By Todd Tucker and Mohammad Khan (ed note: Khan was our star intern this summer, helping bring us up to speed with his considerable knowledge of financial markets. We thank him for helping co-write this blog post.)
Note: This post assumes some level of understanding of high frequency trading (HFT); a comprehensive introduction can be found on pages 8-14 of The New Bull Market Fallacy. This post examines the compounding difficulties in the regulation of HFT.
Last week, the Securities and Exchange Commission (SEC)
attracted headlines when its commissioners unanimously voted to propose
a ban on the controversial use of flash trading.
Yet, what is this practice, and what are its implications
under international pacts like the World Trade Organization (WTO)?
Some brief background into the development of HFT is useful at this point. Accusations of espionage and intellectual property theft have recently become common in the HFT community, as individuals move from one HFT institution to another in an attempt to replicate their successes for more compensation. Goldman has been embroiled in a recent scandal regarding its “trading huddles” stemming from a WSJ article that accused Goldman of exclusively tipping off its major clients with internal recommendations unavailable to other Goldman clients.
Not all exchanges are similarly repentant. Direct Edge is
the lone market center that has unrepentantly (and almost single-handedly)
forced flash trading down the throats of other exchanges and continues to
defend this position. Unsurprisingly, it has gained considerable market share
since employing its Enhanced Liquidity Provider flash trading program.
To complicate matters a bit more, a recent WSJ article notes
Edge is “owned 31.5% by the German-Swiss owned International Securities Exchange.”
While these conflicting interests certainly complicate the regulation of HFT, any new restrictions face yet more limitations in the form of international agreements like the World Trade Organization’s (WTO) provisions on financial services.
These provisions are contained in the General Agreement on Trade in Services, the GATS Annex on Financial
Services, the Second and Fifth Protocols to the GATS, the Understanding on
Commitments in Financial Services, and countries’ schedule of commitments on
financial services under the GATS.
For example, the New Financial Services sub-clause in the Understanding on
Commitments in Financial Services states, “A Member shall permit financial
service suppliers of any other Member established in its territory to offer in
its territory any new financial service.” Similarly, the Understanding’s
standstill commitment obligates countries to limit any “conditions,
limitations and qualifications to the commitments” they adopted to be limited
to what was in place by the time the financial services negotiations wrapped up
in the 1990s.
WTO tribunals have interpreted GATS rules
as prohibiting a country from enacted bans in covered sectors: The U.S.
Internet gambling ban – which prohibited both U.S. and foreign gambling
companies from offering online gambling to U.S. consumers – was found to be a
“zero quota” and thus violate GATS market access requirements.
Does HFT constitute a specific commitment under GATS
obligations? HFT would almost certainly fall under the definition at Annex’s
5(a)(x): “Trading for own account
or for account of customers, whether on an exchange, in an over-the-counter
market or otherwise.” Even if it didn’t, the list in the Annex is
illustrative, not exhaustive.
And the Understanding compels countries that used it in
scheduling their GATS financial services commitments (this includes the U.S.,
Nigeria, and most developed countries) to “permit its residents to purchase in
the territory of any other Member the financial services indicated in” the
above list, and also to “grant financial service suppliers of any other Member
the right to establish or expand within its territory, including through the
acquisition of existing enterprises, a commercial presence.” This is not just
limited to the list above. These two “modes of delivery” are known as
consumption abroad and commercial presence, and the U.S. headnote in its
schedule of specific commitments specifically references the list that includes
Such broad guarantees for financial services providers
clearly pose a threat to the regulation of recent financial innovations, like
HFT. Thus, the SEC could potentially encounter difficulties in preventing
Direct Edge, whose largest owner is the German-Swiss owned International
Securities Exchange (ISE), from utilizing flash orders. Foreign organizations
like the ISE stand to gain exorbitant amounts of money from the continued
implementation of HFT and likely would oppose domestic regulation in the U.S.,
citing expectations of returns and deregulation doctrines embodied in these
international agreements (similar versions of which are contained in other
recent trade and investment agreements, like the proposed Korea and Panama
Might Direct Edge pressure its home countries to launch a WTO case? Certainly, the deregulation commitments under the Understanding remain substantial, in particular with respect to the standstill requirement noted above.
And, Article 2 of the GATS Annex
on Financial Services – which restricts domestic prudential regulations to
those that are not “used as a means of
avoiding the Member’s commitments or obligations under the Agreement” – would
appear to constitute an additional constraint.
Hopefully, the mere existence of these provisions will put
pressure on the SEC and other regulators to get behind an agenda of WTO reform. We need bans on risky practices like flash trading, and we also need WTO reform.
We need bans on risky practices like flash trading, and we also need WTO reform.
Additionally, the G-24 recently released an item by GTW ally Chakravarthi Raghavan that makes an excellent paper on this topic.