Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Secret deals between exchanges and traders: securities fraud implications

Dolgopolov has a nice paper on the conditions under which secret arrangements between exchanges and high frequency traders might or might not constitute securities fraud. Modern exchanges use complex order types and intricate order hiding and matching rules, and they could claim that any bugs or flaws in their trading protocols are honest implementation mistakes. Smart traders who exploit these trading imperfections and frictions could simply claim to be skillful beneficiaries who discovered the bugs by their own effort. In many cases, there appears to be collusion between the exchange and the HFT firms (the exchanges often disclose undocumented features and bugs privately to their best customers in return for getting more business from these firms), but this is not easy to prove. Dolgopolov proposes legal theories under which securities fraud liability could be imposed on the HFT firms themselves.

For over a decade now, I have been arguing for a different solution: regulators should mandate that critical exchange software be open source (here, here, here and here). At the risk of sounding like a broken record, I would like to reiterate my view that “regulators and self regulatory organizations have not yet understood the full power of the open source methodology in furthering the key regulatory goals of market integrity.”


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