Published in McLure’s between October 1902 and November 1904, Ida Tarbell’s 19-part series about the ascent and methods of Standard Oil painted John D. Rockefeller as an unethical monopolist. Public reaction to the articles is credited with setting in motion a chain of events which led to the 1911 Supreme Court decision that Standard Oil violated the Sherman Antitrust Act and the eventual breakup of the company.
While the issues may not be as momentous for the general public, Michael Lewis’s book Flash Boys: A Wall Street Revolt has set off a furious debate in the financial community and led to investigations of high speed trading by the FBI and the New York Attorney General, as well as the appearance by SEC Chair Mary Jo White before Congress to assure us that the markets are not “rigged.”
The issue was already on the SEC’s radar. In September 2009, then Chair Mary L. Schapiro proposed a ban on flash trading. Then not much happened until the current SEC Chair Mary Jo White on June 5, 2014 promised to ratchet up oversight and propose rules to regulate high speed traders. The SEC’s desultory pace was surely quickened by the Lewis book and the ensuing debate.
The invention of high speed trading coupled with high speed traders’ access to information not immediately available to the rest of the market has enabled them to see what stocks other investors are about to purchase before the other orders are executed. Armed with that information, the high speed trader can trade milliseconds (thousands of a second) ahead of everyone else and thereby make the transactions of others somewhat less profitable.1
High speed trading looks like a modern version of medieval coin clipping, the practice of cutting or filing small slivers from gold and silver coins, melting them into bars and selling the bars to a goldsmith. In 1677, a judge in the Old Bailey Court in London said, ” ‘Tis sadly now common that mischievous crime of Counterfeiting, Clipping and Filing of his Majesty’s Coin is become in most parts, to the great abuse of all good Subjects.”
High speed traders may not have much to worry about, given the fitful progress of the SEC and the uncertainty surrounding the current investigations. An adversary they may not have expected recently appeared–the plaintiffs’ class action law firm. There are at least two high profile suits now underway.
In the first, the City of Providence, on behalf of a class of investors who traded stock between April 18, 2009 and the present, sued 14 brokerages, 16 securities exchanges and 12 high speed traders. The complaint alleges that the high frequency traders, with the help of the brokers and exchanges, used material, non-public information to manipulate the market to the detriment of public investors. The exchanges helped by providing material trading data, and the brokerages by providing access to their customers’ bids and offers, so that the traders could place their orders ahead of everyone else’s.
The problem with the theory may be that insider trading involves the misuse of non-public information in breach of a fiduciary duty. High frequency trading firms pay the exchanges for access to order information, so no fiduciary obligation is involved. Their practices may not amount to front running, a violation in which a broker trades ahead of its clients to profit from its knowledge of their orders. High speed traders are not brokers and are trading for their own accounts, not clients’.
In a March 31, 2014 DealBook column in the New York Times, Andrew Ross Sorkin faulted Michael Lewis for blaming the wrong villains. It was the exchanges, Sorkin said, that created a system where certain traders could pay a premium for information that gives them the ability to front run the orders of ordinary investors. In other words, the markets were themselves realizing substantial profits by enabling high speed trading. Michael Lewis called Sorkin’s piece “idiotic.” We’re not so sure. Which brings us to the second lawsuit.
This June, another Michael Lewis (no relation to the author), a lawyer famous for leading a class action lawsuit which resulted in a $368.5 billion recovery against big tobacco in the 1990’s, brought suit on behalf of a class of all persons who receive market data from the stock exchanges. The defendants, which the suit claims have “broken promises” to their subscribers, are 13 securities exchanges. This is a more intriguing and, we think, possibly a more meritorious theory.2
In short, the theory is that the stock markets, in their contracts with subscribers, promise to be fair by providing “valid” market data in a non-discriminatory fashion. The exchanges breach these contracts by entering into “lucrative side deals with certain customers [the high speed traders] to whom they sell advance access to the very market data that subscribers had contracted for.”
The modern class action dates back to 1966. Such a suit against Standard Oil at the beginning of the 20th century might have transformed the oil business in different ways and more quickly than did the antitrust laws. The purposes of the recently filed suits, of which there will undoubtedly be more, are to realize a recovery for subscribers to market data and fees for their law firms. If the actions also enhance the integrity of our markets, that would be a welcome byproduct and one that class action process can claim only rarely.
1 Lest there be any doubt about the profitability of the practice, the high frequency trading firm Virtu Financial said in public offering documents that it had lost money on just one day in nearly five years of trading (apparently due to a trading error). The firm postponed its offering as a result of the controversy surrounding the practice of high speed trading in the industry.
2 In a similar suit, traders of financial futures contracts have sued the derivative contracts markets for falsely maintaining that they were selling real-time market data.