Streetwise Professor

March 1, 2015

The Clayton Rule on Speed

Filed under: Commodities,Derivatives,Economics,Exchanges,HFT,Politics,Regulation — The Professor @ 1:12 pm

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

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

High Frequency Trading has created the possibility of the promiscuous application of the Clayton Rule, because there is a lot of things about HFT that do not suit a lot of gentlemen at this moment, and a lot of ladies for that matter. The CFTC’s Frankendodd-based Disruptive Practices Rule, plus the fraud based manipulation Rule 180.1 (also a product of Dodd-Frank) provide the agency’s enforcement staff with the tools to pursue a pretty much anything that does not suit them at any particular moment.

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

Here’s my description of spoofing:

What is spoofing? It’s the futures market equivalent of Lucy and the football. A trader submits buy (sell) orders above (below) the inside market in the hope that this convinces other market participants that there is strong demand (supply) for (of) the futures contract. If others are so fooled, they will raise their bids (lower their offers). Right before they do this, the spoofer pulls his orders just like Lucy pulls the football away from Charlie Brown, and then hits (lifts) the higher (lower) bids (offers). If the pre-spoof prices are “right”, the post-spoof bids (offers) are too high (too low), which means the spoofer sells high and buys low.

Order cancellation is a crucial component of the spoofing strategy, and this has created widespread suspicion about the legitimacy of order cancellation generally. Whatever you think about spoofing, if such futures market rule enforcers (exchanges, the CFTC, or the dreaded DOJ) begin to believe that traders who cancel orders at a high rate are 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 order cancellation. In particular, market making strategies, including market making strategies 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 rapidly in response to new information. High volatility essentially means a high rate of information flow, and a need to adjust quotes frequently. Moreover, HFT traders can condition their quotes in a given market based on information (e.g., trades or quote changes) in other markets. Thus, to be able to quote tight markets in these conditions, market makers need to be able to adjust quotes frequently, and this in turn requires frequent order cancellations.

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

This creates a considerable tension if order cancellation rates are used as a metric to detect potential manipulative conduct. Tweaking strategies to reduce cancellation rates to reduce the probability of getting caught in an enforcement dragnet increases the frequency that a trader is picked off and thereby raises trading costs: the rational response is to quote less aggressively, which reduces market liquidity. But not doing so raises the risk of a torturous investigation, or worse.

What’s more, the complexity of HFT strategies will make ex post forensic analyses of traders’ activities fraught with potential error. There is likely to be a high rate of false positives-the identification of legitimate strategies as manipulative. This is particularly true for firms that trade intensively in multiple markets. With some frequency, such firms will quote one side of the market, cancel, and then take liquidity from the other side of the market (the pattern that is symptomatic of spoofing). They will do that because that can be the rational response to some patterns of information arrival. But try explaining that to a suspicious regulator.

The problem here inheres in large part in the inductive nature of legal reasoning, which generalizes from specific cases and relies heavily on analogy. With such reasoning there is always a danger that a necessary condition (“all spoofing strategies involve high rates of order cancellation”) morphs into a sufficient condition (“high rates of order cancellation indicate manipulation”). This danger is particularly acute in complex environments in which subtle differences in strategies that are difficult for laymen to grasp (and may even be difficult for the strategist or experts to explain) can lead to very different conclusions about their legitimacy.

The potential for a regulatory dragnet directed against spoofing catching legitimate strategies by mistake is probably the greatest near-term concern that traders should have, because such a dragnet is underway. But the widespread misunderstanding and suspicion of HFT more generally means that over the medium to long term, the scope of the Clayton Rule may expand dramatically.

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

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

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

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

When there is hidden liquidity (due to non-displayed orders or iceberg orders), it makes perfect sense for traders to attempt to learn about market depth. This can be valuable information for liquidity providers, who get to know about competitive conditions in the market and can gauge better the potential profitability of supply ing liquidity. It can also be valuable to informed strategic traders, whose optimal trading strategy depends on market depth (as Pete Kyle showed more than 30 years ago): see a nice paper by Clark-Joseph on such “exploratory trading”, which sadly has been misrepresented by many (including Lewis and Scopino) to mean that HFT firms front run, a conclusion that Clark-Joseph explicitly denies. To call either of these strategies front running, or deem them deceptive or fraudulent is disturbing, to say the least.

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

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

Fortunately, these are now just gleams in an ambitious attorney’s eye. But from such gleams often come regulatory progeny. Indeed, since there is a strong and vocal constituency to impede HFT, the political economy of regulation tends to favor such an outcome. Regulators gonna regulate, especially when importuned by interested parties. Look no further than the net neutrality debacle.

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

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  1. there is a lot to unpack in this post. one thing that no one is touching on is co-location, and the ability of exchanges to sell their data to market participants ahead of others. Sort of legalized front running. When Virtu has 1500 trading days without a loss-there is something wrong with the structure of the system. They aren’t taking risk.

    Comment by pointsnfigures — March 1, 2015 @ 2:54 pm

  2. @pointsandfigures-HFT is a big subject, and can’t address all the issues in one post. I do have to tweak you a little on the co-location point, since you paid to co-locate when you were in the pit. There has always been inequality in access, and traders have always paid (in one way or another) to get superior access. Preferential data access is a more complicated issue.

    The ProfessorComment by The Professor — March 1, 2015 @ 3:35 pm

  3. @pointsandfigures: as for Virtu, their business model is well-described by CNBC’s Bob Pisani last year here: . As you can see from Pisani’s breakdown of their S-1, Virtu’s success is reasonably explained by the fact that they are efficiently diversified across many products and market centers. They are taking risk and managing that risk very efficiently. Having a sustainable, and profitable, business model is not evidence of something being wrong with market structure. They have fewer losing trades than winning trades, but still have many losing trades. It seems odd that they would have such a high percentage of losing trades if, as you say, they were not taking risk.

    Comment by Scooter — March 1, 2015 @ 4:00 pm

  4. I don’t think you can equate the mutual membership model with a public exchange model. Exchanges took the consumer surplus that was once the members domain, and took a piece of it for themselves.

    As to Virtu, it is impossible to make money every day in the market unless you have a competitive advantage. Virtu’s business model isn’t a competitive advantage. The only traders I ever knew that never lost money rarely took their foot off first base-and had a great pit location. I don’t think Virtu is any different.

    Comment by pointsnfigures — March 1, 2015 @ 4:53 pm

  5. @pointsnfigures-The point about whether the exchange or the members get the rents is merely a distributive issue. And still the point is that people pay to get preferential access, and that the people on the floor had a time and space advantage just like the colo firms do. There has never been a level playing field and there never will be.

    @Scooter & pointsnfigures-Virtu model is based on the law of large numbers. Very slight edge on a large number of largely independent transactions per day can lead to a daily probability of making money that is very close to 1.

    The ProfessorComment by The Professor — March 1, 2015 @ 5:25 pm

  6. @pointsnfigures: I do not want to detract from the SWP’s excellent discussion of spoofing, but as to your point on Virtu’s profitability, I think there is a big difference between your experience in one pit trading one product versus Virtu’s business model of trading across 10,000 listed securities on more than 210 exchanges in 30 countries. As for the SWP’s post, I agree with his characterization of the vagueness of the alleged offense and the problems this poses for compliance and for defending yourself if accused. The ability to quickly cancel orders and replace them with revised orders is beneficial to the overall market as it is the risk management process that allows market makers to offer narrow bid-ask spreads and to trade for size. To the extent that regulators mistakenly view cancel-and-replace orders as evidence of spoofing, the ultimate losers will be the end-users of markets, as market makers will choose instead to manage their market-making risk though wider spreads. I worry that the wide-ranging enforcement activities of regulators on matters such as this are becoming an unaccountable back-door means for regulators to make trading rules for the market.

    Comment by Scooter — March 1, 2015 @ 5:58 pm

  7. I think you may be overestimating the stupidity of enforcers a tad for once.

    First off, spoofing cases that have been brought have all been spotted and escalated either by exchanges or FCMs in the first instance. We know this because no regulator has until recently troubled to get ahold of the tools to spot this for themselves. So it must have been the FCM or the exchange, because they do.

    The case will then be built by the exchange (the FCM is conflicted and can’t provide the view of overall market behavior, which the exchange can. The regulators can’t and also need it all explained to them).

    If you look at what was published about the Panther Trading case, they looked not at cancellations but at the percentage of orders that traded or not **by size**. All of Coscia’s 1-lot orders traded, and none of his 100-lot orders traded (because they were spoofs and the trade of a 1-lot order was what cancelled the 100-lot order).

    It’s the order size asymmetry that gave him away.

    If CFTC etc rocks up and says “Son, you were spoofing the WTI, because you cancelled a lot of orders” you just say “yes, in what size were these orders?” and when they say “all the 1-lots”, you say “show me how you spoof WTI with a 1-lot order, and then show me what the market average fill/canx rate is”.

    Those would give enough of a defence they’d chicken out, I suggest.

    Of course if all your small orders trade right before all your big orders got cancelled….Houston, you have a problem.

    Comment by Green as Grass — March 3, 2015 @ 9:39 am

  8. I have a more optimistic view.

    Not only are HFTs themselves a large interest group capable of capturing regulators, but it’ll be virtually impossible to implement such a rule without raising the risk of manipulation accusations so much that spreads will (at least initially) noticeably widen after decades of tightening.

    As you say, the vagueness of the rule will make it extremely difficult for the court to differentiate between legitimate activity and spoofing and that will leave plenty of reasonable doubt for those conducting legitimate strategies, still the standard in criminal cases. That will in turn lead to enough losses in court o dampen the regulators’ enthusiasm.

    One heartening sign that at least the SEC still has some sense is that Joe Stigler (who understands exactly nothing about financial markets and particularly nothing about market intermediaries, as evidenced by that paper he delivered last year) was denied an attempt at manhandling the markets at the SEC. There seems to be a lot of grandstanding by the regulators on this issue, but I doubt much will happen. Sure, there will be regulation, but in my experience, unless the regulator faces huge political pressure, they aren’t willing to make sweeping changes that have a deleterious effect on the market beyond raising the cost of compliance.

    As always, market participants are smarter than the Cretins in regulation. Not only have smart market makers figured out how to use regulations in their favour and often against the regulator, but they have often found a perfectly legal way around regulation either with simple but clever methods (like delivering sub-penny spreads by splitting the execution between the bid and offer) but also by innovating entirely new structures that do not fall under current regulation. And that’s how we have a very liquid markets, characterized by tightening spreads while swimming in a sea of moronic regulation. Obviously, the markets would be better and stronger without the manipulation of the regulators.

    Finally, your post illustrates very clearly that often the cost of ridding the world of an undesirable activity (say, spoofing) is much costlier than tolerating that activity. Intermediaries have developed sophisticated techniques to differentiate between market noise, informed orders, and innocuous trading activity (hedging, rebalancing, etc.). I have no doubt that market participants are far better able to innovate efficient techniques to minimize the cost of spoofing than are the regulators. And the cost of spoofing can’t be that high in the first place. It’s a stupid game, not without its own risks, and one easily detected and mitigated by intermediaries – and that’s why you don’t have hedge funds advertising excess returns from a spoofing strategy.

    Comment by Methinks — March 6, 2015 @ 5:34 pm

  9. […] what do we think? I’ve mentioned a couple of times (from Craig Pirrong) the Clayton Rule of Manipulation, which is that manipulation is “any operation of the cotton […]

    Pingback by Oreos, Vomitoxin and the Price of Wheat | Navigating the Commodity Markets with Freight and Spreads — April 3, 2015 @ 2:08 am

  10. […] what do we think? I’ve mentioned a couple of times (from Craig Pirrong) the Clayton Rule of Manipulation, which is that manipulation is “any operation of the cotton […]

    Pingback by Oreos, Vomitoxin and the Price of Wheat — April 4, 2015 @ 7:35 pm

  11. […] Craig Pirrong, Professor of Finance and Energy Markets and Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston, has written a post examining HFT practices that lead to tighter spreads which benefit investors.  He warns that misinterpretation of legitimate trading strategies may impair market performance in the name of improving it. Read more here […]

    Pingback by Modern Markets Initiative - The Clayton Rule on Speed — December 10, 2015 @ 9:26 am

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