LegiStorm

Summary:

High-frequency trading (HFT) generally refers to trading in financial instruments, such as securities and derivatives, transacted through supercomputers executing trades within microseconds or milliseconds (or, in the technical jargon, with extremely low latency). There is no universal or legal definition of HFT, however. Neither the Securities and Exchange Commission (SEC), which oversees securities markets, nor the Commodity Futures Trading Commission (CFTC), which regulates most derivatives trading, have specifically defined the term. By most accounts, high frequency trading has grown substantially over the past 10 years: estimates hold that it accounts for roughly 55% of trading volume in U.S. equity markets and about 40% in European equity markets. Likewise, HFT has grown in futures markets—to roughly 80% of foreign exchange futures volume and two-thirds of both interest rate futures and Treasury 10-year futures volumes. The CFTC oversees any HFT, along with other types of trading, in the derivatives markets it regulates. These include futures, swaps and options on commodities, and most financial instruments or indices, such as interest rates. The SEC oversees HFT and other trading in the securities markets and the more limited securities-related derivatives markets which it regulates. In general, traders that employ HFT strategies are attempting to earn small amounts of profit per trade. Broadly speaking, these strategies can be categorized as passive or aggressive strategies. Passive strategies include arbitrage trading—attempts to profit from price differentials for the same stocks or their derivatives traded on different trading venues; and passive market making, in which profits are generated by spreads between bid and ask prices. Aggressive strategies include those known as order anticipation or momentum ignition strategies. Various observers, including SEC staff, have said that these aggressive strategies should be a central focus of public policy concerns. This may be because such strategies can share some similarities to practices such as front-running and spoofing, which are generally illegal. In addition, regulators have expressed concern over whether certain aggressive HFT strategies may be associated with increased market fragility and volatility, such as that demonstrated in the "Flash Crash" of May 6, 2010; the October 15, 2014, extreme volatility in Treasury markets; and the August 24, 2015, market crash in which the Dow Jones Industrial Average fell by more than 1,000 points in early trading. The SEC and CFTC have taken recent steps to bring some HFT under closer scrutiny, both through recent regulatory proposals and enforcement actions. The SEC has proposed requiring certain HFT broker-dealers to register with the Financial Industry Regulatory Authority (FINRA), which oversees broker-dealers. In January 2016, the SEC announced settlements with Barclays and Credit Suisse totaling more than $150 million, over allegations that Barclays had misled its investors on HFT practices permitted on its private trading platforms known as dark pools, and that Credit Suisse failed to operate its trading systems as advertised. The CFTC has cracked down on spoofing, using the anti-spoofing authority granted in the Dodd-Frank Act (P.L. 111-203) in a number of recent enforcement actions involving algorithmic trading. On November 24, 2015, the CFTC released a proposed rule, Regulation Automated Trading (Reg AT), governing certain HFT practices. The purpose of Reg AT broadly is to update the CFTC's rules on trading practices in response to the evolution from pit trading to electronic trading. Reg AT mandates risk controls for the exchanges; large financial firms called "clearing members" of the exchanges; and firms that trade heavily on the exchanges for their own accounts. The rule also proposes requiring the registration of proprietary traders engaging in algorithmic trading on regulated exchanges through what is called "direct electronic access." Although no legislation has been introduced in the 114th Congress directly impacting the regulation or oversight of HFT, several bills have been introduced imposing a tax on a broad array of financial transactions that could impact HFT. These bills include S. 1371, S. 1373, and H.R. 1464. Congress has also held hearings in the 114th Congress touching on HFT issues as part of its oversight of the SEC and CFTC. This report provides background on various HFT strategies and some associated policy issues, recent regulatory developments and selected enforcement actions by the SEC and CFTC on HFT, and congressional action such as proposed legislation and hearings related to HFT.