Nov. 6: Updates with response from DRW.
In what may be the opening salvo in its war with high-frequency traders, the Commodity Futures Trading Commission just took aim at the 1,000-pound gorilla in the room. In a complaint (pdf) filed Wednesday, the CFTC charged DRW Investments, one of Chicago’s biggest high-frequency trading firms (and among the biggest in the world), with conducting a manipulative trading scheme that netted it a profit of at least $20 million in 2011.
The CFTC alleges that DRW, at the behest of its chief executive officer and founder, Donald R. Wilson, used a strategy dubbed Banging the Close. Here’s how it works: A firm will put on a position in a particular market and then use a flurry of fake orders at the end of the day to move prices in its favor. In this case, around July 2010, the CFTC alleges that DRW acquired a long position in an interest rate futures contract in excess of $350 million. DRW was betting that interest rates would rise over the three-month duration of the contract, sending the price of the contract higher.
For its part, DRW says it entered fair orders it had every intention on filling.
By December 2010, the price of the contract hadn’t moved much, largely because “significant trading never materialized,” according to the complaint. Also, interest rates weren’t budging in any market back then. According to the complaint, “Wilson and DRW took matters into their own hands” and “developed and executed a manipulative scheme … by injecting bids that DRW knew would never be accepted, and in turn increase the value of DRW’s positions.”
The idea of a Bang the Close strategy is to fake the rest of the market into thinking there is a big order coming down the road and that prices are going to move in one direction or the other. HFT firms that are good at Banging the Close can fire off thousands of orders in a few microseconds, only to cancel them just as quickly. The intent is to give other traders the false impression that lurking behind all those orders is a huge institutional player coming into the market to either buy or sell. As a result, people want to get out in front of that big order and buy up contracts they can later sell to that big buyer for a slightly higher price. The result is that prices can jump more than they would’ve otherwise.
The CFTC alleges that DRW put in lots of fake bid orders at higher interest rates to try to drive the price of the futures contract higher. In this case, DRW’s orders were entered more slowly over a longer timeframe, though the CFTC complaint focuses on a 15-minute window when the contracts settled each day. The strategy was executed over the course of at least 118 days, according to the complaint, and netted DRW “unlawful profits of at least $20 million.”
In September, DRW sued the CFTC in a preemptive attempt to stop it from bringing the case. In that suit, filed in federal court in Chicago, DRW argues that the CFTC’s lawsuit is unconstitutional in that back when these trades were executed, there were no rules qualifying them as illegal.
In a statement issued today, DRW said, “The CFTC has yet to file a formal response to DRW’s complaint in the Chicago case. Today, before giving the Chicago court a chance to consider the issues, the CFTC brazenly filed its enforcement action in the U.S. District Court for the Southern District of New York.”
In a CFTC filing on Nov. 4, the commission stated that it would move to dismiss DRW’s complaint. The suit is still in progress.
By taking aim at Wilson, the CFTC has decided to call out one of the titans of high-frequency trading. According to a 2011 Financial Times article, HFT accounts for about a quarter of DRW’s business. The 45-year-old Wilson started as an option trader in 1989 and founded DRW when he was just 24. Making it even more awkward is that Wilson serves as a member of the CFTC’s Global Markets Advisory Committee.