SEC Charges HFT Firm with Fraudulent Trading to Manipulate Closing Prices
sec.gov
sec.gov
How they did it - shill bidding.[1]
Why this is illegal - You aren't allowed to manipulate the market.
Why the regulator acted - They needed to make an example of a HFT firm as there is a perception that HFT firms manipulate the market but regulators don't understand and therefore can't regulate them.
My take - This was 'low hanging fruit' and an 'easy win'. Obviously market participants need to trust in the integrity of the market prices and I think the firm in question made it obvious what they were doing. I'm skeptical that the SEC will catch the 'big boys' who are a heck of a lot better at covering their tracks.
[1] See the auction section of the Wikipedia page here: http://en.m.wikipedia.org/wiki/Shill
It seems to me, that unless the penalty is _more_ than what you made, then it doesn't do anything to discourage these practices.
I looked at Rule 10b-5 and that wasn't helpful, so presumably the answer is in the case law?
Okay so in a simple model of the market you have buyers, sellers and market makers who are supposed to step in when there are buyers but no sellers, or are supposed to step in when there are sellers but no buyers.
A key function of the market is to answer the question, "what is something worth?" Through buying and selling, aka price discovery, this question is answered.
However, what if you wanted to manipulate the price? Well to gain you would have to make prices cheaper if you're a buyer or make prices more expensive if you're a seller. Obviously your gains will be at the expense of someone else which isn't fair because the person taking the opposite side of the trade is acting in good faith that you are giving them a fair price.
In this case it's like artificially creating scarcity so that the price goes up or artificially creating over-supply so the price goes down.
Normally you cannot do this sort of thing. If you tried the market would adjust as other market participants react to your actions. However this firm was exploiting how orders were filled at the close.
The best analogy I can think of is the following scenario:
Imagine that you need something at the supermarket but it closes soon and just before the shop closes they suddenly remove stock from their shelves so it looks like there aren't anymore goods. Well the remaining customers are in a bind, the shop is closed. Just as you walk out you are offered what you wanted but for a higher price, which you pay because you figure that's the last one and you need it. Except it's not the last one and you got ripped off.