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Norwegian traders guilty of market manipulation against robot

November 2010 - Litigation & Dispute Resolution. Legal Developments by Wikborg Rein.

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Norwegian traders found guilty of market manipulation against automated trading system

Two Norwegian retail traders received suspended sentences on 12 October for imprisonment by Oslo City Court for market manipulation in trades executed against an automated trading system on the Oslo Stock Exchange. The traders worked out the robot's trading pattern, pushed prices by executing a series of small transactions against the robot during a short period of time before positions were reversed and profit was taken. The ruling has already attracted international attention and made the front page of the Financial Times yesterday.

Trading pattern of the investors
The retail traders were convicted of market manipulation in relation to around 70 trades they conducted in illiquid stocks on the Oslo Stock Exchange during November 2007 - March 2008. The traders exploited a weakness in the algorithm of counterparty Timber Hill, a European brokerage entity acting as market maker for the US parent company, Interactive Brokers. Observing that this market maker systematically responded in an identical manner to certain specific trading patterns, the traders started off placing one large bid in an illiquid stock at a certain price level. Once matched, the identity of the counterparty to the transaction was disclosed to the traders, and a series of small volume trades were thereafter conducted by the traders in the same stock against the same counterparty at increasing price levels. When prices had reached a certain level the traders reversed their positions and took profit against the market maker. All transactions were executed within very short time spans, typically within a couple of minutes.

Over-simplistic programming of robot
The traders noted that the market making robot always raised (or lowered) its bid and offer prices subsequent to trades executed at an increased (or lowered) price level. The spread between the bid and offer prices was small, the market maker's changes in their bid and offer prices were always equal and no account was taken by the robot of the volumes that had been traded. Hence, the traders knew from experience that the over-simplistic programming of the robot would enable them to push prices in a given direction very quickly before they could reverse their positions with profits. The low liquidity and absence of other significant investors trading in the stock therefore allowed the traders to outsmart their counterparty at a very low risk when the trading was executed rapidly.

Trading pattern misled market and kept prices at abnormal level
Both traders were found guilty of market abuse and sentenced respectively to 3 and 4 months suspended imprisonment as well as confiscation of all gains from the illicit trades. Despite the fact that all the traders' orders and transactions had been real and non-fictitious, the large number of smaller transactions were held to have had no legitimate purpose. These trades were not regarded as representing genuine sale and purchase interests in the market, and prices were only seen as an expression of the traders' attempt to trick the market making robot into mispricing the stock at a level where the traders could reverse their positions with profit. The Court therefore held that the traders' orders and transactions had misled the market about the price of the stock. The orders and transactions carried out with the purpose of generating changed bid and offer prices from the market maker were also regarded as having secured the prices of the stock at an abnormal or artificial level, albeit for a very short period of time.

Situation caused by the traders or by the robot?
Counsel for the defense claimed no causal connection existed between the traders' actions and the influenced market prices, arguing that the market maker robot - by constantly changing its bid and offer prices - had itself moved market prices. This argument was rejected by the Court. The traders knew in advance how their counterparty would react and they sought actively to provoke the robot into changing its bid and offer prices.

Defending the robot or the market?
The ruling has been criticized for protecting the robot of a professional brokerage firm arguing that such players should be responsible for their own poor algorithms. The ruling, however, does not convict the traders of having misled their counterparty, but of having caused damage to the market as such. While direct consequences to other market participants were minor, the ruling states that the traders' actions temporarily led to a high degree of volatility in the stock and that such behavior, - if accepted - could destroy investors' confidence in the market. The Court therefore disagreed that the traders had been contributing to increase market efficiency and stated that there is a need to punish this type of behavior in order to protect the integrity of the market place.

The convicted traders have announced that they will appeal against the ruling. The ruling raises a debate on how the line should be drawn between acceptable clever trading and market abuse. Possibly, the lesson to learn from the ruling is that low risk trading with advance knowledge of price movements is not risk free.


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