Marking the Close – Old Fraud by New Means

trader computer

The US Security and Exchange Commission (SEC) recently fined a high-frequency trading firm a cool $1 million to settle charges that the firm had used their sophisticated algorithmic trading system to “mark the close” or “bang the close.”

“Marking the close” is a form of market manipulation.  Simply put, the practice is an attempt to influence the closing price of a security by executing purchase or sale orders just prior to the close of trading.  Such a rush of orders can artificially inflate or depress the closing price for the security and impacts orders that are to be executed at the closing price.

Rule 10b-5: Employment of Manipulative and Deceptive Practices

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a)     To employ any device, scheme, or artifice to defraud,

(b)     To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c)     To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Such tactics are nothing new but technology has added some disturbing new concerns.

This recent fine is the first example of high-frequency trading manipulation that has come to light.  It won’t be the last.  It is critical that all securities firms, high-frequency traders included, understand the rules against deceptive trading.

What Constitutes a Violation?

There are 4 key elements regulators must establish to prove a Rule 10b-5 violation:

  1. Manipulation or Deception (through misrepresentation and/or omission)
  2. Materiality
  3. “In Connection With” the purchase or sale of securities
  4. Scienter (knowledge of wrongdoing)

Internal emails at the sanctioned firm referred to “owning the game,” and the algorithm used was named “Gravy.”   For a six-month period in 2009 the firm’s trading made up more than 70% of the total NASDAQ trading volume of the affected stocks in the seconds before the market closed. These supported the government’s contention that the firm was aware of the attempt to manipulate the market.

While the firm ultimately agreed to pay the fine without admitting guilt, it is clear that the SEC will be monitoring end-of-day trading more carefully than ever – particularly in light of today’s high-speed trading capabilities and sophisticated algorithms.

In my experience, compliance officers will have a difficult job ahead because traders may not use regulatory terms like “mark the close” or “bang the close,” but more trading vernacular – such “owned,” “dominated,” or “stuffed.”  Without careful attention market manipulation can look like smart trading to the untrained eye, and technology can also help mask the violation.

Beware, just because your firm’s trading is done via an electronic program or algorithm does not mean it is not manipulating the market or in violation of Rule 10b-5.

About Richard Magrann-Wells

Richard is a Executive Vice President with Willis Towers Watson’s Financial Institutions Group based in Los Angel…
Categories: Financial Services | Tags:

Leave a Reply

Your email address will not be published. Required fields are marked *