High-frequency trading: Considerations and risks for pension funds

Potential negative effects of the subset of automated algorithm-based trading known as high-frequency trading have recently generated significant attention, including congressional hearings, regulatory investigations, lawsuits and widespread media coverage.

The most general allegations are well known. Certain exchanges and other trading venues are alleged to have created trading environments where high-frequency traders use sophisticated technology (e.g., cutting-edge hardware, software, bandwidth and location access) combined with advance access to market data to trade ahead of other market participants (including pension funds) by milliseconds, causing those participants to buy or sell at artificially increased or decreased prices. Trading venues have purportedly lured market participants into those predatory environments through misleading marketing materials or by paying kickbacks to brokers to execute clients' trades in those venues.

A fiduciary to a pension fund should carefully consider whether and how the fund may have been harmed by HFT and related practices. This includes considering whether such practices violate legal duties owed to the fund, by whom those duties are owed, and the existence and extent of harm the fund may have suffered.

Recent Developments: Where Are We Now?

Since the publication of Michael Lewis' book "Flash Boys" in March 2014, a flurry of activity has occurred involving both governmental entities and private litigants, alleging that HFT and related practices have unlawfully harmed investors, examples of which are set forth in Table A below. Numerous investigations have begun and a number of lawsuits are pending (with more likely to be filed). Thus far, regulators and private litigants have proceeded under different legal theories.

Given the alleged actions of brokers, exchanges and HFT firms that may have caused unlawful harm to investors, what issues should pension funds consider?

1. What types of funds may have suffered meaningful harm?

While allegations of the unlawful impact of practices related to HFT have been thus far limited to equities markets, published reports have also explored similar practices and impact in commodities, futures and foreign exchange markets. Funds invested in these markets may have been harmed.

The impact, if any, of improper practices related to HFT on a single market participant likely depends on the volume of its participation in the market. HFT is founded on speed and the execution of hundreds of thousands of trades per second and, therefore, the potential impact by high-frequency traders could be as little as pennies per share traded. Where a fund is a large market participant, however, the impact could still be meaningful.

2. How should a fund investigate whether and how it has suffered harm?

A fund should consider analyzing a sample of its own trading data, including the quality of brokers' execution of its trades, and thus determine the existence and impact of improper manipulation or predation. For example, by working with advisers (including, in some instances, counsel and economic experts), a fund could analyze:

• The fund's past bids, offers and executions for a particular period (e.g., for a week, month or quarter);


• Publicly available and proprietary data concerning the best bids or offers available at the time of the fund's bids and offers;


• Market routing practices of the broker or other entity executing the fund's trades; and


• The proportion of trades by high-frequency traders among all participants at the venues in which the fund's trades are executed.

3. What steps should a fund consider if it believes it has sustained harm?

If a pension fund believes it has sustained material harm in connection with HFT practices, when considering potential avenues for recourse, a fund must consider what entities owe duties to the fund, as these are the entities most likely to be liable for such harm. Brokers, investment managers and others in whom the fund has placed trust likely owe such duties. Third-party exchanges and HFT firms are unlikely to owe similar duties to pension funds and, therefore, unlikely to have breached such a duty. However, those third-parties can be liable to a fund if they have aided and abetted breaches of duties owed to the fund by others.

The duties that a fund's service providers may owe the fund include:

• Keeping the fund's information confidential;


• Making only choices that serve the fund's best interests;


• Providing the fund with complete and truthful information about how its trades are executed;


• Protecting the fact of the fund's orders, purchases and sales from being known or exploited (e.g., by other parts of the broker's firm, such as by use of that data in an order routing algorithm); and


• Executing the fund's orders in a manner and at a venue most likely to provide the fund with best execution (including by avoiding venues where predatory activity is likely).

A fiduciary can take steps to understand how those acting on behalf of the fund have protected or failed to protect the fund's interests. Among other things, a fund manager should understand:

• How a broker determines the manner in which to execute trades on behalf of the fund;


• How the broker keeps the fund's trading information confidential, including segregation from other parts of the broker's business;


• How a broker determines the venue in which trades are executed, including whether such determinations consider rebates paid by venues to the broker and what impact those rebates may have on the quality of execution of trades; and


• In what venues the fund's trades have been executed.

If, after such analysis, a fund believes that its potential damages are material and steps taken by its agents to protect it were potentially inadequate, the fund may consider various avenues for legal recourse.

A fund is most likely to establish a breach of duties owed by parties with which the fund has a direct relationship (e.g., the fund's brokers) rather than a violation of the securities laws by third parties who are more removed from the fund (e.g., third-party HFT firms). However, state and federal securities laws prohibit all participants in trading markets from manipulating those markets. To the extent that exchanges, HFT firms or others have created unfair market structures (e.g., by allowing high-frequency traders access to market data before other participants and then luring those other non-high-frequency participants to trade against the high-frequency traders), those participants may have violated securities laws at the expense of other investors, including pension funds.

Some investors can obtain significant benefits by opting out of a class and bringing their own separate lawsuits. The pending class actions, which purport to include every entity or person that has traded stock on any U.S. exchange since April 2009, face the difficult if not impossible task of demonstrating how every allegedly deficient trade should have been executed. This task may be more manageable for a single plaintiff than a massive class, as long as the single plaintiff has sufficient trading volume to make the lawsuit worthwhile.

As an individual, rather than as one part of a larger class, a fund may also be in a better position to explain its trading strategy and patterns to demonstrate the harm caused by a defendant's wrongful acts and to tailor its litigation strategy to those facts. An individual fund can also focus on certain fact-specific claims not available to the entire class. For example, an opt-out plaintiff fund might consider claims against agents (e.g., brokers) who have breached duties owed to that plaintiff but not to the class, such as if brokers or investment managers have funneled a fund's trades to exchanges or dark pools despite that execution at those venues was not in the fund's best interest.

Finally, to the extent a fund decides to remain a passive participant in a class action and to determine whether to opt out at a later date, it should be aware that recent U.S. Supreme Court case law has limited the ability of putative class members to argue that the existence of a class action has tolled the statutes of limitations applicable to its individual claims. By deferring a decision to opt out, a fund risks allowing its individual claims to become time-barred.