Wednesday, September 26, 2012

Regulators Fine High-Frequency Trader for Manipulative Trading

By Tim Dulaney, PhD

FINRA recently announced the censure and fining of Hold Brothers On-Line Investment Services, LLC ("Hold Brothers").  This action is in lockstep with that of NYSE Arca (PDF),  NASDAQ (PDF), NASDAQ OMX BX (PDF) and BATS (PDF) as well as the SEC (PDF).  Hold Brothers is a registered self-clearing broker-dealer and a member of FINRA operating as a "day-trading firm by facilitating direct market access to customers and to its proprietary traders."

The action centers primarily on the trading activity in one large account ("Demonstrate, LLC") wholly owned, funded and controlled by Hold Brothers.  Several hundred thousand trades were placed through this account on average each trading day between January 2009 and December 2011.  One particular alleged illicit trading activity involved a process known as "spoofing".  "Spoofing" is trading activity involving non-bona fide trades within NBBO primarily to elicit other traders to expand NBBO.   Because other high-frequency trading algorithms base their decision on when to trade on order book depth, the algorithms interpreted these orders as increased demand.  Other illicit trading activities alleged by the regulators include: layering, wash selling and pre-arranged trading.

According to FINRA, by writing an algorithm to exploit the simplicity of another trader's algorithm, Demonstrate manipulated the market.  As algorithms become more complex, it is likely that we will see more actions like this one: algorithms taking advantage of the simple assumptions in other algorithms to produce small profits at a high frequency.   Consistent with most cases of this nature, Hold Brothers "neither admitted nor denied the charges, but consented to the entry of FINRA's findings" and has been fined nearly $6 million dollars for their involvement in this market manipulation and anti-money laundering activity.

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