Implied Contract

In the realm of algorithmic trading, understanding all the legal implications of the transactions and agreements that take place is of paramount importance. One key area that traders and firms need to be familiar with is the concept of an implied contract. This in-depth examination will cover the definition, forms, application, and legal context of implied contracts, particularly focusing on their relevance and role in algorithmic trading.

Definition of Implied Contract

An implied contract is an agreement that is not expressly stated in words or writing, but is assumed to exist based on the actions, behaviors, or circumstances of the parties involved. Unlike explicit contracts, implied contracts are formed through the conduct of both parties, and their terms are inferred from their interactions and the situation.

There are generally two types of implied contracts:

1. Implied-in-Fact Contract: This type of contract arises when the circumstances imply that the parties have reached an agreement based on their behavior or actions. It is formed by non-verbal conduct rather than explicit words.

2. Implied-in-Law Contract (Quasi-Contract): This is not actually a contract but is a legal substitute formed to impose equity between the parties. It is created by the court to prevent unjust enrichment when one party benefits unfairly at the expense of another.

Forms of Implied Contracts

Implied-In-Fact Contracts in Algorithmic Trading

Implied-in-fact contracts in algorithmic trading can arise under several circumstances:

• Trading Practices and Routines: For example, if two parties frequently trade with each other in a particular manner and have established a consistent routine without formal documentation, their conduct may form an implied contract. Their repeated behavior suggests mutual consent to the terms of trading.

• Communication Patterns: In the digital age, many communications in trading are automated. Actions such as algorithmic bidding, offering, or accepting trades can imply a contract based on the established patterns and practices followed by the trading algorithms.

Case Study: High-Frequency Trading (HFT)

High-Frequency Trading (HFT) involves the use of sophisticated algorithms to transact a large number of orders at extremely high speeds. Within this context, implied contracts become particularly relevant because:

• Latency Arbitrage: When two HFT firms engage in latency arbitrage, the very act of repeated interactions based on price discrepancies and millisecond timing can create an implied contract scenario, where it is assumed that one firm will continue to fill orders based on the established pattern of behavior.

• Algorithmic Matching Engines: When using algorithmic matching engines provided by exchanges, the implied agreement between the algorithm users and the exchange’s automated system facilitates the smooth execution of trades without the need for explicit contracts for each transaction.

Implied-In-Law Contracts in Algorithmic Trading

An implied-in-law contract or quasi-contract might be invoked in algorithmic trading under circumstances where one party benefits unjustly:

• Erroneous Trades: If an algorithm erroneously executes trades that result in a substantial benefit to one party at the unintentional and significant loss to another, courts may establish an implied-in-law contract to rectify the unfair advantage gained.

• System Failures: In cases where technology or system failures lead to unexpected and unfavorable trades, the rectification might be handled through the establishment of quasi-contracts to ensure equity.

Legal Context of Implied Contracts in Algorithmic Trading

Jurisprudence and Precedents

The legal framework governing implied contracts is foundational yet complex. Various legal precedents help in understanding how courts might interpret implied contracts:

• Case Law and Rulings: Numerous judgments have formed the basis of how implied contracts are viewed. These cases often involve an analysis of the relationship, behavior, and circumstances surrounding the interactions.

• International Trade Law: Given the global nature of algorithmic trading, understanding the implications of implied contracts under different jurisdictions is crucial. The interpretation can vary significantly across countries, affecting how an algorithmic trader might operate internationally.

Regulatory Environment

Regulatory bodies around the world have set guidelines that indirectly affect implied contracts in algorithmic trading:

• SEC and FINRA Regulations (USA): The Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority (FINRA) regulations stipulate the conditions under which trading activities occur. Compliance with these regulations can imply contract terms indirectly.

• MiFID II (Europe): The Markets in Financial Instruments Directive II (MiFID II) mandates transparency and fairness in trading. Algorithmic traders must ensure their systems comply with these regulations, again forming an implied contractual obligation through adherence.

Example: Flash Crash of 2010

The Flash Crash of May 6, 2010, is a pivotal event often cited in the context of algorithmic trading and the legal implications of implied contracts. During the crash, major US stock indices plunged and recovered within minutes. The event illuminates various elements of the implied contract in algorithmic trading:

• Market Integrity: The rapid fluctuation highlighted the implied agreements that trading algorithms had with exchanges to maintain market stability, despite the lack of explicit contracts addressing such extreme scenarios.

• Regulatory Response: Subsequent investigations and regulatory responses underscored the importance of implied contracts, with new rules such as the SEC’s “Circuit Breakers” to automatically halt trading under certain conditions. These rules create an implied contract for algorithmic traders to comply with market integrity standards.

Applications in Algorithmic Trading

Managing Counterparty Relationships

In the context of algorithmic trading, managing relationships with counterparties often involves implied contracts:

• Broker-Dealer Agreements: Firms frequently interact with broker-dealers to execute trades. While explicit contracts exist, the day-to-day operations may rely heavily on implied agreements about order execution quality, algorithm behavior, and pricing.

• Liquidity Providers: Relationships with liquidity providers can form implied contracts where the provider is expected to offer a certain level of liquidity based on historic interactions, even if not formally documented.

Risk Management

Proper risk management in algorithmic trading also involves recognizing the existence of implied contracts:

• Margin Requirements: Implied contracts play a role in margin requirements. For example, if a trading firm regularly meets margin calls from a broker, it implies a contractual expectation of maintaining margin levels even if not explicitly stated.

• Algorithm Testing and Deployment: When deploying algorithms, firms must ensure that the behavior of their algorithms aligns with market norms and expectations, forming an implied contract of compliance with market standards.

Enforcing Implied Contracts

When disputes arise, enforcing implied contracts requires robust legal arguments supported by evidence of conduct and industry practice:

• Documenting Interactions: Traders and firms should document interactions and behaviors that could form the basis of an implied contract, such as routine communications and transaction records.

• Expert Testimony: Expert testimony in algorithmic trading can provide insights into standard practices and norms, helping to establish the existence and terms of an implied contract.

Conclusion

Implied contracts play a significant role in the ecosystem of algorithmic trading. Their presence might not always be overt, but their influence permeates through various facets of trading activities. Understanding the forms, applications, and legal contexts of implied contracts helps traders and firms navigate the complex landscape, ensuring smoother operations and mitigating potential legal disputes.

For algorithmic traders, recognizing and respecting the principles of implied contracts is crucial for maintaining trust, compliance, and integrity in the fast-paced, technology-driven trading environments. By fostering a deeper comprehension of these unwritten agreements, the algorithmic trading community can better anticipate and adapt to both market dynamics and legal expectations.