The Clayton Rule on Speed

By Prof Craig Pirrong

I have written often of the Clayton Rule ofManipulation, named after a cotton broker who, in testimony before Congress,uttered these wise words:

“The word ‘manipulation’ . . . in its use is so broadas to include any operation of the cotton market that does not suit thegentleman who is speaking at the moment.”

High Frequency Trading has created the possibility ofthe promiscuous application of the Clayton Rule, because there is a lot ofthings about HFT that do not suit a lot of gentlemen at this moment, and a lotof ladies for that matter. 

The CFTC’s Frankendodd-based Disruptive PracticesRule, plus the fraud based manipulation Rule 180.1 (also a product ofDodd-Frank) provide the agency’s enforcement staff with the tools to pursue apretty much anything that does not suit them at any particular moment.

At present, the thing that least suits governmentenforcers-including not just CFTC but the Department of Justice as well-isspoofing. As I discussed late last year, theDOJ has filed criminal charges in a spoofing case.

Here’s my description of spoofing:

What is spoofing? It’s the futures market equivalentof Lucy and the football. A trader submits buy (sell) orders above (below) theinside market in the hope that this convinces other market participants thatthere is strong demand (supply) for (of) the futures contract. If others are sofooled, they will raise their bids (lower their offers). 

Right before they dothis, the spoofer pulls his orders just like Lucy pulls the football away fromCharlie Brown, and then hits (lifts) the higher (lower) bids (offers). If thepre-spoof prices are “right”, the post-spoof bids (offers) are too high (toolow), which means the spoofer sells high and buys low.

Order cancellation is a crucial component of thespoofing strategy, and this has created widespread suspicion about thelegitimacy of order cancellation generally. Whatever you think aboutspoofing, if such futures market rule enforcers (exchanges, the CFTC, orthe dreaded DOJ) begin to believe that traders who cancel orders at a high rateare doing something nefarious, and begin applying the Clayton Rule to such traders,the potential for mischief-and far worse-is great.

Many legitimate strategies involve high rates of ordercancellation. In particular, market making strategies, including market makingstrategies pursued by HFT firms, typically involve high cancellation rates,especially in markets with small ticks, narrow spreads, and high volatility. 

Market makers can quote tighter spreads if they can adjust their quotes rapidlyin response to new information. High volatility essentially means a highrate of information flow, and a need to adjust quotes frequently. Moreover, HFTtraders can condition their quotes in a given market based on information(e.g., trades or quote changes) in other markets. 

Thus, to be able toquote tight markets in these conditions, market makers need to be able toadjust quotes frequently, and this in turn requires frequent ordercancellations.

Order cancellation is also a means of protectingmarket making HFTs from being picked off by traders with better information.HFTs attempt to identify when order flow becomes “toxic” (i.e., ischaracterized by a large proportion of better-informed traders) and rationallycancel orders when this occurs. This reduces the cost of making markets.

This creates a considerable tension if ordercancellation rates are used as a metric to detect potential manipulativeconduct. Tweaking strategies to reduce cancellation rates to reduce theprobability of getting caught in an enforcement dragnet increases the frequencythat a trader is picked off and thereby raises trading costs: the rationalresponse is to quote less aggressively, which reduces market liquidity. But notdoing so raises the risk of a torturous investigation, or worse.

What’s more, the complexity of HFT strategies willmake ex post forensic analyses of traders’ activities fraught with potentialerror. There is likely to be a high rate of false positives-theidentification of legitimate strategies as manipulative. This isparticularly true for firms that trade intensively in multiple markets. 

With some frequency, such firms will quote one side of the market, cancel, andthen take liquidity from the other side of the market (the pattern that issymptomatic of spoofing). They will do that because that can be the rationalresponse to some patterns of information arrival. But try explaining that to asuspicious regulator.

The problem here inheres in large part in theinductive nature of legal reasoning, which generalizes from specific casesand relies heavily on analogy. With such reasoning there is always a dangerthat a necessary condition (“all spoofing strategies involve high rates oforder cancellation”) morphs into a sufficient condition (“high rates of ordercancellation indicate manipulation”). This danger is particularly acute incomplex environments in which subtle differences in strategies that aredifficult for laymen to grasp (and may even be difficult for the strategist orexperts to explain) can lead to very different conclusions about theirlegitimacy.

The potential for a regulatory dragnet directedagainst spoofing catching legitimate strategies by mistake is probably thegreatest near-term concern that traders should have, because such a dragnet isunderway. But the widespread misunderstanding and suspicion of HFT moregenerally means that over the medium to long term, the scope of the ClaytonRule may expand dramatically.

This is particularly worrisome given that suspectedoffenders are at risk to criminal charges. This dramatic escalation in thestakes raises compliance costs because every inquiry, even from an exchange,demands a fully-lawyered response. Moreover, it will make firms avoid someperfectly rational strategies that reduce the costs of making markets, therebyreducing liquidity and inflating trading costs for everyone.

The vagueness of the statute and the regulations thatderive from it pose a huge risk to HFT firms. The only saving grace is thatthis vagueness may result in the law being declared unconstitutional andpreventing it from being used in criminal prosecutions.

Although he wrote in a non-official capacity, anarticle by CFTC attorney Gregory Scopino illustrates howexpansive regulators may become in their criminalization of HFTstrategies. In a Connecticut Law Review article,Scopino questions the legality of “high-speed ‘pinging’ and ‘front running’ infutures markets.” It’s frightening to watch him stretch theconcepts of fraud and “deceptive contrivance or device” to cover a variety ofdefensible practices which he seems not to understand.

In particular, he is very exercised by “pinging”, thatis, the submission of small orders in an attempt to detect large orders. Asremarkable as it might sound, his understanding of this seems to be even morelimited than Michael Lewis’s: see Peter Kovac’sdemolition of Lewis in his Not so Fast.

When there is hidden liquidity (due to non-displayed ordersor iceberg orders), it makes perfect sense for traders to attempt to learnabout market depth. This can be valuable information for liquidity providers,who get to know about competitive conditions in the market and can gauge betterthe potential profitability of supplying liquidity. 

It can also be valuable toinformed strategic traders, whose optimal trading strategy depends on marketdepth (as Pete Kyle showed more than 30 years ago): seea nice paper by Clark-Joseph on such “exploratory trading”, which sadlyhas been misrepresented by many (including Lewis and Scopino) to mean that HFTfirms front run, a conclusion that Clark-Joseph explicitly denies. To calleither of these strategies front running, or deem them deceptive or fraudulentis disturbing, to say the least.

Scopino and other critics of HFT also criticize thealleged practice of order anticipation, whereby a trader infers the existenceof a large order being executed in pieces as soon as the first pieces trade. Isay alleged, because as Kovac points out, the noisiness of orderflow sharply limits the ability to detect a large latent order on thebasis of a few trades.

What’s more, as I wrote in some posts on HFT justabout a year ago, and in a piece in the Journalof Applied Corporate Finance, it’s by no means clear that orderanticipation is inefficient, due to the equivocal nature of informed trading.Informed trading reduces liquidity, making it particularly perverse thatScopino wants to treat order anticipation as a form of insider trading (i.e.,trading on non-public information). Talk about getting things totallybackwards: this would criminalize a type of trading that actually impedesliquidity-reducing informed trading. Maybe there’s a planet on which that makessense, but its sky ain’t blue.

Fortunately, these are now just gleams in an ambitiousattorney’s eye. But from such gleams often come regulatory progeny. Indeed,since there is a strong and vocal constituency to impede HFT, the politicaleconomy of regulation tends to favor such an outcome. Regulatorsgonna regulate, especially when importuned by interested parties. Look nofurther than the net neutrality debacle.

In sum, the Clayton Rule has been around for the goodpart of a century, but I fear we ain’t seen nothing yet. HFT doesn’t suit a lotof people, often because of ignorance or self-interest, and as Mr. Claytonobserved so long ago, it’s a short step from that to an accusation ofmanipulation. Regulators armed with broad, vague, and elastic authority (andthings don’t get much broader, vaguer, or more elastic than “deceptivecontrivance or device”) pose a great danger of running amok and impairingmarket performance in the name of improving it.

For more see http://streetwiseprofessor.com/