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HAL vs Watson

22 December 2014 By Reynolds Holding

A new test is coming for U.S. law: the first criminal case against an algorithm. The prosecution of an energy trader essentially turns on whether one computer program duped another. Proving intent seems futuristic at best where software is the de facto defendant.

There’s little doubt that Michael Coscia’s program engaged in “spoofing,” the practice of placing and quickly cancelling big futures-contract orders in the hope that prices will move to where a trader can profitably buy or sell other contracts. The question, though, is whether the accused trader intended to fool his counterparts.

The answer isn’t obvious. Prosecutors claim Coscia designed the algorithm, which amounts to circumstantial evidence that he meant to lie about what bids and offers were available. But high-frequency traders often cancel the vast majority of their orders – in April, broker Charles Schwab claimed in a critical statement that this cancellation rate was above 95 percent in 2013. Such high figures make it hard to argue that Coscia believed he could deceive other market participants. In any event, many of them were probably other computers using similar strategies.

What’s more, the software operated largely automatically. Coscia may have been responsible for its actions, but a criminal conviction requires proof that those actions were intended to defraud the market rather than just earn a profit. That’s a tall order without direct evidence like emails.

Similar challenges arise in other areas of the law. Best Buy, Wal-Mart and assorted online retailers, for example, increasingly use sophisticated algorithms to determine prices. If those prices are set at anticompetitive levels, trustbusters may not be able to do much about it. That’s because price fixing generally isn’t illegal without proof of collusion – evidence that rarely exists when computers are involved.

In any event, the benefits of fast, efficient pricing may outweigh any risk of competitive harm. And in financial markets, it’s not clear that watchdogs should worry about whether traders are faking each other out.

Yet market integrity is worth protecting – sometimes with criminal prosecutions. The trick will be applying the law when humans take a backseat to computers. With Coscia potentially headed for trial in 2015, judges and juries may face that challenge sooner than they expect.

This view is a Breakingviews prediction for 2015. Click here to see more predictions.

 

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