On Oct 16, 2014 the Securities and Exchange Commission (“SEC”) settled with Athena Capital Research (“Athena”)[1] over their High Frequency Trading (“HFT”) system, known as “Gravy,” that defrauded the Nasdaq. Athena carried out a series of “marking the close” [2] orders in an attempt to illegally alter the prices of “tens of thousands”[3] of publicly traded securities. Athena used complex computer programs that carried out advanced algorithms, trading in milliseconds. Gravy was used to move the price of Nasdaq stocks within the last ten minutes of trading, without any intent to invest in the actual stocks. This program was so pervasive that Gravy made up 70% of all trading volume of affected stocks in the last few minutes of the Nasdaq closing.[4]
The SEC held administrative proceedings and issued a Cease-and-Desist to Athena over their HFT systems.[5] Athena, in their settlement with the SEC, neither denies nor accepts the SEC charges and paid a penalty of $1 million. Public outcry over HFT systems has been steadily increasing and this case, the first HFT case the SEC has pursued, marks an important moment for both the SEC and market confidence.
For years the SEC has attempted to use all possible tools at their disposable to minimize the rampant market abuse that led to the recent stock market crash, subsequent public outcry, and resulting legislation. In the case of Athena, the SEC imposed liability through Section 21C of the Securities Exchange Act of 1934 (“1934 Act”) and Section 203(e) of the Investment Advisers Act of 1940. Moreover, the new forum is a result of the 2010 Dodd-Frank Act, which authorizes the SEC to seek penalties in an administrative case against any defendant. Before Dodd-Frank, only those subject to the SEC’s direct regulation, such as brokers, could be sued in an administrative proceeding. Athena is a securities fraud case, and before Dodd- Frank, would have had to be filed in a federal district court if the SEC wanted to impose a fine or an injunctive measure. Under the current law, the SEC has discretion on how to proceed against Athena and other potential HFT cases. But why is the SEC suddenly focusing on HFT?
HFT in and of itself is not illegal. HFT is “a program trading platform that uses powerful computers to transact a large number of orders at very fast speeds.”[6] The program uses complex algorithms to examine markets and execute orders based on market conditions. Algorithms are not inherently bad; they are just functions carried out by computers. An algorithm is a simple math equation of “If this, then that,” but in this setting, executed countless amounts of time, at unfathomable speeds.[7] What actually matters is the intent behind the implementation of the algorithm and how it is used to achieve that intent.[8] Even in the current Athena decision, the SEC focuses on the intent of Gravy and clarifies that this is a “what happened here was fraud.”[9]
There is nothing inherently illegal about HFTs, but as the Athena case demonstrated, it could be used for improper purposes such as an attempt to defraud the market. HFT is legal as long as the intent is not to defraud the market. With HFT, and its lightning speed algorithms, you can even make money in the market by simply being the fastest algorithm around. This too is okay and it is called “latency arbitrage.” In this scenario, you always make money by being able to be faster than the other traders, you can interpret information quicker and you can execute trades faster as well. However, some HFT platforms are not being used simply for speed, but rather to manipulate prices and trick other algorithms into making errors. The issue is that regulators find it difficult to draw the line between acceptable trading strategies and manipulation because of the complexity of the strategies.[10] Meanwhile, the trading public has begun to notice that for some, the game is rigged, and the market as a whole is suffering.
Public outcry has grown rapidly since Michael Lewis’s book “Flash Boys” was published this year. In the book, Lewis explains how high-frequency traders use “sophisticated computer programs that can whipsaw prices by flooding the market with orders in milliseconds.”[11] Days after the book was released both the FBI and NY Attorney General announced an investigation into HFT.[12] The ever-increasing public focus on HFT, combined with the prior absence of a SEC prosecution for this type of infraction, has led the public to question the transparency of the market and the abilities of the SEC.
In the Athena proceeding, the SEC finally has a response to the outcry, and more importantly, a starting point for legal precedent on HFT cases. High frequency trading became a common trading tool around 2009, and since then the SEC has been trying to stop illegal HFT. Even the Athena case is about activity that happened in a six-month period in 2009. HFT cases may involve violations of Section 10b of the ’34 Act by intending to defraud the market. While Section 10b is a general provision prohibiting any person from using fraud in connection with the purchase or sale of any security, Rule 10b-5 specifically prohibits making any materially[13] false statements or omissions in connection with the sale or purchase of securities.[14] Moreover, to be actionable under 10b-5, the statement must be made with the intent to deceive, manipulate or defraud.[15] In the Athena order, the SEC repeatedly points to Athena’s intent to defraud the market, and thereby investors.[16]
The SEC outlined Athena’s fraudulent strategy as such:
Immediately after the first Imbalance Message[17], Athena would issue an Imbalance Only on Close order[18] to fill the imbalance. These orders are only filled if there is an imbalance in a security at the close. Athena would then purchase or sell securities on the continuous book on the opposite side of its on-close order, until 3:59:59.99, with the goal of holding no positions (being ““flat”)[19] by the close. [20]
It is not yet fully clear how long Athena had been engaging in its HFT scheme known as Gravy. What is certain is that Gravy was in use for at least 6 months in 2009, the “relevant period” according to the SEC, and that Athena was, at the very least, “acutely aware”[21] of Gravy’s manipulative trading scheme. For example, at a time when Gravy was only working at 25% accumulation, one email from an Athena manager to the Chief Technology Officer and another manager stated, “[M]ake sure we always do our Gravy with enough size.”[22] The next day Gravy operated at 60% accumulation. More egregiously, when Nasdaq issued an automated regulatory alert due to suspicious activity and possible stock price manipulation, the Chief Technology Officer forwarded the alert through email and noted, “Let’s make sure we don’t kill the golden goose.”[23] The administrative order is filled with more examples of Athena’s awareness of Gravy.[24] During the relevant period, Gravy was executed with $40 million for trading on the Nasdaq. Gravy dominated all trading in the last seconds that the Nasdaq was open with the intention of not holding any positions (i.e. being flat). Not being flat meant Athena would “incur overnight risk, and the price of the stock would often move in an unfavorable direction, resulting in losses, sometimes significant.”[25] Athena referred to this as being “stuck.”[26] As Gravy proved lucrative, Athena increased the sophistication of the Gravy scheme with the use of “collars.”[27] The purpose of Gravy was to defraud the market by “owning the game.”[28] The SEC used the suspicious pattern of trading and other evidence such as the inculpating emails to sue Athena to an administrative proceeding.
Although the SEC had a victory, it was in the form of a “neither admit-nor-deny” settlement As of 2012, certain types of cases may require an admission or denial of guilt, but this matter did not apparently meet the threshold. This position leaves unanswered the question of whether or not the Department of Justice (“DOJ”) will file suit in federal court. Moreover, the case does highlight some more unanswered questions and concerns such as: (1) “Why did it take such a large total trading volume at a given time in the market to trigger FINRA notices and SEC investigation?;” (2)“Is this conduct more widespread?;” and (3) “What has been the total aggregate impact of these HFT schemes that have been operating since 2009?” Still, the SEC does answer the major question of whether or not this type of trading exists and will be prosecuted.
As the SEC tries to expedite the enforcement of legal regulations through administrative orders, their primary goal must be providing notice of swift penalties in hopes of deterring this fraudulent type of trading. The settlement came five years after the manipulative trading, only further highlighting the challenge the SEC faces in targeting illegal strategies to artificially affect stock prices. Waiting for a DOJ investigation is a luxury the SEC and the markets it regulates cannot afford. Bad actors need to be shown that some form of swift justice will occur upon discovery of illegal behavior, and that the consequences will be substantial enough to be a deterrent. In this case, Athena paid $1 million despite the limit for typically similar cases being $725,000.[29] All individuals who consider implementing a “Gravy-like” system have been put on notice. The Director of the SEC’s Division of Enforcement said it best, declaring, “This action should send a clear message that the Commission and its Division of Enforcement have the expertise to investigate and charge even the most sophisticated fraudulent algorithmic trading strategies.”[30] In addition to a looming, possible DOJ suit, the SEC, upon discovery of illegal behavior, will act immediately through the administrative courts to inflict the heaviest fines possible.
What does this mean for the SEC? As SEC Chair White said, “When high frequency traders cross the line and engage in fraud we will pursue them as we do with anyone who manipulates the markets.”[31] While this is a settlement that did not require an admission of guilt, the consensus is that this is still a big victory for the SEC. At a recent speaking engagement,[32] SEC Commissioner Gallagher spoke of the SEC losing some it its “swagger in D.C.” as a result of overreaching, recent legislation that forces the agency to cast too wide of a net. Moreover, SEC NY Regional Director Andrew Calamari, speaking at a recent event at Fordham University School of Law talked about the impact of this case. Director Calamari addressed the challenges of the SEC having to oversee such a broad spectrum of laws and regulations, with limited manpower and resources, while still having to maintain the level of quality expected of the SEC. The answer to this challenge, he said, is to win a few major message cases, in different types of cases. Athena, as the first HFT case to be settled, represents a major piece of that answer. The precedent has now been set. After Athena, the SEC can now walk a little taller whether in D.C. or NY.
[1]“Athena is a Delaware limited liability company with its office in New York, New York. It serves as the general partner and investment manager for its master and feeder funds, which traded using the relevant algorithmic strategies.” In the Matter of Athena Capital Research, LLC, Respt.., Release No. 3950 at 1(S.E.C. Release No. Oct. 16, 2014)
[2] Investopedia, LLC (http://www.investopedia.com/terms/p/portfoliopumping.asp) (Marking the Close or Portfolio Pumping is “the illegal act of bidding up the value of a fund’s holdings right before the end of a quarter, when the fund’s performance is measured. This is done by placing a large number of orders on existing holdings, which drives up the value of the fund.”)
[3] In the Matter of Athena Capital Research, LLC, Respt.., Release No. 3950 at 1(S.E.C. Release No. Oct. 16, 2014)
[4] Id. at 2
[5] Section 21C of the Securities Exchange Act of 1934 (“Exchange Act”) and Section 203(e) of the Investment Advisers Act of 1940
[6] Investopedia, LLC (http://www.investopedia.com/terms/h/high-frequency-trading.asp).
[7] Mark Cuban, Blog Maverick: The Idiots Guide to High Frequency Trading, (April 3, 2014), http://blogmaverick.com/2014/04/03/the-idiots-guide-to-high-frequency-trading/.
[8] See generally In the Matter of Athena Capital Research, LLC, Respt.., Release No. 3950 (S.E.C. Release No. Oct. 16, 2014).
[9] SEC Press Release, SEC Charges New York-Based High Frequency Trading Firm With Fraudulent Trading to Manipulate Closing Prices (Oct. 16, 2014), available at http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370543184457#.VGzWaZPF81d.
[10] Peter J. Henning, Why High-Frequency Trading Is So Hard to Regulate, N.Y. Times, (Oct. 20 2014) http://dealbook.nytimes.com/2014/10/20/why-high-frequency-trading-is-so-hard-to-regulate/.
[11] Id.
[12] Bradford, Harry (April 1, 2014). “FBI Investigating High-Frequency Traders: WSJ”. Huffington Post. Retrieved April 1, 2014.
[13] See 15 U.S.C. § 78a; See also Justia (https://www.justia.com/consumer/securities-fraud/). (A statement is material if it would be important to a reasonable investor making an investment decision.).
[14] See Id.
[15] 17 C.F.R. 240.10b-5.
[16] See generally In the Matter of Athena Capital Research, LLC, Respt.., Release No. 3950 (S.E.C. Release No. Oct. 16, 2014).
[17] Id. at 2 (“Imbalances for the close of trading occur when there are insufficient on-close orders to match buy and sell orders, i.e., when there are more on-close orders to buy shares than to sell shares (or vice versa), for any given stock.”).
[18] Id. at 3 (“Imbalance-Only-On-Close Orders (“Imbalance-Only Orders”), limit orders that would be executed when the market closed, but only if there was an imbalance at the close.”).
[19] Id. at 2 (Athena called this process “accumulation,” and the algorithms that accumulated these positions were called “accumulators.” ).
[20] Id.
[21] Id.
[22] Id.
[23] Id. at 3
[24] Id. at 5 (“We can have some aggressive Gravy if we know we have a 100% chan[c]e of getting the fill.”); Id at 5 (“dominating the auction.”).
[25] Id.
[26] Id.
[27] see Id. at 5-6. For a detailed explanation of Gravy at its peak and the use of collars
[28] Id. at 6.
[29] See 17 C.F.R. 188.
[30] SEC Press Release, Supra.
[31] Id.
[32] 15th Annual A.A. Sommer, Jr. Lecture on Corporate, Securities and Financial Law. Oct. 16th 2014.
