’, 14 September 2011

<http://phys.org/news/2011-09-algorithmic-humans-stock.html> 5 Foresight Report: The Future of Computer Trading in Financial Markets, Final Project Report, The

Government Office for Science, London, 2012 6 This paper further elaborates on previous findings: Revue Trimestrielle de Droit Financier, n°3 2012, pp.55-63

4

In Part 1, I will set the basis of my demonstration by explaining the two main

innovations of modern financial markets. They consist of new trading techniques called high

frequency trading (HFT) and new trading platforms known as dark pools.

In Part 2, I will focus on the nexus between those new technologies and financial

market abuses. Building on previous empirical studies, I suggest that market abuses are not

only increasing but also taking new forms. I have identified two of them: market manipulation

implemented by high frequency traders and informed trading i.e. traders exploiting

confidential information about upcoming orders.

In Part 3, I will study the challenges faced by regulators to enforce market abuse

prohibitions. Bringing together enforcement figures, I show the incapability of regulators to

follow the pace of the increase in market abuses. I find an explanation in the explosion of

market data coupled with the internationalisation of financial markets. I will then analyse and

compare the enforcement models and on-going reforms in the US and the EU before reaching

the conclusion that the former is much better than the latter. Consequently, inspired by the US

system, I formulate two proposals for the EU: conferring to a federal authority the jurisdiction

to investigate and prosecute cross-border market abuses and focusing on collecting and

processing market data.

In Part 4, I will finally question the ability of US and EU substantive laws to

encompass the abusive schemes identified in Part 2. Employing the syllogism method, I find

that only the most classical forms of market manipulation fall within the scope of the

regulation, leaving abusive quote stuffing and informed trading strategies unregulated. Thus, I

consider if the current reforms remedy this deficiency and realise that even though they

improve the market abuse legal framework, they fail to address the problem. As a result, I

ultimately support two other proposals, namely the creation new quote stuffing and informed

trading offences, for which I provide potential drafts.

5

Part 1 – The Rise of New Technologies in Financial Markets

The rise of new technologies in financial markets has profoundly changed the essence

of trading on exchanges. Traditional manual trading is being replaced by computerised trading

(I) and traditional exchanges7 are being challenged by the development of dark pools (II).

I – A New Trading Technique: High Frequency Trading

HFT has been staggering in financial markets for the past twenty years. Today, it is

widely reported that HFT accounts for over 60% in the US and 40% in Europe of the daily

volume in equity markets8. This high growth development has taken place without any

specific regulation. However, since a few years now, regulators from all over the world are

questioning and debating the need to regulate those innovations and to adapt national financial

market frameworks.

Despite the lack of any statutory definition of HFT, certain public authorities have

attempted to provide their own. For the Securities and Exchange Commission (SEC), HFT is

characterized by:

“The use of extraordinarily high-speed and sophisticated computer programs for generating,

routing, and executing orders; use of co-location services and individual data feeds offered by

exchanges and others to minimize network and other types of latencies; very short time-

frames for establishing and liquidating positions; the submission of numerous orders that are

cancelled shortly after submission; and ending the trading day in as close to a flat position as

possible.”9

In comparison, the European Securities and Markets Authorities (ESMA) defines HFT

as:

“Trading activities that employ sophisticated, algorithmic technologies to interpret signals

from the market and, in response, implement trading strategies that generally involve the high

frequency generation of orders and a low latency transmission of these orders to the market.

Related trading strategies mostly consist of either quasi market making or arbitraging within

very short time horizons. They usually involve the execution of trades on own account (rather

than for a client) and positions usually being closed out at the end of the day.”10

Those two definitions highlight a number of HFT distinguishing features.

7 Lit markets are exchanges applying full pre-trade transparency.

8 Leo, Sarah, ‘Infographic: Trading at the Speed of Light’, 16 September 2012 <

http://www.thebureauinvestigates.com/2012/09/16/infographic-trading-at-the-speed-of-light/> 9 SEC, ‘Concept Release on Equity Market Structure’, p.45, 21 January 2010

10 ESMA, Final Report, ‘Guidelines on Systems and Controls in an Automated Trading Environment for Trading

Platforms, Investment Firms and Competent Authorities’, p.10, 21 December 2011

6

First, HFT is algorithmic trading. This means that computer programs are used to

interpret signals and automatically enter trading orders as well as to decide on aspects of

execution such as timing, quantity or price of the order11

.

Secondly, these algorithms deploy trading strategies that are implemented through

computer in an extremely fast automated fashion. Amongst others, the main are quasi market

making and arbitrage12

. The former refers to non-contractual provision of liquidity to the

market on both sides of the book to earn the spread13

i.e. The latter consists in taking

advantage of market inefficiencies, essentially mispricing of the same asset between two or

more trading platforms, to earn the difference of price between them. Another interesting one

is called news reaction: automatically acquiring and processing public information flowing

from the Internet to subsequently trigger trading decisions to buy or sell accordingly14

.

Thirdly, these algorithmic strategies are deployed through high frequency process. The

speed element refers to the amount of time needed to access market data, process them, taking

a trading decision and executing it. Without any doubt, fastness is the most important element

of HFT business model. To this end, high frequency traders use different techniques. To begin

with, HFT has recourse to colocation, whereby trading venues host HFT firms’ computers in

their data centre against remuneration to reduce the length of cables transmitting information

thereby reducing communication time15

. Besides, instead of using the consolidated data feeds

available to the public, high frequency traders pay trading centres to benefit from faster direct

trading centre data feeds16

. Furthermore, HFT firms generally enter into contract with broker

dealer members of exchanges under which the latter provide the former with direct market

access (DMA). This arrangement permits fast and anonymous trading by giving access to the

market under the service provider’s name and enabling to send orders directly to the market17

.

Last but not least, certain exchanges offer against payment the benefit of flash orders. Flash

trading entitles to view orders from other market participants fractions of second before them

being displayed to the public18

.

Fourthly, HFT involves proprietary trading. There is not much to say about it except

that it involves the firm’s own money as opposed to its customer’s money. Thus, high

frequency traders search to make a profit for themselves.

Fifthly, all of the above is implemented on an intraday basis. This means that HFT

involves short term strategies searching to close the trading day with flat positions. The aim is

11

Foresight Report, p.165 (n.5) 12

Jones, Charles, ‘What Do We Know About High-Frequency Trading?’, Columbia Business School Research

Paper No. 13-11, 20 March 2013 13

The spread is the difference of price between the bid and the offer 14

Angel, James and Douglas, McCabe, ‘Fairness in Financial Markets: The Case of High Frequency Trading’,

<http://www.sec.gov/comments/s7-02-10/s70210-316.pdf> 15

Rogow, Geoffrey, ‘Colocation: The Root of All High-Frequency Trading Evil?’, 20 September 2012

<http://blogs.wsj.com/marketbeat/2012/09/20/collocation-the-root-of-all-high-frequency-trading-evil/> 16

Barnes, Stephane, ‘Regulation High-Frequency Trading: an Examination of U.S. Equity Market Structure in

Light of the May 6, 2010 Flash Crash’, December 2010 <http://www.sec.gov/comments/s7-02-10/s70210-

341.pdf> 17

Brigagliano, James, Speech by SEC Staff to the National Organization of Investment Professionals, 19 April

2010 <http://www.sec.gov/news/speech/2010/spch041910jab.htm> 18

International Securities Exchange, ‘Flash Orders in the U.S. Options Markets’, August 2009

<http://www.ise.com/assets/files/ise_position_paper_on_flash_website.pdf>

7

to mitigate the risk of loss arising out of holding positions over more than one day. Moreover,

the massive order flow takes place within very short time horizon while the cancellation rate

is usually very high (90%). This results in position being taken and abandoned in

millisecond19

.

In the end, the rise of HFT has radically changed financial markets. Individual traders

and manual trades are being replaced by ultrafast computerised trading system. This major

evolution is also accompanied by another important one with the development of dark pools

and dark liquidity.

II – An Alternative Trading Venues to Traditional Exchanges: Dark Pools

There is nothing new in the concept of dark pool which exists in the equity market for

many years20

. The reason is that traders have always been extremely reluctant to disclose the

full extent of their trading interest especially when they need to trade in large size. For

instance, if the seller of a block of shares reveals his intention to the public, the resulting

unbalance between the offer and demand is likely to result in a sharp drop of the stocks’ price.

That is why market participants prefer confidential trades in order to avoid any adverse

pricing impact. In the past, floor traders were slicing large orders in small ones and broker-

dealers were providing over-the-counter liquidity.

In today’s financial markets, this old practice has taken the form of new types of

exchanges known as dark pools. Tabb group recently estimated that trading on dark pools

accounts for 32% of trades in 2012 against 26% in 2008 in the US equity market21

. Even

though it is a fast growing industry, the notion of dark pool still remains vague and

heterogeneous. As for HFT, there is no statutory definition of what is it. The starting point is

that they are electronic trading platforms operating without pre-trade transparency22

. This

means that pieces of information such as price, quantity or identity are not made available to

the public before the trade is filled. Hence, these exchanges permit participants to dive in

murky water to find dark liquidity, benefiting from anonymity and minimising price impact of

large trades.

To better understand from a regulatory perspective what a dark pool is, it is possible to

distinguish between regulated or alternative exchanges without pre-trade transparency (strict

meaning) and other types of dark liquidity (large meaning)23

.

To begin with the strict meaning, it is necessary to explain the divergence of

regulatory frameworks in the US and in the EU.

19

Croning, Kevin, Statement at the SEC Market Structure Roundtable, 2 June 2010

<http://www.sec.gov/comments/4-602/4602-11.pdf> 20

Brigagliano, James, Testimony Concerning Dark Pools, Flash Orders, HFT, and Other Market Structure Issues

before the Senate Banking Subcommittee on Securities, Insurance and Investment, 28 October 2009

<http://www.sec.gov/news/testimony/2009/ts102809jab.htm> 21

Philips, Matthew, ‘Where Has All the Stock Trading Gone?’, 10 May 2012,

<http://www.businessweek.com/articles/2012-05-10/where-has-all-the-stock-trading-gone> 22

Brigagliano, James, Remarks at the Trader Forum 2009 Fall Workshop, 8 October 2009

<http://www.sec.gov/news/speech/2009/spch100809jab.htm> 23

Erb, Jean-Philippe, ‘Les Opportunités et les Menaces Liées à l’Emergence et au Développement des Dark

Pools’, 1 June 2010 <http://www.professionsfinancieres.com/docs/2011103206_93--dark-pool.pdf>

8

In the US, the SEC explains that dark pool refers to alternative trading system (ATS)24

that do not publicly display quotations in the consolidated quotation data, which is the main

element of pre-trade transparency in US equity markets25

. Also, even though post-trade

transparency is still required, a filled order must be reported, to the consolidated trade data, it

is nuanced with the absence of obligation to identify the executing trading venue. In the US,

there is no specific restriction for exchanges to offer dark liquidity services to investors.

On the contrary, in the EU, dark pool refers to exchanges exploiting waivers to pre-trade

transparency laid down by the Market in Financial Instruments Directive (MiFID). Within the

actual legal framework (MiFID I), dark pools are generally categorised as multilateral trading

facilities (MTF)26

which is more or less the equivalent of US ATS. As such, they exploit three

types of waivers to pre-trade transparency:

waivers in relation to transactions which are large in scale according to an annexed

table27

;

waivers in relation to MTF or regulated market based on a trading methodology by

which the price is determined in accordance with a reference price generated by

another system28

;

waivers in relation to MTF or regulated market formalising privately negotiated

transactions but executed on the exchanges29

.

In a larger sense, dark pool refers to any type of mechanism allowing trade without

pre-trade transparency. Apart from the above described dark pools, this also regroups iceberg

orders, systematic internalisers and crossing networks.

First, iceberg orders are large size single orders divided into smaller ones in order to

hiding from other investors the market participant’s trading interest. As soon as the apparent

small order is filled, it is replaced by another one of the same size, and so on until full

execution of the original order. In the EU, these orders benefits from an exemption laid down

by the MiFID30

.

Secondly, systematic internalisers are investment firms which, on an organised,

frequent and systematic basis, deal on own account by executing client orders outside a

regulated market or MTF, matching them internally with other clients’ orders or within their

own books31

. However, they are exempted from pre-trade transparency when their activity is

24

SEC, Regulation ATS, 1998: “ATS means any organization, association, person, group of persons, or system

that constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers

of securities or for otherwise performing with respect to securities the functions commonly performed by a stock

exchange” 25

SEC, ‘Regulation of Non-Public Trading Interest’, 17 CFR PART 242, Release n°34-60997, File n°S7-27-09 26

Article 4(15) of the Directive 2004/39/EC of 21 April 2004, MTF is “a multilateral system, operated by an

investment firm or a market operator, which brings together multiple third-party buying and selling interests in

financial instruments in the system and in accordance with non-discretionary rules in a way that results in a

contract” 27

Article 20, Regulation CE n°1287/2006 28

Article 18.1(a), Regulation CE n°1287/2006 29

Article 18.2(b) and 19, Regulation CE n°1287/2006 30

Article 18.2, Regulation CE n°1287/2006 31

Article 4(7), Directive 2004/39/EC

9

performed on an ad hoc and irregular bilateral basis with wholesale counterparties as part of

dealings above standard market size and when the transactions are carried out outside the

systems habitually used by the firm concerned32

. Under these conditions, a systematic

internaliser is allowed to enter into transactions freed from pre-trade transparency

requirements.

Thirdly, crossing networks are non-regulated platforms. They refer to the practice of

matching client order flows internally between them. Crossing networks differ from

systematic internalisation systems in that the intermediary generally executes its clients'

orders against those of other clients rather than against its own book. Being outside the scope

of MiFID regulation, crossing network transactions are considered over-the-counter and

outside pre-trade transparency obligations. However, given the vagueness of the crossing

network characterisation, it offers room for regulatory arbitrage. Indeed, by choosing this

qualification rather than the one of systematic internaliser, an exchange can be placed outside

any regulation and hence outside market abuse prohibitions. This paper does not focus on this

qualification issue but does recognise the need to further elaborate on it.

In the end, dark pools, apprehended either in a strict or large meaning, enable market

participants to trade without the rest of the public being informed about the identity of the

parties, the price of the transaction or the amount of securities being sold, thereby minimising

adverse price impact. However, they are often contested on the reasons that they undermine

the fundamental principle of financial market transparency and do not contribute to pricing

efficiency.

As has been said, the rise of new technologies is impacting the nature of financial

markets. For the past years, this has taken place outside any regulation. That is why today

those two innovations now are under regulators’ scrutiny. Amongst others, the central concern

stems from the question whether they increase and change the forms of market abuses.

32

Article 21(3), Regulation CE n°1287/2006

10

Part 2 – The Development of New Forms of Market Abuses

In this second part, it is suggested that the rise of new technologies in financial market

increase market abuses (I) before explaining the new forms they take, namely market

manipulation (II) and informed trading (III).

I – The Empirical Nexus Between New Technologies and Market Abuses

In this introducing paragraph, this paper asks the question whether the development of

new technologies has increased market abuses.

First, the answer should be given focusing on statistical evidence. However, according

to certain authors, there is simply no market data available. Irene Aldridge, a renowned expert

in HFT, explained:

“One [misconception] is that all automated trading exists to abuse the market. I hear that

again and again. But people do not have real proof of that […] the argument you hear is that,

"You just have to watch the market, and you can see how automated trading abuses the

market." But with no scientific examination, that's not a justifiable argument from my

perspective.”33

In the same vein, researchers in the Foresight report on the future of computer trading

in financial markets have also expressed the lack of direct evidence:

“Economic research thus far, including the empirical studies commissioned by this Project,

provides no direct evidence that HFT has increased market abuse. However, the evidence in

the area remains tentative: academic studies can only approximate market abuse as data of

the quality and detail required to identify abuse are simply not available to researchers.”34

Nevertheless, the absence of empirical studies about market abuses is not completely

true. Indeed, certain empirical studies do exist and show that, to a certain extent, HFT firms

regularly manipulate financial market. In particular, a recent paper prepared by Credit Suisse

provides statistical data and concrete examples showing that high frequency traders

implement manipulative strategies35

. Another paper focusing on quote stuffing explains that

this manipulative strategy occurs each trading day on equity markets36

. In a third research, it

has been demonstrated that traders can implement order anticipation strategies and anticipate

buying and selling pressure37

. Brought together, those three papers constitute a good starting

point to affirm that market abuses increased by new technologies.

33

Heires, Katherine, ‘Fives Questions: Irene Aldridge on High Frequency Trading’, April 2012

< http://www.institutionalinvestor.com/article.aspx?articleID=3009963> 34

Foresight Report, p.12 (n.5) 35

Credit Suisse, ‘High Frequency Trading - Measurement, Detection and Response’, 2012 36

Egginton, Jared and Van Ness, Bonnie and Robert ‘Quote Stuffing’, 2012

< http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1958281> 37

Hirschey, Nicholas, ‘Do High-Frequency Traders Anticipate Buying and Selling Pressure?’, 2011 <

https://www2.bc.edu/~taillard/Seminar_spring_2012_files/Hirschey.pdf>

11

Secondly, this premise should now be supplemented by qualitative evidence based on

market participants’ perceptions. The Foresight report, analysing testimonies found in

specialised press and regulatory consultations reach a conclusion that strongly supports our

precedent point:

“The evidence appears strikingly consistent in its flavour, even though it originates from

different sources and regulatory areas: large investors believe that there is a clear link

between abuse and high-speed trading techniques […] The abusive strategies evoked include

‘quote stuffing’, ‘order book layering’, ‘momentum ignition’, ‘spoofing’, and ‘predatory

trading’ (sometimes referred to as ‘liquidity detection’ or ‘order anticipation’) […] Therefore

the evidence on the perception of abuse seems compelling in its consistency across sources,

perhaps a sign that something potentially damaging could be at work.”38

Consequently, building on these pieces of evidence, there is a nexus between the

development of new technologies and the increase in market abuses. Hence, it is now time to

explain the new forms they take: market manipulation and order anticipation.

II - The New Possibilities for High Frequency Traders to Manipulate Market

Price

As previously seen, one of the main features of HFT is the implementation of trading

strategies, which can be divided in two groups39

. The “good” ones, comprising market making

or arbitrage, contribute to market quality by increasing liquidity and improving pricing

efficiency. The “bad” ones, regrouping quote stuffing, momentum ignition and layering,

undermine market integrity by defrauding investors.

To begin with, quote stuffing consists in inundating the market with massive numbers

of orders and cancellations in a very short period of time without any economic justification.

The aim underlying the manoeuvre could be, for example, to create suboptimal trading

conditions for other market participants, to disconnect the pricing of financial instrument on

two exchanges in order to create arbitrage opportunity or to camouflage a fraudulent

transaction such as a price manipulation. It has been demonstrated that quote stuffing is a

widely spread practice. Analysing STOXX60040

data, Credit Suisse explained: “each stock on

average experiences high frequency quote stuffing 18.6 times a day, with more than 42% of

stocks averaging 10+ events per day.”41

In the same vein, another research reached the

conclusion that: “quote stuffing is pervasive and over 74% of US exchange listed securities

experience at least one episode during 2010.”42

Another strategy is momentum ignition, whereby entry of orders intends to start or

exacerbate a trend and to encourage other participants to accelerate or extend it in order to

create an opportunity to open/unwind a position at a favourable price43

. Again, the Credit

Suisse report provides preoccupying figures about it: “we estimate that momentum ignition

38

Foresight Report, p.92 (n.5) 39

Credit Suisse, High Frequency Trading – ‘The Good, The Bad, and The Regulation Market’, 2012 40

Stoxx 600 is an index tracking 600 publicly-traded companies based in one of 18 EU countries 41

Credit Suisse, p.2 (n.35) 42

Eggington and Van Ness, p.2 (n.36) 43

Foresight Report, p.167 (n.5)

12

occurred on average 1.6 times per stock per day […] we note that the average price move is

38bps, and the time it takes for that move to occur is approximately 1.5 minutes.”44

Last but not least, the layering strategy45

consists in entering hidden orders on one side

of the book, and simultaneously submitting visible orders on the other side of the book to

encourage others in the market to believe there is strong price pressure. Once the price moves

up or down, the manipulator executes the hidden order and then cancels the visible orders46

.

Another variant is spoofing, which involves using, and immediately cancelling, limit orders in

an attempt to lure traders to raise their own limits, again for the purpose of trading at an

artificial price47

. In both cases, when traders cancel their orders, this results in a phenomenon

called order book fade where order book volume on same venue (price fade) or another

(venue fade) disappears48

. The layering strategy has considerably drawn the attention of

regulators and HFT firms implementing it have been sanctioned in the US and in the UK.

In the US, the Financial Industry Regulatory Authority (FINRA)49

fined, as part of a

settlement, Trillium Brokerage Services LLC, its director of trading, its chief compliance

officer, and nine of its traders $2.26 million for illicit equities trading strategy50

. The facts

concerned a high frequency strategy implemented by nine proprietary traders on behalf of the

firm consisting in entering massive orders without any intention to trade in order to create

false appearance of buying or selling pressure. Once the price was manipulated either up or

down and other market participants were following the illusory trend, the fraudsters were

classically cancelling their initial orders while maintaining the contrary ones. The FINRA

mentioned that the manipulators entered into 46,000 fraudulent transactions resulting in

$575,000 illegal profit.

In a very recent and similar case, the SEC charged a New York brokerage firm, Hold

Brothers On-Line Investment, as well as three executives, for having allowed overseas traders

to access the market through the firm’s customer accounts and to manipulate market prices

with layering strategies from January 2009 to September 201051

. The fraudulent scheme

involved 8 million orders, 325,000 fraudulent transactions and $1.8 million dollars profit52

.

The regulator also charged Trade Alpha Corporate Ltd and Demostrate LLC, created and

partially owned by one executive, because their accounts have been used to carry on the fraud.

Above all, the three executives were perfectly aware of the manipulation and recklessly

turned a blind eye it. In total, the SEC reached a settlement where the individuals and entities

involved agreed to pay $4 million in disgorgement and penalties53

.

44

Credit Suisse, p.6 (n.35) 45

Sreenivasan, Ven, ‘Beware the potential abuse of high-frequency trading’, The Business Times - Singapore,

19 September 2011 46

Foresight Report, p.166 (n.5) 47

Angel and McCabe, p.13 (n.14) 48

Credit Suisse, p.4 (n.35) 49

FINRA is the largest independent regulator for all securities firms doing business in the US 50

Trillium case, FINRA Press Release <http://www.finra.org/newsroom/newsreleases/2010/p121951> 51

Hold Brothers case, SEC Press Release <http://www.sec.gov/news/press/2012/2012-197.htm> 52

Hold Brothers case, SEC Administrative Proceedings <http://www.sec.gov/litigation/admin/2012/34-

67924.pdf> 53

Scannell, Kara, ‘US brokerage settles manipulation charges’, 25 September 2012

<http://www.ft.com/intl/cms/s/0/fb30556c-074a-11e2-b148-00144feabdc0.html#axzz2chlEzqxR>

13

In the UK as well, the Financial Services Authority (FSA)54

sanctioned twice

layering/spoofing strategies. In the first case, the FSA fined Swift Trade, a non FSA

authorised Canadian company, £8 million for market abuse55

. The company lodged an appeal

which is still pending before the Upper Tribunal56

. The firm is accused of having

systematically and deliberately engaged, between 1 January 2007 and 4 January 2008, in

layering resulting in small price movements in a wide range of individual shares on the

London Stock Exchange, ending with £1.75 million profit earned. This case concerned “tens

of thousands of trading orders by many individual traders sometimes acting in concert with

each other across many locations worldwide”. Tracey McDermott, director of enforcement

and financial crime at the FSA, explained: “This was a particularly cynical case where a

business model was based on market abuse.”57

In the second case, the FSA issued proceedings against Da Vinci Invest, a UK-

registered but Swiss-based fund manager, two related Singapore and Seychelles-based

companies and three individuals who traded on their behalf, for having engaged, from August

2010 to July 2010, in layering strategies resulting in £1 million gross profit58

. In response, the

English regulator obtained a High Court injunction to stop such manipulation and to freeze

the assets of those companies.

All of this supports the conclusion that market abuses are increasing and evolving.

Increasing because in three years’ time five similar cases have been brought in two different

countries with very important financial markets. Evolving because the modus operandi is

completely new, bringing together millions of orders, slight price variations, thousands of

transactions, millions of profit, all of that implemented at a large scale and involving several

jurisdictions. And the biggest concern is that these identified fraudulent behaviours might be

the tip of the iceberg, leaving the vast majority of them undetected and unpunished throughout

the world.

In addition, it must be borne in mind that all the above mentioned strategies can be

implemented on traditional exchanges but also on dark pools. In the latter case, detection

becomes extremely difficult because it requires regulators to cross supervision in time

between different venues, some of them being opaque. There is a particular method to

manipulate price in dark pools using reference price from another market59

. Generally, this

matching point is the midpoint, that is to say the central point between the bid and the offer

price. Hence, by distorting the spreads on referenced lit markets, it is possible to influence the

price used by dark pools. Such practice has been referred to as “quote manipulation” by the

Canadian regulator: “quote manipulation is trading activity intended to affect the price at

which dark orders that are tied to prices on visible marketplaces, trade in dark pools or

54

The FSA has been split by the Financial Services Act 2012 between two new agencies : the Prudential

Regulation Authority and the Financial Conduct Authority 55

Swift Trade case, FSA Administrative Proceedings

<http://www.fsa.gov.uk/static/pubs/decisions/swift_trade.pdf> 56

Swift Trade case, FSA Press Release <http://www.fsa.gov.uk/library/communication/pr/2011/075.shtml> 57

Market Media, ‘Europe’s Watchdog Urged to Curb More Aggressive HFT Pratices’, 14 February 2013

<http://www.cmegroup.com/education/market-commentary/industry-news/2013/02/mid-session-industry-

news_514.html> 58

Da Vinci case, FSA Press Release <http://www.fsa.gov.uk/library/communication/pr/2011/077.shtml> 59

Coupe, Matthew, ‘Dark pools need clampdown’, 5 April 2013 < http://www.ft.com/intl/cms/s/0/1111cb44-

9144-11e2-b839-00144feabdc0.html#axzz2chlEzqxR>

14

displayed marketplaces.”60

In fact, this paper prefer using the name “imported price

manipulation” because the manipulation occurs on a lit market and is imported into the dark

pool where the transaction is ultimately realised. The Credit Suisse report gives a concrete

example of such practice:

“In particular, dark pools using a synthetic EBBO (consolidated book) for their reference

price are at higher risk of being gamed by quote stuffing. Exhibit 10 shows an example in

Ashmore Group, where the Primary Bid and Ask are static, but the Chi-X bid moves. The

consolidated EBBO shows a locked book, with the bid equal to the ask at 356.2. This scenario

could be exploited in EBBO-referenced dark pools. A gamer could place a sell order in the

pool with a 356.2 limit, then place (and rapidly cancel) a Chi-X bid, also at 356.2. Any buy

order pegged to mid would trade at the temporary gamed “mid” of 356.2 (as the EBBO bid

and offer are both temporarily 356.2), paying the whole spread rather than half.”61

Therefore, high frequency traders are able to manipulate market price on lit market as

well as dark pools. But, apart from the strategies explained above, there is another abusive

behaviour that has now to be studied.

III - The New Possibilities for Traders to Practice Abusive Informed Trading

New technologies not only enable new forms of market manipulation but also the

implementation of informed trading strategies. This dissertation understands informed trading

as the situation in which a market participant obtains confidential information about an

upcoming order and exploits it for his benefit to the detriment of the anticipated trader. An

author has rightly pointed out this rising practice and its nexus with new technologies: “The

existence of short-term informed trading based on some combination of uneven distribution of

information, as well as different capabilities with respect to its acquisition, processing, and

aggregation, stale quotes, and transaction cost and speed advantages is a permanent fixture

of securities markets that is fueled by technological developments.”62

Here, the general term

of informed trading is used to refer to many different practices known as abusive liquidity

detection, front running, tape racing, order anticipation, latency arbitrage, gaming or

predatory strategies. They all share one common denominator: exploitation of information

asymmetry. This paper has identified three possibilities to get information advantage and

subsequently exploit it: order anticipation/liquidity detection strategies, flash trading or dark

pools information leakage.

First, market participants can detect liquidity and anticipate orders. This type of

strategy has been given as example in the previous document to illustrate informed trading:

“One example of a market participant in today’s high-speed securities markets, is “a

quantitative trader ... who performs bleeding edge statistical analysis on screaming-fast

computing hardware .... [to] make reasonably confident predictions based on very strong

60

IIROC, ‘Proposed Guidance on Certain Manipulative and Deceptive Trading Practices’, 2012 61

Credit Suisse, p.3 (n.35) 62

Dolgopolov, Stanislav, ‘Insider Trading, Informed Trading, and Market Making: Liquidity of Securities

Markets in the Zero-Sum Game’, 3 Wm. & Mary Bus. L. Rev. 1, 2012

15

alpha signals, thereby seeing something in the markets that others do not, or at least before

they do.”63

Order anticipation strategy has been best explained by Arnuk and Saluzzi64

. Using

cutting edge technology, colocation, direct data feeds and HFT, traders can achieve “(almost)

risk free arbitrage opportunities”. This is because, through speed advantage, they are able to

know before other market participants the orders sent to the market and accordingly trade

ahead of them. The two authors give a concrete example of latency arbitrage:

“1. The market for ABC is $25.53 bid / offered at $25.54.

2. Due to Latency Arbitrage, an HFT computer knows that there is an order that in a moment

will move the NBBO quote higher, to $25.54 bid /offered at $25.56.

3. The HFT speeds ahead, scraping dark and visible pools, buying all available ABC shares

at $25.54 and cheaper.

4. The institutional algo gets nothing done at $25.54 (as there is no stock available at this

price) and the market moves up to $25.54 bid / offered at $25.56 (as anticipated by the HFT).

5. The HFT turns around and offers ABC at $25.55 or $25.56.

6. Because it is following a volume driven formula, the institutional algo is forced to buy

available shares from the HFT at $25.55 or $25.56.

7. The HFT makes $0.01-$0.02 per share at the expense of the institution.”65

A few years ago, Paul Krugman also denounced this practice: “Some institutions,

including Goldman Sachs, have been using superfast computers to get the jump on other

investors, buying or selling stocks a tiny fraction of a second before anyone else can react.”66

Through such abusive behaviours, high frequency traders are able to anticipate orders and,

trading ahead, to impose a slight additional transaction cost on every trade at the expense of

the rest of the market.

Moreover, as previously seen in Part I, institutional investors go to great length to

conceal their large trading positions either by slicing them into small orders or in trading into

dark pools to avoid adverse price impact. Nevertheless, it still remains possible to detect

liquidity and anticipate orders67

. To describe this type of trading, Turbeville has used the

metaphorical concept of “hunting whales”68

. This consists in placing multiple small orders to

be executed or cancelled immediately in order to detect the presence of a market participant

accumulating or liquidating a large position. As soon as the small order pings, the high

frequency trader trades ahead, buying all the available instruments between the bid/ask spread

price. Once detected, the ‘whale’ is fished and will not be able to find any counterparty in the

market but the HFT firm. The author explains the bitter end for the whale: “The algorithmic

trader establishes a narrow band of absolute market power controlling the particular

securities or derivatives that the whale seeks to buy or sell. The whale will be compelled to

63

Ibid p.14 64

Arnuk, Sal and Saluzzi, Joseph, ‘Latency arbitrage : the real power behind predatory high frequency trading’,

Temis Trading White Paper, 4 December 2009 65

Ibid p.2 66

Krugman, Paul, ‘Rewarding Bad Actors’, New York Times, 2 August 2009 67

Angel and McCabe, p.11, (n.14) 68

Turbeville, Wallace, ‘Cracks in the Pipeline 2 High Frequency Trading’, February 2013

<http://www.demos.org/sites/default/files/publications/HFT_CracksInThePipeline_Demos.pdf>

16

either abandon the market or transact at the price demanded by the algorithmic trader.”69

According to a HFT firm, such unfair practice is widely spread in the US equity market

because of the abuse of the legal framework’s loopholes: “Using publicly-available data more

intelligently than your competitors is a FAIR practice, even if the goal is to predict their

behaviour. Jumping ahead of an order that was placed earlier at the same price by another

trader is an UNFAIR practice, because it undermines the principle of PRICE-TIME priority

on which our equity markets are premised. Unfortunately, this UNFAIR practice is

widespread, due to a deficiency in Rule 611 of Regulation NMS. HFTs should not be blamed

for exploiting it – in fact, many HFTs who exploit this deficiency do so unwittingly.”70

Confronted to liquidity detection and order anticipation, market participants trade their

large position in dark pools. However, they are not protected anyways because the same

unfair practices can still be implemented. Mittal has identified those occurrences in what he

calls “toxic dark pools”71

. They are slightly more complex because they bring together

“fishing” strategies within a dark pool and subsequent market price manipulation of the

referenced lit market. More specifically, there are three main steps: ensuring that a large

buying/selling position is being accumulated/liquidated within a dark pool, manipulating the

price of the referenced lit market and trading on that basis on the dark pool. This scheme is

also very well described by Zero Hedge website:

“Dark pools are open to gaming, but it is a risky business, predicated on being able to guess

both the existence of large liquidity and the pricing mechanism being used. As an example

suppose that, by whatever means, you believe that there is a large amount of hidden liquidity,

say a buyer pegged to the public bid price. If the public market has much less quantity than

you suspect is hidden on the bid, you can buy a similar amount of the asset, pushing up the

price. Once the price is high enough, you place a limit price buy order of sufficient quantity

onto the public market and simultaneously place a limit price sell order for the total quantity

you just bought on the dark venue. You now hope that the hidden order will cross with you at

the current high price bringing the profit.”72

Second, it is also possible to practice informed trading through flash trading. Stricto

sensu, flash trading refers to flash orders on lit market. However, this paper will use the term

flash trading lato sensu to encompass actionable indication of interest in dark pools.

Flashing orders, as described in Part I, is a process through which exchanges, against

payment, send first the orders received to selected market participants for a very short

duration. The order is not yet included in the consolidated quotation data and recipients can

trade upon it. If there is no filling, it is then cancelled or transmitted to the public73

. Flash

orders essentially developed in US financial markets with NASDAQ, BATS or Direct Edge74

.

69

Ibid p. 11 70

Tradeworx, ‘Comments on SEC Market Structure Concept Release’, 21 April 2010

<http://www.sec.gov/comments/s7-02-10/s70210-129.pdf> 71

Mittal, Hitesh, ‘Are You Playing in a Toxic Dark Pool? A Guide to Preventing Information Leakage’, June

2008 < http://www.positjapan.org/news_events/papers/ITGResearch_Toxic_Dark_Pool_070208.pdf> 72

Zero Hedge, ‘Wall Street’s Secretive and Dangerous Dark Pools’, 3 June 2009

<http://www.zerohedge.com/article/wall-streets-secretive-and-dangerous-dark-pools-0> 73

Brigagliano (n.22) 74

Themis Trading, ‘Comments on SEC Concept Release on Equity Market Structure, 21 April 2010

<http://www.sec.gov/comments/s7-02-10/s70210-131.pdf>

17

Interestingly, they seem to be inexistent in Europe75

. In US law, even though Rule 602 of

Regulation NMS requires exchanges to make their best bids and offers available in the

consolidated quotation data, its paragraph (a)(1)(i)(A) excludes bids and offers that either are

executed immediately after communication or cancelled or withdrawn if not executed

immediately after communication76

. Historically, such exception intended to facilitate manual

trading where such “ephemeral” quotations were considered impractical to include in the

consolidated quotation data77

. Later on, with the rise of computerised trading, these orders

developed with a duration time much shorter than the former manual quotations. Nowadays,

flash orders have strongly been criticised by market participants. Charles Schumer, New York

senator, best described what is wrong with flash orders:

“Flash orders allow certain members of these exchanges to obtain access to order flow

information before that information is made available to the public, allowing those members

to use rapid trading programs to trade ahead of those orders and profit from advanced

knowledge of buying and selling activity. While pre-routing programs can benefit markets by

providing additional liquidity, this kind of unfair access seriously compromises the integrity

of our markets and creates a two-tiered system where a privileged group of insiders receives

preferential treatment, depriving others of a fair price for their transactions.”78

A very similar practice can also be found in dark pools with actionable indication of

interest (IOI). Dark pools have recently started sharing IOI conveying substantial information

that are not included in the consolidated quotation data to selected market participants79

.

These indications of interest are actionable because, despite not specifying the precise price

and size of positions lying in the dark pool, they alert the beneficiary about a trading interest

“in a particular symbol, side (buy or sell), size (minimum of a round lot of trading interest),

and price (equal to or better than the national best bid for buying interest and the national

best offer for selling interest).”80

Therefore, recipients can trade upon it by sending contra-

side order provided that the position hasn’t been executed nor cancelled yet. That is why IOI

are pretty much the same as orders not displayed to the public and hence contribute to create

two-tiered market where privileged participants are notified trading opportunities not offered

to the rest of the market81

. And again, IOI can be the basis of informed trading strategies: “the

IOI information may also be used by the recipient to game or trade ahead of the order in the

dark pool, as the recipients of an IOI are generally under no obligation to trade against the

investor's order.”82

This potential occurrence has also been described in Mittal’s already

quoted paper about ‘toxic’ dark pool83

.

75

Grant, Jeremy, ‘Europe Calm on Flash Orders’, 3 August 2009 <http://www.ft.com/intl/cms/s/0/495092a0-

7f8d-11de-85dc-00144feabdc0.html#axzz2chlEzqxR> 76

SEC, ‘Elimination of Flash Order Exception from Rule 602 of Regulation NMS’, 17 CFR Part 242, Release

No. 34-60684; File No. S7-21-09, p.4 77

SEC Release No.14415, 26 January 1978 and 43 FR 4342, 1st February 1978

78 Schumer Charles Urges Ban on So-Called ‘Flash Orders’ that Give Privileged Traders Sneak Peek at Stock

Sales Before Other Investors, 27 July 2009

<http://www.schumer.senate.gov/new_website/record.cfm?id=316252&> 79

SEC, p.11 (n.25) 80

Ibid 81

Brigagliano (n.20) 82

OICV, Consultation Report, ‘Issues Raised by Dark Liquidity’, October 2010 83

Mittal (n.67)

18

As a result, both flash orders and IOI enable confidential information about trading

positions to be shared by exchanges with certain privileged market participants. Using their

speed advantage, such participants are then able to implement predatory strategies.

Third, informed trading is not only possible through speed advantage or flash methods,

but also when dark pools illegally share confidential information about customers’ orders.

This must not be confused with actionable IOI where information sharing takes place with the

members’ knowledge and regulators’ tolerance. Here, dark pools are also “toxic” because

they bypass the confidentiality owed to their members.

In the US, the SEC has recently sanctioned two dark pools for unauthorized

information sharing. In the first case, Pipeline Trading System LLC (Pipeline) and two of its

top executives have been charged with failing to disclose to customers that the vast majority

of orders were filled by a trading operation affiliated with Pipeline84

. Pipeline accepted to pay

$1 million penalty to settle the charges as well as the two executives who paid $100,000

each85

. More precisely, the SEC explained that (i) one of the affiliate was a trading entity

owned by Pipeline’s parent company within which the manager had access to customer’s

confidential information and (ii) another affiliate, Milstream Strategy Group LLC, was

provided with special access to certain information about operations in the dark pool, which

were used to try “to predict the trading intentions of Pipeline’s customers and trade

elsewhere in the same direction as customers before filling their orders on Pipeline’s

platform.” Therefore, where Pipeline advertised that the dark pool would not reveal the side

or price of customer orders and would protect customers from pre-trade information leakage

and front-running predators, it was actually doing the opposite by permitting the affiliates to

perform informed trading strategies on the basis of illegally shared information.

In the second case, the SEC charged eBX LLC (eBX) for having failed to protect

confidentiality over customers’ information as well as to disclose that it allowed an outside

firm to use them while pretending the contrary86

. EBX accepted to settle the charges by

paying $800,000 penalty87

. The regulator explained that the outside firm received an

information advantage over other subscribers and was using it for its own profit. In the case in

hand, the beneficiary of the information was not gaming the market but using it to fill more

efficiently its client orders. However, this case shows that information leakage does happen

and can end up with savvy trading entities fraudulently using them.

Consequently, dark pools are not always dark and instead sometimes have different

shades of grey. They become then ‘toxic’ for their members in the sense that confidential

trading interest are known by certain participants and enable them to practice informed

trading.

84

Pipeline case, SEC Administrative Proceedings <http://www.sec.gov/litigation/admin/2011/33-9271.pdf> 85

Pipeline case, SEC Press Release <http://www.sec.gov/news/press/2011/2011-220.htm> 86

EBX case, SEC Administrative Proceedings <http://www.sec.gov/litigation/admin/2012/34-67969.pdf> 87

EBX case, SEC Press Release

<http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171485204#.UfEuy41A1NI>

19

Part 3 – The Challenges Faced by Regulators to Prevent and Punish New

Forms of Market Abuse

New technologies in financial markets increase the quantity and modify the quality of

market abuse. The question is then whether regulators are able to cope with it. This paper

finds that these structural changes render supervision and enforcement more difficult for

public authorities: the enforcement models are outdated (I) and the on-going reforms fall short

in trying to improve them (II). Considering (I) and (II), this research will propose two reforms

for the EU (II).

I - The Inadequacy of Enforcement Models with Modern Trading Environments

In Part I, the conclusion drawn from statistical and qualitative evidence is that the

quantity of market abuses on financial market is increasing. Thus, assessing the ability of

regulators to follow this pace requires a comparison with the number of sanctions imposed by

competent authorities. To this end, this paper brings together in the following tables public

figures released by the SEC88

and the ESMA89

about administrative sanctions imposed for

insider dealing or market abuse for the period 2008 to 2010.

Table 1: US - SEC

Year 2008 2009 2010

Insider trading 19 8 20

Market manipulation 20 6 10

Table 2: EU - ESMA

Reporting the sanctions pronounced by the competent authorities of Member States

Year 2008 2009 2010

Insider trading 78 45 83

Market manipulation 73 153 127

These tables clearly demonstrate the lack of any coherent trend in sanctions imposed

by regulators in the US and in the EU. However, considering the increasing number of market

abuses, this compilation should have showed an increase in regulators enforcement over the

years. As a result, bringing together the fact that (i) market abuses are increasing and that (ii)

enforcement proceedings are not, this paper concludes that regulators are not able to cope

with new forms of market abuses.

This should not be surprising. Nowadays, regulators have to deal with superfast

computers flooding lit exchanges as well as dark pools with millions of orders and

cancelations. Hence, it seems that real time surveillance has become an illusion: "The biggest

challenge with real time reporting is the increase in volume and the rapid rate at which

trading activity occurs […] A lot of automated and high-frequency trading occurs on markets

88

SEC:

2008: <http://www.sec.gov/about/secstats2008.pdf>, p.3

2009: <http://www.sec.gov/about/secstats2009.pdf>, p.3

2010: <http://www.sec.gov/about/secstats2010.pdf>, p.3 89

ESMA: 2008 to 2010: <http://www.esma.europa.eu/system/files/2012-270.pdf>, p.41

20

and that becomes harder to monitor because you've got massive amounts of volume in short

periods of time.”90

Moreover, today’s financial markets are internationalised. This means that market

participants come from all over the world and perform trading operations everywhere on the

planet. They are able to perform regulatory arbitrage by establishing themselves in the most

favourable jurisdictions eventually ending up within tax heavens as well as opaque and non-

cooperative jurisdictions. Furthermore, trading activity is extremely fragmented, yet spread at

the same time between several accounts, exchanges and jurisdictions. In a recent intervention,

the FINRA admitted: “In today's fragmented trading environment, it is very plausible that

market participants will spread their activity across multiple markets and accounts in an

attempt to avoid detection of trading abuses such as wash sales, front running, insider

trading, marking the close and open, and manipulative trading strategies like layering […]

the risk of missing instances of manipulation, wash sales, abusive short selling and other

improper "gaming strategies" is still unacceptably large.”91

In the same vein, The Foresight

report best summarised this challenge explaining: “Detecting evidence of market abuse from

vast amounts of data from increasingly diverse trading platforms will present a growing

challenge for regulators.”92

On this point, the ability of regulators to meet these challenges

leaves market participants perplex: “About 90% of respondents do not believe that regulators

have sufficient data, technology or expertise to effectively detect market abuse”.93

This is not

a mere feeling as the Boston Consulting Group (BCG) recently warned the SEC that: “The

agency does not have sufficient in-house expertise to thoroughly investigate the inner

workings of such [trading] algorithms (…) [and recommends that] The SEC should have staff

who understand how to (…) perform the analytics required to support investigations and

assessments related to high-frequency trading. (…) the SEC requires people who know how

high-frequency traders use technology.”94

In the end, taking into consideration all the above difficulties, this paper reaches the

conclusion that even the most advanced public authorities are overwhelmed by financial

markets development and hence that enforcement models are outdated. Thus, the question is

now whether the on-going reforms are capable to improve the regulators’ missions.

II - The Unequal Effort of the US and the EU to Improve Market Abuse

Enforcement Efficiency

Faced with the challenges described above, regulators are trying to adapt their

enforcement model. Without any doubt, the US take the leadership when it comes to do so.

This is because their model is federal and thus capable to concentrate the available resources

within few regulatory authorities having global jurisdiction for the US financial markets. On

the contrary, the European model is delocalised, with the ESMA as coordinating institution

and 27 national competent authorities in charge of enforcing market abuse regulation.

Therefore, the enforcement being left to Member States, the available resources are divided

90

Dew-Jones, Steve, ‘Mission Impossible?’, Waters, April 2012 91

Luparello, Stephen, Testimony Before the Subcommitte on Securities, Insurance, and Investment Committee

on Banking, Housing and Urban Affairs, 8 December 2010

<http://www.finra.org/newsroom/speeches/luparello/p122605> 92

Foresight Report, p.13 (n.5) 93

Ibid p.96 94

BCG, ‘U.S. SEC, Organizational Study and Reform’, 10 March 2011, p.260

21

and the supervision is fragmented, which ultimately undermines market abuse regulation

efficiency. In both cases, on-going reforms try to improve enforcement.

In the US, the SEC is pro-actively trying to meet the challenges caused by the

development of new technologies. Indeed, Mary Jo White, the SEC new chairman, explained

very recently before the Senate Banking Committee:

“It will be a high priority throughout my tenure to further the SEC needs to be in a position to

fully understand all aspects of today’s high-speed, high-tech, and dispersed marketplace so

that it can be wisely and optimally regulated, which means without undue cost and without

undermining its vitality. High frequency trading, complex trading algorithms, dark pools, and

intricate new order types raise many questions and concerns […] I will work not only to

ensure that the SEC has the cutting-edge technology and expertise necessary to enable it to

keep pace with the markets and its responsibilities to monitor, regulate, and enforce the

securities laws, but also to see around the corner and anticipate issues.”95

To this end, the SEC has taken several measures. In 2012, the US regulator has set up

a Quantitative Analytics Unit dedicated to abuses that might arise from the use of HFT and

dark pools96

. This unit gathers together expert in mathematics, physics and computer science

and is to play a key role in examining the most advanced computerised trading techniques.

Moreover, this structure has joined force with the FBI to enhance its ability to tackle the threat

of market manipulation posed by high speed computerised trading97

.

In so doing, the SEC has set up the preliminary basis to process market data. Now, the

regulator priority lies in collecting them via two specific innovations. The first one is the

introduction of the market information data analytics system (MIDAS)98

. This will aggregate

trading information data: orders, modifications, cancellations, trade executions on lit market

as well as on dark pools. It will enable regulators to understand the speed of quotes and

subsequent cancellations, the full depth of book for liquid and illiquid stocks and the intraday

volatility, which ultimately will enable to detect market abuses. The second one is the

adoption of a new Rule 613 under Regulation NMS, requiring national securities exchanges

and the FINRA to establish a market-wide consolidated audit trail (CAT)99

. The aim is to

significantly enhance regulators ability to monitor and analyse trading activity by identifying

every order, cancellation, modification and trade execution across all US markets. Such

mechanism will give the regulator the ability to reconstruct based-market events, eliminating

delays and imprecisions, which will give the regulator a timely, accurate, complete and

95

Jo White, Mary, Testimony Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, 12

March 2013

<http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=619e5603-c2c8-4085-

98c6-0014ce29bde7> 96

The Telegraph, ‘FBI Joins Forces with SEC on Computer Trading’, 6 March 2013

<http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/9911886/FBI-joins-forces-with-SEC-on-

computer-trading.html> 97

Scannell, Kara, ‘FBI Joins SEC in Computer Trading Probe’, 5 March 2013 <

http://www.ft.com/intl/cms/s/0/11b81d74-85a4-11e2-9ee3-00144feabdc0.html#axzz2chlEzqxR> 98

Walter, Elisse, ‘Harnessing Tomorrow’s Technology for Today’s Investors and Markets’, 19 February 2003

<http://www.sec.gov/News/Speech/Detail/Speech/1365171492300#.UhZVjZJA1NJ> 99

SEC Press Release, ‘SEC Approves New Rule Requiring Consolidated Audit Trail to Monitor and Analyse

Trading Activity’, 11 July 2012

< http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171483188#.UhZV9ZJA1NJ>

22

accessible picture of the market state at any point in time. The difference with MIDAS is that

CAT will gather public but also non-public data, for example the identity of the parties to a

trade. On this point, the SEC explained: “A consolidated audit trail will increase the data

available to regulators investigating illegal activities such as insider trading, wash sales, and

market manipulation. In particular, increased data will facilitate risk-based examinations,

allow more accurate and faster surveillance, improve the process for evaluating tips,

complaints, and referrals, and promote innovation in cross-market and principal order

surveillance.”100

Finally, in order to further improve market participants’ identification, the SEC has

adopted two other important rules. It has established a large trader reporting requirement

under which large traders have to identify themselves to the regulator which will in return

assign them a unique identification number101

. In addition, to ensure full transparency in

trading activities, the SEC will now prohibit broker-dealers from providing customers with

“naked” access to exchanges or ATS as well as requiring them to put in place risk

management controls and supervisory procedures102

. As small HFT firms are the main

customers of DMA services, this new obligation will inter alia allow regulators to supervise

their compliance with regulation more easily103

.

To conclude, the SEC’s effort to collect market data and to have competent staff to

process and understand them is a tremendous step to counter the resurgence of market abuses.

On the contrary, in Europe, there is clearly no such intense willingness to improve

enforcement efficiency. Again, this is mostly because enforcement is left to Member States.

Anyhow, the Markets in Financial Instruments Directive (MiFID)104

and the Market Abuse

Directive (MAD)105

are currently being reviewed under MAD II106

and MiFID II107

and a few

new rules would contribute to improve enforcement efficiency.

The MiFID review, following US law, provides for the creation of a European

consolidated tape (article 61-68). The aim is to address market data fragmentation arising

from the original MiFID. Accordingly, market participants would be required to publish their

trade report through approved publication arrangement and market data would then be

brought together by consolidated tape providers. Furthermore, the review also tries to ensure

100 Ibid

101 SEC Press Release, ‘SEC Adopts Large Trader Reporting Regime’, 26 July 2011 <

http://www.sec.gov/news/press/2011/2011-154.htm> 102

SEC Press Release, ‘SEC Adopts New Rule Preventing Unfiltered Market Access’, 3 November 2010

<http://www.sec.gov/news/press/2010/2010-210.htm> 103

Spicer, Jonathan, ‘Exchanges Want Delay of SEC’s Naked Access Ban’, 21 June 2011

<http://www.reuters.com/article/2011/06/21/us-financial-regulation-nakedaccess-idUSTRE75K4PD20110621> 104

Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial

instruments 105

Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on insider dealing

and market manipulation 106

Proposal for a Regulation of the European Parliament and of the Council on Markets in Financial Instruments

Amending Regulation [EMIR] on OTC derivatives, central counterparties and trade repositories 107

Proposal for a Directive of the European Parliament and of the Council on Markets in Financial Instruments

Repealing Directive 2004/39/EC of the European Parliament and of the Council ; Proposal for a Directive of the

European Parliament and of the Council on criminal sanctions for insider dealing and market manipulation

23

that HFT firms are regulated. The project provides that all entities engaging in HFT must be

authorised (article 2), subjected to organisational safeguards and appropriate risk controls

(article 16 and 51) and must provide at least annually a description of the nature of their

algorithms to regulators (article 17.2). Those few rules will indirectly enhanced regulators

enforcement by giving them better access to market data and enabling them to identify and

monitor more closely trading entities using HFT. Concerning the MAD review, the project

wants to strengthen investigations by giving European regulators the power to enter private

premises, to seize documents without prior court authorization, to request telephone and data

traffic records held by investment firms and telecommunication providers as well as to receive

communication of information by whistleblowers. Nevertheless, even though the previous

changes are obviously welcomed as part of an harmonization effort, such possibilities already

exist in many Member States and thus will simply perpetuate the existing statu quo.

To conclude on enforcement, the SEC’s measures are definitely the ones to follow as

they properly address the identified challenges. However, in the EU, there is no willingness to

meet them and the difficulties are ultimately left to each Member State.

III - Proposals to Improve Enforcement of Market Abuse Regulation in the EU

Drawing from the findings, this paper finally submits that the US enforcement model

with its on-going reforms is more adapted to the new challenges posed by financial markets

than the EU one. That is why I suggest that the latter should be reformed to take into account

the benefits of the latter. Accordingly, I formulate the two following propositions.

The first one is to confer jurisdiction to the ESMA to investigate and prosecute cross-

border market abuses while preserving Member States jurisdiction for internal market abuses.

The main advantages would be the concentration of resources coupled with the extension of

jurisdiction to the whole EU. This would better suit the globalised reality of modern financial

markets. To this end, I suggest to reproduce the system of split jurisdiction used in EU

competition law. Here, the Member States and the European Commission cooperate to tackle

antitrust issues, sharing their competence and using procedures of renvoie. As always, one

obstacle lies in the Member States’ reluctance to pass over sovereignty to federal institutions.

Nevertheless, even though there would be certain European countries with important financial

markets very concerned by this project, others would be more than glad to benefit from the

synergies highlighted. Overall, this would harmonise the market abuse legal framework and

prevent regulatory competition as well as legal arbitrage between Member States. Ultimately,

the most important argument is that all the elements needed for the reform already exist: the

institution (ESMA), the model (competition law), the legal framework (MiFID and MAD).

The second proposition answers the core challenge of enforcement which is access to

and understanding of market data. Thus, I support the proposition that the ESMA should

devote a significant part of his budget and energy to the collection of market data as well as to

set up special units with the technological means and human resources to process them.

Following the US current reforms, the aim would be to allow real time surveillance of

financial markets for regulators.

The consequence would be a significant increase in market supervision and detection

of potential global scale fraudulent behaviours. Even though concrete details have to be

further elaborated, those two proposals would remedy the EU difficulties identified in Part 3.

24

Having seen enforcement challenges, this paper will now analyse another important

element for regulators to tackle market abuses, namely substantive law on market abuses.

25

Part 4 – The Incapacity of Market Abuse Substantive Laws to Encompass

New Forms of Market Abuses

In this final part, the question is whether the market abuse legal frameworks in the US

and in the EU are capable to grasp the fraudulent behaviours previously described. This paper

finds two serious gaps in both regulations (I) which would not be filled by on-going reforms

(II). Accordingly, this research proposes the creation of new market abuses (III).

I - The Regulatory Gaps of US and EU Laws on Market Abuses

In order to audit the US and the EU legal frameworks, this paper will follow the

syllogism method by applying the legal grounds of market manipulation (a) and insider

dealing and front running (b) to the misconducts identified in Part 2.

a) Market Manipulation

The substantive law on market manipulation is pretty similar in US and EU laws. In

both instances, the actus reus consists in wilfully “creating false and misleading appearance”

on the trading of a security resulting in price fluctuation.

Under US law, market manipulation is prohibited by Section 9(a) of the Securities and

Exchange Act of 1934 (SEA):

“It shall be unlawful for any person, directly or indirectly, by the use of the mails or any

means or instrumentality of interstate commerce, or of any facility of any national securities

exchange, or for any member of a national securities exchange—

(1) For the purpose of creating a false or misleading appearance of active trading in any

security other than a government security, or a false or misleading appearance with respect

to the market for any such security, (A) to effect any transaction in such security which

involves no change in the beneficial ownership thereof, or (B) to enter an order or orders for

the purchase of such security with the knowledge that an order or orders of substantially the

same size, at substantially the same time, and at substantially the same price, for the sale of

any such security, has been or will be entered by or for the same or different parties, or (C) to

enter any order or orders for the sale of any such security with the knowledge that an order

or orders of substantially the same size, at substantially the same time, and at substantially

the same price, for the purchase of such security, has been or will be entered by or for the

same or different parties.

(2) To effect, alone or with 1 or more other persons, a series of transactions in any security

other than a government security, any security not so registered, or in connection with any

security based swap or security-based swap agreement with respect to such security creating

actual or apparent active trading in such security, or raising or depressing the price of such

security, for the purpose of inducing the purchase or sale of such security by others.

[emphasise added]”

In the same vein, under EU law, Article 5 of the MAD states: “Member States shall

prohibit any person from engaging in market manipulation.” Accordingly, article 1(2) defines

market manipulation as follow:

26

“‘Market manipulation’ shall mean:

(a) transactions or orders to trade:

which give, or are likely to give, false or misleading signals as to the supply of,

demand for or price of financial instruments, or

which secure, by a person, or persons acting in collaboration, the price of one or

several financial instruments at an abnormal or artificial level, unless the person

who entered into the transactions or issued the orders to trade establishes that his

reasons for so doing are legitimate and that these transactions or orders to trade

conform to accepted market practices on the regulated market concerned;

(b) transactions or orders to trade which employ fictitious devices or any other form of

deception or contrivance; [emphasise added]”

First, when it comes to the identified market manipulations, there are no difficulties to

apply those two definitions to layering and spoofing practices. Indeed, they both consist in

exercising massive pressure on one side of the book which in the end definitely aims at

creating false and misleading appearances and signals. That is why layering and spoofing

techniques have already been sanctioned several times in the US and in the UK. Also, it

makes no doubt that those two grounds could be applied to momentum ignition strategies. As

layering and spoofing, the fraudster’s aim is to create an artificial level of supply and demand

to lure other traders. On the contrary, quote stuffing strategies seem to be left unregulated.

Here, the trader floods the market with huge amount of orders without any economic rationale

in order to encumber traffic data, to slow down other market participants or to conceal another

fraudulent behaviour. As a result, quote stuffing is not in itself market manipulation and

therefore does not come under those two legal grounds.

Second, contrary to market manipulation, informed trading, whichever form it takes,

does not create any false or misleading appearance or signals on the demand and supply of

securities. In such case, the trader knows in advance, thank to speed advantage, flash trading

or information leakage, the content of upcoming orders. It then trades ahead, buying all the

available securities, thereby becoming the only counterparty available and controlling the

price. Hence, as there is no artificial appearance or signal, the whole scheme building on real

transactions, informed trading does not come under the legal ground of market manipulation.

Nevertheless, two other grounds could potentially prohibit it.

b) Insider Dealing and Front Running

Informed trading is sometimes referred to as insider dealing or front running. This is

because those two market abuses are based on exploitation of information asymmetry.

Therefore, prima facie, those two grounds seem to encompass this unfair practice.

Under US law, insider dealing and front running prohibitions are independent grounds

which both protect financial markets integrity108

. As regard insider dealing, it has been laid

down by Section 10(b)-5 of the SEA and further developed by court interpretations:

108

Newkirk, Thomas, ‘Insider Trading – A U.S. Perspective’, 19 September 1998

<http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm>

27

“It shall be unlawful for any person, directly or indirectly […]:

(a) to employ any device, scheme, or artifice to defraud,

(b) to make any untrue statement of a material fact or omit to state a material fact necessary

in order to make the statements made, in light of the circumstances under which they were

made, not misleading, or

(c) to engage in any act, practice, or course of business which operates or would operate as a

fraud or deceit upon any person, in connection with the purchase or sale of a security.”109

After several contradicting precedents, US law has finally been fixed by the Supreme

Court decision US v O’Hagan, according to which insider trading is prohibited for insider as

well as outsider on the basis of the misappropriation theory:

“The “misappropriation theory” holds that a person commits fraud “in connection with” a

securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates

confidential information for securities trading purposes, in breach of a duty owed to the

source of the information.” 110

As regard front running, US law is rather complex and fragmented. Front running

happens when a broker trades on a security while in possession of material non-public

information concerning the imminent block transaction of one of his customers or passes such

information to another who then trades on it. There is no general statutory rule prohibiting

front-running in US law. Instead, there are many financial market self-regulatory

organisations forbidding it. For example, one is to be found in Rule IM-21110-3 under

Section 2100 (General Standards) of the NAD Conduct Rules111

, currently under codification

as FINRA Rule 5270 with an expanded scope112

. However, the general anti-fraud provision

contained in section 10(b) and Rule 10b-5 of the SEA has been construed by certain authors

as prohibiting front-running: “it is clear that front-running does fall within the ambit of the

insider trading prohibitions under section 10(b) and Rule 10b-5. Although a broker and his

firm will likely escape liability under the “traditional theory” of insider trading, the

“misappropriation theory,” where it is adopted, attaches insider trading liability to a broker

and his firm for engaging in front-running activity. In more ways than one, it is now evident

that broker-dealer front-running violates Rule 10b-5.”113

In Europe, the MAD prohibits insider dealing and front running114

. The core difference

with US law is that EU law does not require the insider to breach a fiduciary duty due to the

source of the information. Indeed, article 2(1) of the MAD provides:

“Member States shall prohibit any person […] who possesses inside information from using

that information by acquiring or disposing of, or by trying to acquire or dispose of, for his

109

SEC Rule 10b-5 codified at 17 C.F.R. 240.10b-5 110

United States v. O'Hagan, 117 S.Ct. 2199, 2211, 1997 111

NAD Conduct Rules <http://www.sec.gov/pdf/nasd1/2000ser.pdf> 112

Buckholz, Robert, Codifying FINRA’s Front-Running Policy, 1 July 2012

<http://blogs.law.harvard.edu/corpgov/2012/07/01/codifying-finras-front-running-policy/#1> 113

Bovi, David, ‘Rule 10b-5 Liability for Front Running: Adding a New Dimension to the “Money Game”, Saint

Thomas Law Review, Volume 7, 1994-1995 114

SEC Press Release (n.98)

28

own account or for the account of a third party, either directly or indirectly, financial

instruments to which that information relates.”

The article 1 of the MAD defines what is an inside information. Contrary to US law,

the definition encompasses the traditional form of insider trading in paragraph 1 but also the

notion of front running in paragraph 2:

“’Inside information’ shall mean information of a precise nature which has not been made

public, relating, directly or indirectly, to one or more issuers of financial instruments or to

one or more financial instruments and which, if it were made public, would be likely to have a

significant effect on the prices of those financial instruments or on the price of related

derivative financial instruments. […]

For persons charged with the execution of orders concerning financial instruments, ‘inside

information’ shall also mean information conveyed by a client and related to the client’s

pending orders, which is of a precise nature, which relates directly or indirectly to one or

more issuers of financial instruments or to one or more financial instruments, and which, if it

were made public, would be likely to have a significant effect on the prices of those financial

instruments or on the price of related derivative financial instruments.”

Now, going back to informed trading, it appears not to come under any of the two

previous legal grounds. First, insider trading concerns trading upon non-public information

related to a public company whereas informed trading concerns non-public information

related to the nature of an upcoming order. Hence, even though they prima facie appear close,

insider trading and informed trading are two different things: “It is critical to make the

distinction between true insider trading and other forms of informed trading, despite the

blurry economic and legal boundaries of these types of transactions […] this type of trading,

whether justly or unjustly called “parasitic” or “predatory,” has little to do with true insider

trading and its regulation.”115

Second, front-running arises from the fiduciary relationship

between brokers and clients where the formers are prevented from trading on the latters’

upcoming orders without their approval. On the contrary, with informed trading hypothesis,

there is no fiduciary relationship between the informed trader and the anticipated trader. In the

end, this paper reaches the conclusion that this practice is left unregulated.

Finally, having audited US and EU substantive laws on market abuses, this paper has

identified two important loopholes: quote stuffing and informed trading do not fall under

market abuse regulation. This must be of great concern because they both undermine financial

markets fairness and integrity. Hence, the question is now whether US and EU on-going

reforms could fill in those gaps.

II - The Shortfall of US and EU Substantive Law Reforms

In the US and in the EU, substantive law governing technological innovations and

market abuses is being reformed. This time, contrary to enforcement, the EU is implementing

a much larger and wider effort than the US. This paragraph will compare the reforms and

analyse to what extent the identified gaps are filled.

115

Dolgopolov, p.12 (n.59)

29

In US law, the scope of reform is quite narrow and focuses mainly on flash orders and

actionable IOI.

First, concerning flash orders, the SEC is concerned with the fact that it creates a two-

tiered market in which the public does not have access through the consolidated quotation

data streams to all the best available prices. Moreover, it is also concerned by the possibility

to implement informed trading strategies: “the flashing of orders to many market participants

creates a risk that recipients of the information could act in ways that disadvantage the

flashed order. With today’s sophisticated order handling and execution systems, those market

participants with the fastest systems are able to react to information in a shorter time frame

than the length of the flash order exposures. As a result, such a participant would be capable

of receiving a flashed order and reacting to it before the flashed order, if it did not receive a

fill in the flash process, could be executed elsewhere.”116

Accordingly, the US regulator is

proposing to amend Rule 602 of Regulation NMS under the SEA to eliminate the exception

allowing the use of flash orders for equity and options exchanges117

. If the proposal were

adopted, flash orders would need to be included in the consolidated quotation data and their

display to certain market participants would be prohibited.

Secondly, the SEC intends to amend the regulatory requirements of the SEA that apply

to non-trading interest in National Market System to reform dark pools118

. Amongst other

propositions, the regulator is supporting two interesting rules which would have an incidence

on market abuses. As flash orders, IOI creates a two-tiered market. That is why the SEC

proposes to amend the definition of “bid” and “offer” in Rule 600(b)(8) of regulation NMS

determining the public quoting requirement to apply explicitly to actionable IOIs. However,

acknowledging the need for large trading interest to benefit from IOI, the new definition

would only exclude actionable IOIs for a quantity of stock having a market value of less than

$200,000. In addition, the SEC is proposing to lower the trading volume threshold in Rule

301(b) of Regulation ATS that triggers the obligation of ATS to display their best-priced

orders in the consolidated quotation data from 5% to 0.25%. The aim is to prevent ATS from

displaying IOIs to selected market participants and to ensure that more quotes are available to

the public in the consolidation quotation data.

In the end, removing flash orders and actionable IOI from financial markets will cut

two important possibilities to practice informed trading. This is a very good starting point

because there is no substantive law prohibiting it. Nevertheless, this reform remains by far too

narrow and should therefore get inspired by the more ambitious European project.

In the EU, the Commission is engaged in a wide review of the two main financial

market directives, namely the MiFID and the MAD. If adopted, the two projects would

significantly improve the European legal framework. Amongst numerous new rules, this

paper will focus on those having an impact on market abuses.

First, similarly to US law, the MiFID II project provides for extending pre-trade

transparency requirement to actionable IOIs (Title II, Chapter 1 – Article 3-6). As

demonstrated above, this would result in mandatory publication of IOIs into consolidated data

116

SEC, p.21 (n.73) 117

SEC (n.73) 118

SEC (n.25)

30

feeds ultimately eliminating one mean to practice informed trading. As there is no flash order

in Europe, the US and the EU would both have eliminated two possibilities to practice

informed trading.

Secondly, even though it does not seem related to market abuses, the MiFID review

contains a provision of great importance for our study: the creation of a new regulated

venue119

. Apart from regulated market and multilateral trading facilities (MTF), a new

category of organised trading facility (OTF) would be introduced to regulate more closely

dark pools120

. Indeed, under the new qualification, operator of an OTF has discretion over

how the transaction is to be executed whereas operator of a regulated exchange or MTF is

bound by non-discretionary execution rules. The creation of the OTF category to cover dark

pools makes then perfect sense in combination with the review of the MAD rules. According

to them, the regulation scope is to be extended from regulated market only to MTF, OTF and

also to any related financial instruments traded over-the-counter which can have an effect on

the covered underlying market (Chapter I General Provisions). Bringing the two previous

provisions together, the scope of market abuse regulation is going to be widely extended to

cover dark pools qualified MTF, OTF or even crossing network. As a result, the EU

regulation would now cover all the hypothesis of market abuses committed on dark pools.

Those two propositions would most definitely fill in the serious gap which, since now,

enabled market participants to perpetrate frauds within unregulated dark pools.

Thirdly, the MAD review, despite acknowledging that market manipulation grounds

are sufficiently large to embrace HFT manipulative strategies, has decided that: “it is

appropriate to specify further in the Regulation specific examples of strategies using

algorithmic trading and high frequency trading that fall within the prohibition against market

manipulation. Further identifying abusive strategies will ensure a consistent approach in

monitoring and enforcement by competent authorities.”121

So doing, the review would target

quote stuffing, layering and spoofing strategies. Even though such clarification is welcomed,

it has been explained earlier that quote stuffing does not really amount to market manipulation

and hence should be the object of an autonomous offence.

Fourthly, the reformed MAD would punish attempted market manipulation. The draft

proposal explains: “there are situations where a person takes steps and there is clear evidence

of an intention to manipulate the market but either an order is not placed, or a transaction is

not executed. The Regulation expressly prohibits attempts at market manipulation, which will

enhance market integrity.”122

Again, without being of an urgent nature, covering attempted

manipulation is welcomed as it will provide regulators with a new tool.

Fifthly, without going into too much detail, the project provides for harmonised

administrative sanctions by setting minimum rules for administrative measures, sanctions,

fines and disgorgement (Chapter V)123

. The review would also add criminal sanctions to

produce a stronger deterrent effect in punishing market abuses (Article 2 and 3) or inciting,

119

MiFID II, Paragraph 3.4.1. (n.102) 120

European Commission Press Release, ‘New Rules for More Efficient, Resilient and Transparent Financial

Markets in Europe’, 20 October 2011 <http://europa.eu/rapid/press-release_IP-11-1219_en.htm?locale=en> 121

MAD II, Regulation, Paragraph 3.4.1.3. (n.103) 122

MAD II, Regulation, Paragraph 3.4.1.4. (n.103) 123

MAD II, Regulation, Paragraph 3.4.5. (n.103)

31

aiding and abetting or attempting market abuses (Article 4)124

. The aim is to prevent

regulatory arbitrage and therefore to promote market integrity all over the EU.

In the end, the US reform of substantive law, while constituting a good starting point,

remains by far too narrow. On the contrary, the MiFID and MAD reviews in the EU are more

ambitious but still, don’t focus on the serious gaps that this paper identified. Ultimately,

neither of them has been able to fully address the issues raised by the development of new

technologies in financial market.

III - Proposals to Adapt the Substantive Laws on Market Abuses

I have demonstrated in this paper that quote stuffing and informed trading practices are

unfair and undermine market integrity. As already seen, quote stuffing consists in flooding

financial markets with artificial orders without any intention to execute them and informed

trading enables market participants to take advantage of confidential information about

upcoming orders. This eventually contributes to destroy market participant’s trust and

confidence which determines the amount of capital invested as well as the duration of holding

patterns. I therefore propose to extend the scope of market abuses to those fraudulent

behaviours. Accordingly and together with the proposals of Part 3, this paper supports the

introduction of new quote stuffing and informed trading offences.

As regard quote stuffing, this paper suggests the adoption of the following offence:

“It shall be forbidden, for any market participant, to send massive amount of orders to

financial markets without any intention to trade and to subsequently cancel them in whole or

in part for the main purpose of encumbering data traffic, slowing down market participants,

camouflaging other wrongful behaviours or any other purpose incompatible with the general

principles governing the functioning of financial markets”.

In this draft, I have decided not to include any specific reference to the number of

orders sent or cancelled in order to confer to the competent authorities some discretion upon

what should be considered an abusive behaviour. Also, this draft would be sufficiently

flexible to suit any increase in trading speed resulting from potential technological

improvements. More specifically, I consider that regulators should implement this market

abuse focusing more on the actus reus rather than on the mens rea. It makes no sense to

search for the intention underlying strategies automatically implemented by computers. That

is why the offence should be characterised every time orders are massively sent without any

other purpose than a fraudulent one. I ended up the drafting by giving a few examples as well

as a general provision referring to the general principles governing financial markets to

encompass any possible fraudulent misconduct.

As regard informed trading, this dissertation proposes the following offence:

“It shall be forbidden, for any market participants, to trade on the basis of material non-

public information concerning the nature of an up-coming order such as the identity of the

counterparty, the number or the nature of financial instruments, or any other relevant detail,

124

MAD II, Directive, Paragraph 3.3. (n.103)

32

where the said order has not yet been released to the public as a whole, as well as to pass

such information.”

As already explained, informed trading is very close to insider trading and front-

running. Therefore, I have been inspired by two abuses when elaborating this draft. Here, the

real issue is when savvy traders get a piece of information about an upcoming order and

generally - but not necessarily – trade ahead of it. In order to protect market participants from

information asymmetry exploitation, I support the prohibition to trade on information relating

to upcoming orders. I decided to focus on the main element of this unfair practice: the

confidential information about an upcoming order. This would counter all the abuses

identified in part 2: order anticipation, liquidity detection, flash trading or information leakage

exploitation as well as would any other type of informed trading.

33

Conclusion

To conclude, it has been studied that financial markets have known significant evolutions

during the past twenty years, most of them having been fueled by ever-increasing

technological innovations. This is questioning, more than ever, the adaptation of law to

modern trading environment. Therefore, this dissertation focused on the interaction between

the development of new technologies, amongst which high frequency trading and dark pools,

and market abuses, in order to determine the adequacy of the US and EU legal frameworks to

the new electronic infrastructure.

Building on statistical and empirical evidence, this combination of new trading techniques

with alternative trading platforms appeared to offer new rooms for market abuses, thereby

increasing their quantity. In addition, these frauds relying heavily on computer-based trading

are evolving in quality. They consist mainly in high speed market price manipulation through

layering, spoofing, momentum ignition or quote stuffing strategies as well as informed trading

based upon exploitation of confidential information about upcoming orders obtained via speed

advantage, flash systems or dark pools information leakage. Hence, savvy traders have now

more opportunities to defraud other market participants than in the past.

Confronted to the resurgence of market abuses, this paper explored the reaction of competent

regulators. Bringing together enforcement data from the US and the EU, I discovered the

worrying absence of any trend in market abuse public sanctions. In fact, regulatory authorities

are faced with unprecedented challenges rendering they supervision mission more difficult to

accomplish, namely the explosion of market data and the internationalisation of financial

market. Then, I turn on questioning the extent to which on-going reforms would be able to

meet these difficulties. I found that the US are implementing an ambitious plan to improve

their enforcement model whereas the EU is left far behind without any willingness to do so.

That is why, inspired by the US model, I formulated two proposals to reinforce market abuse

enforcement in the EU: to confer to a federal authority the jurisdiction to investigate and

prosecute cross-border market abuses, and to focus on collecting and processing market data

in order to ensure real time surveillance.

Then, this research analysed the appropriateness of the US and the EU substantive laws on

market abuses to encompass the financial misconducts earlier identified. Applying the

syllogism method by cautiously comparing the available legal grounds to the potential frauds,

I reached the conclusion that only the most classical examples of market manipulation were

reprehensible. Indeed, quote stuffing strategies and informed trading are left unregulated

under current laws. Again, I then dealt with the current reforms to verify if there would be

able to fill in those gaps. I realised that, even though they globally improve the legal

framework, none of them really addresses the identified issue. In the end, concerned by those

serious regulatory loopholes undermining market fairness and integrity, this paper offered two

draft proposals in order to extend market abuses to quote stuffing and informed trading.

In the end and above all, this study has proven that, when it comes to financial market,

nothing should be taken for granted. As a matter of fact, financial markets are evolving as fast

as the speed at which high frequency traders operates. This is continuously challenging the

foundations of the legal framework which then need to be readapted accordingly. This

research has ultimately shown the current disconnection between market abuse regulation and

potential fraudulent behaviours and its dramatic effect on market participants’ trust and

34

confidence. In the US as well as in the EU, the legal frameworks are partly outdated, the

reforms fall short and urgent proposals must be implemented. Finally, such work is nothing

but going back to Boileau’s French poem: “Hâtez-vous lentement, et, sans perdre courage,

Vingt fois sur le métier remettez votre ouvrage”125

.

125 In English: "Hasten slowly, and without losing heart put your work twenty times upon the anvil."

35

BIBLIOGRAPHY

LEGISLATION

US

SEC, Regulation ATS, 1998

SEC, Regulation NMS, 2007

NAD Conduct Rules <http://www.sec.gov/pdf/nasd1/2000ser.pdf>

SEC Rule 10b-5 codified at 17 C.F.R. 240.10b-5

EU

Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on

markets in financial instruments

Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on

insider dealing and market manipulation

Proposal for a Directive of the European Parliament and of the Council on criminal sanctions

for insider dealing and market manipulation

Proposal for a Regulation of the European Parliament and of the Council on Markets in

Financial Instruments Amending Regulation [EMIR] on OTC derivatives, central

counterparties and trade repositories

Proposal for a Directive of the European Parliament and of the Council on Markets in

Financial Instruments Repealing Directive 2004/39/EC of the European Parliament and of the

Council

Regulation CE n°1287/2006

CASES

US

EBX case, SEC Administrative Proceedings

<http://www.sec.gov/litigation/admin/2012/34-67969.pdf>

EBX case, SEC Press Release

36

<http://www.sec.gov/News/PressRelease/Detail/PressRelease/1365171485204#.UfEuy41A1

NI>

Hold Brothers case, SEC Administrative Proceedings

<http://www.sec.gov/litigation/admin/2012/34-67924.pdf>

Hold Brothers case, SEC Press Release

<http://www.sec.gov/news/press/2012/2012-197.htm>

Pipeline case, SEC Administrative Proceedings

<http://www.sec.gov/litigation/admin/2011/33-9271.pdf>

Pipeline case, SEC Press Release

<http://www.sec.gov/news/press/2011/2011-220.htm>

Trillium case, FINRA Press Release

<http://www.finra.org/newsroom/newsreleases/2010/p121951>

United States v. O'Hagan, 117 S.Ct. 2199, 2211, 1997

EU

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37

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SEC

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2009: <http://www.sec.gov/about/secstats2009.pdf>, p.3

2010: <http://www.sec.gov/about/secstats2010.pdf>, p.3

ESMA

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40

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