High-frequency trading is an order-based

innovation and manipulation1

Viktoria Dalko
is Professor of Finance at Hult International Business School and Instructor at Harvard
University.

Michael H. Wang
is Senior Researcher at Research Institute of Comprehensive Economics, a think tank in
Boston, MA.

Correspondence: Viktoria Dalko, Department of Finance, Hult International Business

School, 1 Education Street, Cambridge, MA 02141, USA
E-mail: [email protected]

Abstract High-frequency trading (HFT) is a financial innovation that focuses on order

flow and relies on quickly evolving information and communication technology. The
innovation is successful, and HFT is highly and consistently profitable. However, the Flash
Crash on 6 May 2010 exposed the unfamiliar side of HFT, thus illuminating the emergent
need to unveil the negative impact that HFT has on other investors and the market. This
paper examines data regarding quote-stuffing, spoofing, and market making provided by
high-frequency (HF) traders, based on the increasing empirical literature. It first defines
order-based manipulation (OBM) as the framework under which quote-stuffing, spoofing
and HF market making find common ground. It then provides details regarding how OBM
is displayed in the three manipulation tactics. In essence, they all seek and exercise
monopoly power in trading albeit through different ways of achieving it. The shared
purpose is to gain monopolistic profit. The essence and common purpose explain why HF
traders are not net liquidity providers, contrary to some proponents’ conclusions. Rather,
this paper points out the three consequences that HF traders have brought to the market;
i.e., increased volatility, increased frequency of unfairness, and instability potential. Recent
regulatory improvement and completed prosecutions against manipulative HFT strategies
justify the analysis.

Keywords high-frequency trading ‧ order-based manipulation ‧ monopoly ‧ instability ‧

regulation

JEL Classification G01 ‧ G18

1
The authors thank Xin Yan for inspiration and session participants at EEA 2017 Annual Conference, 23–
26 February, NY, USA and SWFA 2018 Annual Conference, 7–10 March, Albuquerque, NM, USA for
their suggestions. The authors also thank Dalvinder Singh, the Editor, and the two anonymous reviewers.
Introduction

Financial markets are full of uncertainty. One main source of uncertainty is the impact of
price-sensitive information flowing constantly into the market. Corporate announcements,
analysts’ ratings, macroeconomic data, and breaking news are among the frequently
encountered price-sensitive news events. However, some of those news events can and
have been manipulated for trading purposes. Numerous insider trading episodes have been
recorded behind manipulation of earnings, spin of analysts’ recommendations, and other
publicly disseminated information for the past 50 years.1-2 Insider trading with or without
the assistance of manipulated insider information adds substantial uncertainty to publicly
available information. Thus, it is risky to make investment decisions by relying on
information content only. Sophisticated investors invest heavily in technology in order to
achieve consistent high performance by focusing on order flow while avoiding
informational uncertainty. Information and communication technology is one area that
plays an important role in the investment.

Since the 1980s, investors have used computer programs or algorithms to implement
investment decisions and trading strategies. The application of information and
communication technology in portfolio management is called program trading or
algorithmic trading (AT). As the information and communication technology has grown,
so has AT.3 High-frequency trading (HFT) is considered as a subset of AT by several
researchers, but the two have different purposes.4-5 While AT may be used for order
management by institutional investors, HFT is used for trading profit only and relies on the
processing power of fast computers to make good use of market data and trading
transactions in as little time as microseconds. Some researchers attribute the birth of HFT
to fragmented trading venues due to Regulation National Market System implementation
by the Securities and Exchange Commission in 2005.3,6 In addition, we believe that HF
traders seek certainty by focusing on order flow and avoid uncertainty created by
continuous, frequent, and globalized information flow of price-sensitive content. Another
important factor is the decimalization of tick size due to regulatory improvement in 2001.6
This leads to more frequent turnover with thinner profit expectation per turnover. Thus, the
main HFT strategies include market making, statistical arbitrage, liquidity detection, and
momentum ignition.7 In brief, HFT is an innovation based on fast advance in information
and communication technology as well as regulatory evolution.

Innovation has awarded HFT large and persistent profits that are not commensurate with
the risks they take.8-9 For example, Virtu Financial, a leading HF market-making firm, had
1,237 days of positive returns but only one day in which it lost money for the period of 1
January 2009 – 31 December 2013.10 This consistency in a firm’s high performance is
superb according to the standard of traditional asset management firms.

Today, HFT provides a significant portion of daily trading volumes in US equity markets.
More recent estimates show that HFT made up 35 percent of equity trades in the U.S. in
2005. This number increased to 56 percent in 2010 and further to 70 percent in 2012.3 The
dominance of HFT in equity trading requires serious research on its impact to investors
and the market as a whole. The Flash Crash on the New York Stock Exchange on 6 May
2010 and the Knight Capital’s software glitch on 1 August 2012 forced regulators and
market participants to assess the negative impact that HFT brings to the market.11-12

This paper first examines two HFT manipulative tactics centered on order submission and
quick cancellation, quote-stuffing, and spoofing. They are all included under the same
category: order-based manipulation (OBM). This type of market manipulation is de facto
creating and exercising monopoly power in seeking trading profit.1,13 In addition, the paper
investigates market making by high-frequency (HF) traders. The finance literature and
practical experience show that market making carries unparalleled monopoly power. Since
HF market makers are volunteers and have no contractual obligation to provide continuous
liquidity, these HF traders seek monopoly power and make a certain trading profit. In
essence, the three types of tactics used in certain HFT strategies share the same purpose.
They are all used to obtain monopoly profits with exercising monopoly power in trading.

The rest of the paper is organized as follows. The next section presents the definition of
OBM and analyzes the major characteristics of OBM. The comparison between OBM and
trade-based manipulation (TBM) exhibits different ways to create monopoly power in
trading with the same purpose of gaining monopolistic profit in the two manipulation
schemes. This paper then shows a detailed description and analysis devoted to two typical
tactics used in OBM – quote-stuffing and spoofing. The authors use tables to demonstrate
how these two tactics are applied in practice. Market making possesses monopoly power
by nature. The volunteer market makers by HF traders seek monopolistic profit but provide
no service of designated market makers. Thus, one understands why HFT is not a net
liquidity provider as some researchers proposed. Rather, the manipulative part of HFT has
brought negative impacts on other investors and the market. Increased volatility in both
frequency and magnitude is one of them. Unfairness to competition regarding trading
profits is another impact. The most disruptive is the instability potential which may lead to
financial crisis and extraordinary unfairness. Thus, manipulative HFT should be and have
been regulated in the developed markets. The final section concludes.

OBM creates monopoly power in trading

According to the manipulator’s tactic to get share prices lifted, market manipulation is
categorized as trade-based, information-based, and action-based.14 There is a new type of
market manipulation that does not belong to any of the above three types of market
manipulation. It has neither public information dissemination nor corporate action
involved. Thus, it is irrelevant to information-based or action-based manipulation. It does
not use actual trading activities, such as self-dealing (wash trades) and cross-dealing
(matched trades), to cause price changes to manipulate numerous investors’ perception.
Hence, it is not TBM. Rather, the manipulator has no intent to trade but relies on order
submission and immediate cancellation to create the appearance of large and incoming
liquidity in order to influence other investors’ trading decision-making. If successful, the
influenced investors will trade, or will have difficulty trading, to speed up or slow down
price change, as desired by the manipulator. The key is the manipulation of order display
or exchange’s processing functionality.1,15 This type of market manipulation is called
order-based manipulation (OBM).
The terminology OBM has been used previously but in situations in which HFT either did
not exist or was not identified. One study selects pre-market hours to investigate the impact
of submit-and-cancel activities by IPO firms on the reactions of investors.16 Another study
presents empirical high frequency data of order cancellations to detect OBM.17 However,
they do not differentiate whether order cancellations in their sample are made by HF or
non-HF traders. The third one provides a complete case study of a convicted manipulator
who conducted OBM in China in 2008.18 Apparently, the account-level data used by the
authors show no HFT involvement. Furthermore, none of the above studies formally
defines OBM.

Today, most equity markets worldwide are order driven, and HFT is an emerging
dominance in developed markets. HFT focuses on order flow and frequently engages in
manipulative schemes. Therefore, formally defining and analyzing OBM in the HFT era is
necessary. Thus, this paper presents a tentative definition of OBM in the following
proposition.

Proposition: Order-based manipulation is a type of market misconduct in which the

manipulator creates illusive order display or artificial processing difficulty but with no
bona fide intent to get submitted orders executed. The manipulator’s purpose is to make
monopolistic profit by inducing acceleration or deceleration of price changes in the
targeted contract desired by the manipulator.

OBM appeared during eras prior to HFT. The primary characteristic is that the fake orders
– orders that are submitted and cancelled quickly before execution – are designed to be
seen by other investors in order to create the false appearance of continuously increasing
liquidity for the contract. Fake orders have to be large in order to facilitate numerous
investors’ perception that large volumes are entering the market. Fake orders are placed
and cancelled in high frequency so as to induce high demand in the direction of fake orders
in a short period of time. Thus, OBM is characterized by a short manipulation time period.
This scheme bears no transaction cost and can be repeated with ease. Hence, it is the least
risky among the known forms of manipulation used to accelerate or decelerate price
changes within a short period of time. Several securities’ litigation releases provide
evidence in OBM prior to HFT era.1,18 Table 1 compares the key characteristics of OBM
with those of TBM in the case of accelerating price changes.
 Table 1. Comparison of OBM with TBM in accelerating price changes

Manipulation Manipulation Essence of Profiting Transaction Legal risk

type tactics manipulation opportunity cost

Order-based Submitting Creating illusive Accelerating No trading Prohibited by

manipulation large orders order display to price changes to cost in the Dodd-Frank

(OBM) and quickly induce substantial distribute US Act (2010)

cancelling them trading by other shares

investors desired previously

by the accumulated

manipulator

Comment No intent to Creating Seeking

trade monopoly power monopolistic

in trading profit

Trade-based Fictitious Creating actual Accelerating Limited Prohibited by

manipulation trading such as price changes to price changes to trading cost Securities

(TBM) wash trades induce substantial distribute Act (1933)

and matched trading by other shares and

trades investors desired previously Securities

by the accumulated Exchange

manipulator Act (1934)

Comment Genuine intent Creating Seeking

to trade with monopoly power monopolistic

limited volume in trading profit

A high ratio of order cancellation to execution is one primary characteristic of HFT. 4,19
Apart from non-manipulative order cancellations, HFT has updated OBM with faster speed
in placing and cancelling orders and larger numbers in submitted and cancelled orders. One
innovation through HFT is to decelerate the price changes of a targeted stock or another
contract in addition to the extant acceleration-oriented OBM. Another innovation is to
simultaneously manipulate multiple targeted contracts and exchanges. Thus, HFT has
created new manipulation tactics with microsecond or nanosecond frequency, which a
human trader can hardly achieve.

Within the framework of OBM, the manipulator’s purpose is either to accelerate or

decelerate the price changes of a targeted contract. When accelerating price changes, the
manipulator can profit at the increased price changes by closing an earlier accumulated
shareholding position, or he can start a new position in a contrarian fashion. In such a case,
he may or may not need another OBM cycle, so he can close the newly established position
at a profit. When decelerating price changes of a targeted stock or contract, the manipulator
usually creates cross-contract or cross-market arbitrage opportunities.

The next section will examine two more researched HFT tactics to determine how they
create monopoly power. These tactics used by HF traders are quote-stuffing and spoofing.
For the convenience of discussion without losing generality, the paper selects the stock
market as a representative of financial markets.

OBM tactics in the HFT strategies

Quote-stuffing

Quote-stuffing is a new manipulative tactic that certain HF traders bring to the stock
market. It deserves serious attention, since it affects the majority of US listed stocks and
operation of large exchanges.19 Its practice is submitting an extraordinarily large number
of orders followed by immediate cancellation. Subsequently, quote-stuffing generates
order congestion. Its purpose is to slow down the processing of the exchange and lift the
entry barrier to other traders.4,15,19-20 Thus, quote-stuffing is an OBM tactic in the category
of causing processing difficulty and decelerating the price changes of the targeted stock.

A large number of order submissions may also cause the exchange receiving the quotes to
lag other exchanges, thus creating arbitrage opportunities for the manipulator.8,15,21-22 Other
investors can be misinformed as to which exchange has the most liquidity or best pricing.
The HFT strategy that employs quote-stuffing is both manipulative and predatory. It
generates more pollution and waste in message traffic. It reduces the probability and causes
delays for other investors’ orders to be filled. It is correlated with short-term volatility,
decreased liquidity, and higher trading cost. It is detrimental to market quality.5,15,19 In
other words, cancelling orders in great numbers at a flash monopolizes resources. The
trading profit gained in the regard is through OBM by slowing down victimized investors,
particularly non-HF traders. Several researchers consider quote-stuffing to be a type of
market manipulation.15,19,20 To be more precise, quote-stuffing is the core tactic in the
complete cycle of some OBM strategies. It is illegal, as Dodd-Frank, Section 724 prohibits
“bidding or offering with the intent to cancel the bid and offer before execution”.19

Table 2 shows how quote-stuffing works on one stock on the targeted exchange that is also
traded on another exchange.
 Table 2. Quote stuffing on a stock traded on two exchanges

Manipulation Normal trading Quote stuffing by Deceleration of price Normal trading

stage on Exchange 1 manipulator on changes on Exchange 1 on Exchange 2

Exchange 1

Action Manipulator’s Large number of Numerous orders by Manipulator’s

buy orders buy orders other investors sell orders

executed submitted and crowded out and stock executed

cancelled quickly prices increase slowed

down

Manipulator’s Genuine intent No intent to trade Genuine intent to

intent to trade trade

Manipulation Shares bought at Monopoly power Shares sold at

outcome lower prices created with order higher prices

congestion

Comment Cross-exchange Seeking Cross-exchange

arbitrage monopolistic profit arbitrage

initiated through arbitrage completed

In short, the purpose of quote-stuffing is essentially to slow down the trade processing of,
and thus to decelerate the stock price changes in, the targeted exchange. This way, the
manipulator has created monopoly power by opening up cross-stock or cross-exchange
arbitrage opportunities. He can hence gain monopolistic profit.

Spoofing

Spoofing by an HF trader is essentially equivalent to engaging in fake orders or fake trading

by human traders. The key to this tactic is to create the appearance of a great amount of
liquidity coming into the market immediately. The HF trader has no genuine intent to trade
and thus cancels all of the orders submitted. The main purpose of this tactic is to speed up
the price changes of the targeted security by inducing other investors to trade in the
direction desired by the HF trader. However, the fake orders and the lack of bona fide
trading assemble manipulation of the order display in the limit order book. Research shows
that some HF traders manipulate order display to speed up price changes with a high
success rate.23 The main reason spoofing works is that the display of the limit order book
is incomplete. The display shows only submitted orders, but no cancelled or executed
orders, which are seen instantly by numerous market participants.

The Flash Crash in the New York Stock Exchange on May 6, 2010, provides an excellent
example of spoofing. Sarao, a London-based HF futures trader, entered thousands of E-
mini futures contracts on the crash day to sell, which he planned to cancel later. These
orders, amounting to about $200 million, were replaced or modified 19,000 times before
they were canceled at various times throughout that day. The spoof orders represented well
over 20 percent of all E-mini sell orders visible to the market and were sufficiently large
to induce numerous genuine sell orders to follow instantly. The resulting panic-selling
quickly caused both E-mini futures and the underlying stock market index to fall steeply
after about 2:32 pm on the day. The Dow collapsed 998.5 points (about 9%), most within
minutes, and recorded the largest intraday point drop by then. After a brief trading halt, the
Dow rebounded as rapidly as it dropped. Within half an hour, nearly 90% of the loss was
recovered.24-25

The convicted HF trader admitted that, on the Flash Crash day, he was able to induce other
market participants to sell E-minis by placing the downwardly layering spoof orders. The
spoof orders were used to significantly but artificially depress the price of E-minis by
creating the appearance of substantial false supply and to induce other market participants
to sell E-minis at prices and quantities they normally would not have traded. Once the E-
Mini prices were decreased to a very low point, the HF trader executed genuine orders to
buy a large number of E-Mini contracts.25 In this scenario, his real intention was to establish
a new long position. He expected to buy shares at a price lower than the current price. By
submitting and immediately cancelling a large number of downwardly layered spoof orders,
he established a long position at a much lower price by trading against the panic-selling
investors.4 The Flash Crash is an excellent example of the case in which the manipulator
“shakes out” shares from selling investors before building a substantial long position.26

Spoofing in the long direction is also called momentum ignition.4,27 The difference between
this and spoofing in the short direction is that the manipulator holds a long shareholding
position before manipulation in this case. He plans to close the position at a higher share
price. His goal is to create the appearance of large buy orders entering the market so
numerous investors will rush to buy and push up the share price. Depending on how much
profit he expects, he can choose to spoof once and sell his holding position after the upward
momentum has been ignited by his spoof orders. He can also choose to engage in
consecutive upwardly layered spoofing multiple times, similar to the tactic used by Sarao
on the Flash Crash day but in the opposite direction. Once the price inflates substantially
higher, he sells his position completely by trading against the induced investors at a sure
profit.4,23,28 Herein the manipulator uses spoofing to increase the share price in his
accumulation-lift-distribution scheme.1

Table 3 shows the full cycle of OBM that features spoofing.

 Table 3. Spoofing in a long manipulation strategy

Manipulation Accumulation by Spoofing by manipulator Induced trades by Distribution by

stage manipulator other investors manipulator

Action Buy orders Buy orders submitted Numerous buy Sell orders

executed and cancelled quickly orders executed executed

and stock prices

lifted

Manipulator’s Genuine intent to No intent to trade Genuine intent

intent trade to trade

Manipulation Shares Monopoly power Monopolistic

outcome accumulated created with appearance profit gained

of incoming large buy

volumes

In sum, spoofing is a tactic of order display manipulation. Spoofing is successful because

the stock market is set up to display only submitted orders but not cancelled or executed
orders. The incomplete disclosure of order information by the exchange facilitates the
OBM and enables some HF traders to use spoofing to make monopolistic profit by creating
and exercising monopoly power in trading.

Market making by HF traders

Financial intermediaries include brokers and dealers or market makers. The literature
shows that these entities have monopoly power based on the insider information of order
flow.29-33 Frequently they are engaged in price manipulation such as frontrunning and
pump-and-dump schemes. The brokers and market makers that conduct more manipulative
trades earn significantly higher profits. The manipulation activity by intermediaries is
prevalent among both developed and emerging markets.34-40 A convicted Canadian
manipulator confirms the above research findings.41 Market makers have the last say than
the investing public in both human and electronic markets. Thus, they are the winners of
the trading game according to an old Wall Street adage, “he who trades last.”30

Market makers or specialists are frequently criticized for the conflict inherent in their dual
roles as brokers for the orders left with them to be entered in the book and to serve as
dealers trading for their own accounts. They use the monopoly power based on access to
the order book and the central role of trade processing for their own benefit at the expense
of the investors who submit the orders into the book.29-30,42

Literature of human market makers shows that they have both an execution advantage (buy
at the bid and sell at the ask, which is higher than the bid in the bid-ask spread) and a timing
advantage (foresee the short-term price movement based on the order imbalance) relative
to other market participants.43-48 These two advantages give market makers monopoly
power, which leads to predictable profit with little risk; i.e., monopolistic profit. Exchanges
such as New York Stock Exchange give this monopolistic position to designated market
makers (or specialists) in exchange for their service of continuously providing liquidity on
both sides of the market. In other words, the designated market makers have contractual
duty to facilitate smooth trading transactions during both tranquil and turbulent times of
the market.

As quote-stuffing and spoofing display that some HF traders create monopoly power
through OBM, some other HF traders gain endowed monopoly power by acting as market
makers. This explains why a substantial portion of HF traders volunteer to act as market
makers. Volunteer HF market makers have no contractual obligation. They are like other
investors and are profit-seekers only. They provide liquidity based on adverse selection.5,49-
51
Thus, it is not surprising that HF market makers are profitable in general.21

Aforementioned Virtu Financial implies that HF market makers earn consistent positive
returns day in day out, at times of either quiet market or turbulence. The reason may be
that they occupy the monopolistic position of market makers but do not provide the
corresponding service. Often, they seek to accelerate price changes of the targeted stock
through OBM, such as spoofing, or not, such as frontrunning. Therefore, they profit more
from buy-low-and-sell-high in the long direction or sell-high-and-buy-low in the short
direction. Financial trading is a zero-sum game to the best, and HF market makers profit at
investors’ expense. When HF traders gain and exercise monopoly power in their trading
strategies, they profit unfairly and sometimes illegally.

To summarize, some HF traders create monopoly power in trading by employing OBM

tactics such as quote-stuffing or spoofing, and some other HF traders gain endowed
monopoly power in trading by taking monopolistic positions such as market making. The
common purpose of all of these HF traders is to seek monopolistic profit by exercising the
created or endowed monopoly power in trading.

HFT is not a net liquidity provider

Research shows that HFT is mainly engaged in intraday speculation and finishes a trading
day with no or negligible shareholding. Thus, HFT needs abundant liquidity to enter and
exit the market with ease.4,21 A number of researchers argue that HFT provides substantial
liquidity, reduces bid-ask spread, mitigates price volatility, and thus improves the market
quality.8,21,52-55 However, the data used by these researchers are provided by US exchanges.
They do not include the broker identifications. Some of the aforementioned researchers use
a proxy for the activity of HF traders by using data on submitted orders which may or may
not be executed. Others use NSADAQ data that exclude brokers-dealers who are important
HFT players.4 These researchers used market quality metrics developed prior to the
prevalence of HFT. Therefore, their conclusions that HFT improves market quality are
questionable.5

Research shows that HFT appears mainly in large liquid stocks, particularly in the stocks
with the greatest capitalization yet the lowest price.8,19,21,56 A natural explanation is that HF
traders are not net liquidity suppliers if not net liquidity takers. It has been shown that HF
traders supply nearly the same amount of liquidity as the liquidity they take.8 Worse, HFT
does not supply liquidity but takes it when liquidity is in shortage. On the other end, HFT
provides substantial liquidity when liquidity is not needed.5

One must bear in mind that the ratio of order cancellation to order execution is very high
among the submitted orders by HF traders. The liquidity generated by HFT may not be
provided by the same HF trader but may be induced from other investors. This is true
because, frequently, HFT strategies include spoofing and other OBM tactics that submit
numerous large orders then quickly cancel them right before execution. The development
is that very likely other investors, particularly slow traders, get spoofed and rush to trade
in the direction desired by the spoofer. In this case, the liquidity provider is not the spoofing
HF trader, but induced investors. They may be non-HF traders. They may be other HF
traders.4,22,57

During market tranquillity times, HFT seems to supply liquidity if induced liquidity counts
as HFT liquidity provision as well. However, HF traders compete fiercely with other
traders for liquidity during stressful times. The subsequence is that either HF traders
compete to draw liquidity away from slower traders or the competition causes non-HFT
liquidity providers to withdraw from the market.49-51 This adverse selection in liquidity
provision may be the more complete truth of HFT strategies.

To summarize, liquidity provision is the key argument that some researchers use to
advocate for HFT. The above analysis shows that one needs to distinguish whether the
liquidity generated by HFT is provided by honest HF traders or induced from other
investors by HF traders who undertake OBM strategies. One should also consider the
interplay between HFT and liquidity at both peaceful and stressful times of trading to gain
a clear complete picture.

Consequences of manipulative HFT strategies

Not all HFT strategies are detrimental to market quality. The HFT strategy that involves
cross-market arbitrage is beneficial to other market participants because it helps to maintain
the law of one price if no manipulative tactics such as quote-stuffing are used.58 Some HFT
strategies are manipulative, and they do have negative impact on other investors and the
market.

Market manipulation is de facto creating and exercising monopoly power in trading.1,13

Consequences of OBM played by HF traders include increased frequency and magnitude
of price volatility, unfair and monopolistic profit at manipulated investors’ loss, and
instability potential. Next, the three aspects will be explored in greater detail.

Volatility increase

In the end of the manipulation strategy that involves spoofing used by an HF trader, the
induced traders, particularly slow investors, are not aware of a sudden and unexpected trend
reversal because the spoofing HF trader will trade against them. This unpredictability of
price trends results in uncertainty among induced investors. Since HFT generates a large
number of trades within very short time periods,59 the frequency of price reversal and other
volatility risks increases substantially.5 That is, spoofing HFT causes more intraday price
volatility. Research shows that short-term volatility systematically increases when AT
and/or HFT intensity increases;55 the responses of HF traders to the large selling pressure
exacerbated market volatility substantially in a short time period;51 and HFT activity
increases long-term volatility.60 HF traders’ fierce competition for liquidity during market
turbulence leads to liquidity dry-up and short-term volatility. Occasionally, the magnitude
of volatility on a short time scale is relatively very high and negatively affects the
functionality of the market. The Flash Crash in 2010 provides a convincing example to
support the argument. Subsequently, the market quality deteriorates and instability
emerges.19,51,61

Increased frequency of unfairness

The setup of the stock trading rule provided every investor the freedom to transact, enter a
position and exit from it, at least theoretically. The market maker provides immediacy by
charging the bid-ask spread. If the investor enters the market at the ask price and
immediately exits the market, he must close his round-trip trade by selling at the lower
price of the bid. By so doing, he incurs a loss of the difference of the ask and bid. In this
sense, trading is a sub-zero sum game for the investor, if prices do not move. However, if
one includes the market maker’s gain, the game is zero-sum. In this case, the investor faces
financial risk only.

However, the stock market evolves hand in hand with technology, particularly information
and communication technology. The evolution of the technology has brought new risk to
investors in addition to some benefits. Because stock exchanges place high priority on
speed in order to display and process incoming orders at the same price, HF traders have
an obvious advantage over slow traders. This creates unfairness if an HF trader competes
with a slow trader for the same profit. Some may argue that slow traders should avoid
competing with HF traders so there is no unfairness. The reality is that slow traders can
hardly avoid being taken advantage of by HF traders, particularly when they place large
orders.5 The only solution slow traders may have is to hold over longer time horizons and
reduce trading frequency. This way, slow traders lose some of their freedom while HF
traders can compete with any investor at will. This path seems to avoid financial unfairness
but creates unfairness in freedom, which ultimately leads to financial unfairness.62
As HFT increases order cancellations substantially, OBM becomes the dominant type of
market manipulation relative to traditional action-based, trade-based and information-
based manipulation. OBM brings additional unfairness between HF traders and slow
traders in addition to the existing sources of unfairness, such as insider trading and
traditional types of market manipulation. This is because OBM incurs no transaction cost
and can be repeated many times on any trading day. Therefore, manipulative HFT increases
the frequency of unfairness. However, OBM dominance is due to the evolution of the stock
market in tandem with information and communication technology. It is not overstated that
the evolution of the stock market creates new dimensions of risk and subsequently new
types of unfairness, which is characteristic of increased frequency.

Not all profits gained by HF traders are unfair simply because they have clear advantages
in speed and processing capacity over other investors. However, some manipulative uses
of HFT are unfair.63 More accurately, if the HFT strategies exercise monopoly power,
either created through OBM or endowed by monopolistic positions, in trading, the gained
profits are monopolistic. Very likely they are unfair. Furthermore, they may be illegal.

Instability potential

HFT makes spoofing and other manipulative practices much more frequent and pervasive
today.5 HFT strategies involving spoofing or other OBM tactics may ignite herding by
other investors. The herding can be fast and more frequent if HF traders are among the
induced crowd. Because HFT can ignite and maintain superfast downward herding or that
would also be measured as serial correlation, it could increase the risk of a sharp price
swing with or without the arrival of any fundamental news. Therefore, HFT has more
potential to create a systemic risk.8,10,22,64 The Flash Crash on the New York Stock
Exchange in 2010 is one of the most severe events that disrupted the market stability. Such
events were caused or exacerbated by HFT.25

Instability has a more potent detrimental effect on market participants than volatility and
unfairness. Serious market instability incidents such as short-term crashes and sharp return
reversals catch numerous investors off guard and may result in steep losses. Thus market
instability is frequently linked to unexpected victimization of some market participants.
The rates of unexpected and large losses may be higher than those of losses due to
unfairness in trading. The extreme of market instability, marketwide crisis, may lead to
global financial crisis. The 2007-2008 global panic has caused more consequences in unfair
losses, unhappiness, and mental and physical health problems than any economic event
since World War II.1

In summary, it is not the trading technology itself but how to use the technology that
impacts the fairness and stability of the market.63 Furthermore, it is not how fast HFT
processes information or execute trades but the HFT strategy that creates and carries
monopoly power that is of concern.5 In response to the Flash Crash of 6 May 2010,
regulators in major economies have proposed or enacted new regulations to curb HFT and
mitigate OBM consequences. The Limit Up – Limit Down enacted by the SEC as well as
the maximum order-to-trade ratio and minimum resting time of displayed orders proposed
by the European Commission are good examples of such regulations.65-66 A number of
prosecutions against spoofing and other manipulative HFT tactics have been
completed.6,25,67 These enforcement actions provide evidence supporting the findings of
the above analysis.

Conclusions

This conceptual paper investigates the essence of quote-stuffing, spoofing, and market
making by HF traders based on a review of the empirical literature on HFT. By formally
defining OBM and analyzing its characteristics, as well as examining the complete picture
of market making volunteered by certain HF traders, this paper points out three different
paths toward achieving monopoly power in trading and one common purpose of gaining
monopolistic profit by the HF traders using the three manipulative tactics. Thus, it adds to
the debate that HFT is not a net liquidity provider. It then analyzes the consequences that
the three tactics have caused to other investors and the market. Increased volatility is one
concern, while increased frequency of unfairness is another. The most worrisome is the
instability potential that HFT can bring to the market. The recent regulatory improvement
includes new regulations and completed prosecution cases against manipulative HFT
tactics. They have implied the securities regulators’ concern for the sake of maintenance
of fair and orderly market.

References

1. Klein, L.R., Dalko, V. and Wang, M.H. (2012) Regulating Competition in Stock Markets:
Antitrust Measures to Promote Fairness and Transparency through Investor Protection
and Crisis Prevention. Hoboken, NJ: John Wiley & Sons.
2. Dalko, V. and Wang, M.H. (2016) Why is insider trading law ineffective? Three antitrust
suggestions. Studies in Economics and Finance 33(4): 704–715.
3. Kauffman, R.J., Liu, J. and Ma, D. (2015) Innovations in financial IS and technology
ecosystems: High-frequency trading in the equity market. Technological Forecasting and
Social Change 99: 339–354.
4. Biais, B. and Foucault, T. (2014) HFT and market quality. Bankers, Markets and
Investors 128(5): 5–19.
5. Partington, G., Philip, R., and Kwan, A. (2015) Is high frequency trading beneficial to
market quality? CIFR Paper No. 083/2015.
6. Sokol, N.E. (2016) High frequency litigation: SEC responses to high frequency trading
as a case study in misplaced regulatory priorities. Columbia Science and Technology Law
Review 17: 402–469.
7. Chlistalla, M., Speyer, B., Kaiser, S. and Mayer, T. (2011) High-frequency trading:
Better than its reputation? Deutsche Bank Research 7: 1–7.
8. Brogaard, J. (2010) High frequency trading and its impact on market quality. Kellogg
School of Management Working Paper No. 66.
9. Baron, M., Brogaard, J. and Kirilenko, A. (2012) The trading profits of high frequency
traders (risk and return in high frequency trading). 8th Annual Central Bank Workshop on
the Microstructure of Financial Markets, 25 October, Ottawa, Canada.
10. O’Hara, M. (2015) High frequency market microstructure. Journal of Financial
Economics 116(2): 257–270.
11. Commodity Futures Trading Commission and Securities and Exchange Commission
joint report (2010) Report of the staffs of the CFTC and SEC to the Joint Advisory
Committee on Emerging Regulatory Issues, Findings regarding the market events on May
6, 2010. 30 September, Washington DC.
12. Securities and Exchange Commission (2013) SEC charges Knight Capital with
violations of market access rule. Press Release, 16 October,
http://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539879795-.U_0aS7xd
XbV, accessed 3 June 2016.
13. Dalko, V., Klein, L.R., Sethi, S.P. and Wang, M.H. (2016) Existence of monopoly in
the stock market: A model of information-based manipulation. In: A.G. Malliaris, L. Shaw
and H. Shefrin (eds.) The Global Financial Crisis: Neglected Ideas from Economics,
Psychology, and Values. Oxford, UK: Oxford University Press, pp: 279–301.
14. Allen, F. and Gale, D. (1992) Stock-price manipulation. Review of Financial Studies 3:
503–529.
15. Egginton, J. F., Van Ness, B. F. and Van Ness, R. A. (2016) Quote stuffing. Financial
Management 45(3): 583–608.
16. Kuk, J., Liu, W. and Pham, P. (2009) Strategic order submission and cancellation in
pre-opening periods and its impact on price discovery: The case of IPO firms. AFA 2010
Atlanta Meetings Paper, Atlanta, GA.
17. Chan, C.-H. and Ma, K.C. (2014) Order-based manipulation: Evidence from Hong
Kong stock market. Journal of Financial Crime 21(1): 111–118.
18. Kong, D. and Wang, M. (2014) The manipulator’s poker: Order-based manipulation in
the Chinese stock market. Emerging Markets Finance and Trade 50(2): 73–98.
19. Gai, J., Yao, C. and Ye, M. (2013) The externalities of high frequency trading.
http://ssrn.com/abstract=2066839, accessed 29 March 2016.
20. Diaz, D. and Theodoulidis, B. (2012) Financial markets monitoring and surveillance:
A quote stuffing case study. http://ssrn.com/abstract=2193636, accessed 5 June 2016.
21. Brogaard, J., Hendershott, T. and Riordan, R. (2014) High-frequency trading and price
discovery. Review of Financial Studies 27(8): 2267–2306.
22. Biais, B. and Woolley, P. (2012) High-frequency trading.
http://www.eifr.eu/files/file8379010, accessed 16 May 2018.
23. Lee, E.J., Eom, K.S. and Park, K.S. (2013) Microstructure-based manipulation:
Strategic behavior and performance of spoofing traders. Journal of Financial Markets
16(2): 227–252.
24. Brush, S., Schoenberg, T. and Ring, S. (2015) How a mystery trader with an algorithm
may have caused the Flash Crash. Bloomberg News, 22 April.
25. Department of Justice (2016) Futures trader pleads guilty to illegally manipulating the
futures market in connection with 2010 “Flash Crash”. Office of Public Affairs, 9
November, https://www.justice.gov/opa/pr/futures-trader-pleads-guilty-illegally-
manipulating-futures-market-connection-2010-flash, accessed 3 July 2017.
26. Montgomery, R.H. (ed.) (1933) Financial Handbook, 2nd ed. New York: The Ronald
Press.
27. Securities and Exchange Commission (2010) Concept release on equity market
structure. Federal Register 75(13): 3609.
28. Martínez-Miranda, E., McBurney, P. and Howard, M.J. (2015) Learning unfair trading:
A market manipulation analysis from the reinforcement learning perspective. arXiv
preprint arXiv:1511.00740.
29. Securities and Exchange Commission (2004) Settlement reached with five specialist
firms for violating federal securities laws and NYSE regulations. 30 March,
http://www.sec.gov/news/press/2004- 42.htm, accessed 6 June 2016.
30. Stoll, H.R. (2006) Electronic trading in stock markets. The Journal of Economic
Perspectives 20(1): 153–174.
31. Saunders, A. and Cornett, M. (2007) Financial Markets and Institutions. New York:
McGraw-Hill Irwin.
32. Wyart, M., Bouchaud, J.P., Kockelkoren, J., Potters, M. and Vettorazzo, M. (2008)
Relation between bid–ask spread, impact and volatility in order-driven markets.
Quantitative Finance, 8(1): 41–57.
33. O’Hara, M. and Ye, M. (2011) Is market fragmentation harming market quality?
Journal of Financial Economics 100(3): 459–474.
34. Christie, W. G. and Schultz, P.H. (1994) Why do NASDAQ market-makers avoid odd-
eighth quotes? Journal of Finance 49(5): 1813–1840.
35. Khanna, T. and Sunder, S. (1999) A tale of two exchanges. Harvard Business School
Case Study, Cambridge, MA: Harvard University.
36. Zhou, C. and Mei, J. (2003) Behavior based manipulation. NYU Working Paper No.
FIN-03-028, http://ssrn.com/abstract=1299470, accessed 6 Jun 2016.
37. Khwaja, A.I. and Mian, A. (2005) Unchecked intermediaries: Price manipulation in an
emerging stock market. Journal of Financial Economics 78(1): 203–241.
38. Aggarwal, R.K. and Wu, G. (2006) Stock market manipulations. The Journal of
Business 79(4): 1915–1953.
39. Chaturvedula, C., Bang, N.P., Rastogi, N. and Kumar, S. (2015) Price manipulation,
front running and bulk trades: Evidence from India. Emerging Markets Review 23: 26–45.
40. İmişiker, S., Özcan, R. and Taş, B.K.O. (2015) Price manipulation by intermediaries.
Emerging Markets Finance and Trade 51(4): 788–797.
41. Specogna, M. (2003) A Convicted Stock Manipulator’s Guide to Investing. Lincoln,
NE: iUniverse, Inc.
42. Anderson, J. (2005) 15 specialists from Big Board are indicted. The New York Times,
13 April: C1.
43. Manaster, S. and Mann, S.C. (1996) Life in the pits: Competitive market making and
inventory control. Review of Financial Studies 9: 953–975.
44. Madhavan, A. and Sofianos, G. (1998) An empirical analysis of NYSE specialist
trading. Journal of Financial Economics 48: 189–210.
45. Manaster, S. and Mann, S. C. (1999) Sources of market making profits: Man does not
live by spread alone. Working paper, Texas Christian University.
46. Kurov, A. and Lasser, D.J. (2004) Price dynamics in the regular and E-mini futures
markets. Journal of Financial and Quantitative Analysis 39: 365–384.
47. Cai, F. (2009) Trader exploitation of order flow information during the LTCM crisis.
Journal of Financial Research 32(3): 261–284.
48. Cao, C., Hansch, O. and Wang, X. (2009) The information content of an open limit-
order book. Journal of Futures Markets 29(1): 16–41.
49. Biais, B., Foucault, T. and Moinas, S. (2011) Equilibrium high frequency trading.
Working paper, Toulouse School of Economics.
50. Madhavan, A. (2012) Exchange-traded funds, market structure and the flash crash.
http://ssrn.com/abstract=1932925, accessed 29 March 2018.
51. Kirilenko, A., Kyle, A.S., Samadi, M. and Tuzun, T. (2017). The flash crash: High‐
frequency trading in an electronic market. Journal of Finance, 72(3): 967-998.
52. Hendershott, T. and Riordan, R. (2009) Algorithmic trading and information. Working
paper, University of California at Berkeley.
53. Hendershott, T., Jones, C.M. and Menkveld, A.J. (2011) Does algorithmic trading
improve liquidity? Journal of Finance 66(1): 1–33.
54. Hasbrouck, J. and Saar, G. (2013) Low-latency trading. Journal of Financial
Markets 16: 646–679.
55. Boehmer, E., Fong, K.Y. and Wu, J.J. (2014) International evidence on algorithmic
trading. AFA 2013 San Diego Meetings Paper, 2 Jun, San Diego, CA.
56. Jones, C. (2013) What do we know about high-frequency trading? Research Paper No.
13-11, Columbia Business School.
57. Easley, D., Lopez de Prado, M.M. and O’Hara, M. (2010) The microstructure of the
“Flash Crash”: Flow toxicity, liquidity crashes and the probability of informed trading.
Journal of Portfolio Management 37: 118–128.
58. Menkveld, A.J. (2013) High frequency trading and the new market makers. Journal of
Financial Markets 16: 712–740.
59. Gomber, P., Arndt, B., Lutat, M. and Uhle, T. (2011) High-frequency
trading. http://ssrn.com/abstract=1858626, accessed 23 October 2017.
60. Zhang, F. (2010) High-frequency trading, stock volatility, and price discovery.
http://ssrn.com/abstract=1691679, accessed 19 June 2018.
61. Hanson, T.A. and Hall, J. R. (2012) Statistical arbitrage trading strategies and high
frequency trading. http://ssrn.com/abstract=2147012, accessed 21 April 2017.
62. Shefrin, H. and Statman, M. (1993) Ethics, fairness and efficiency in financial markets.
Financial Analysts Journal 49(6): 21–29.
63. Angel, J.J. and Mccabe, D. (2013) Fairness in financial markets: The case of high
frequency trading. Journal of Business Ethics 112(4): 585–595.
64. Chaboud, A., Hjalmarsson, E., Vega, C. and Chiquoine, B. (2009) Rise of the machines:
Algorithmic trading in the foreign exchange market. Federal Reserve Board International
Finance Discussion Paper No. 980, Washington, DC.
65. Dalko, V. (2016) Limit Up–Limit Down: An effective response to the “Flash Crash”?
Journal of Financial Regulation and Compliance 24(4): 420–429.
66. Dalko, V. and Wang, M.H. (2018) How effective are the order-to-trade ratio and resting
time regulations? Journal of Financial Regulation, 4(2): 321-325.
67. Rossi, M., Deis, G., Roche, J. and Przywara, K. (2015) Recent civil and criminal
enforcement action involving high frequency trading. Journal of Investment
Compliance 16(1): 5–12.