Wall Street to Get Graded on How Much Spoofing It's Facilitating

2015: The Year Spoofing Went Mainstream
  • Finra plans `report cards' on potentially manipulative trading
  • Regulator's assessments are meant to root out wrongdoing

U.S. regulators have grown so concerned that traders are using high-speed computers to manipulate markets that they’re planning a new tactic to clamp down on the practice -- rating brokers on how much spoofing flows through their order books.

The Financial Industry Regulatory Authority said it plans to issue report cards this year that will grade firms on how many phony bids to buy or sell stock they might have a role in facilitating. Finra, a market cop funded by Wall Street, expects brokers to use the assessments to root out any misconduct, the regulator said Tuesday in its annual letter on exam priorities. The reports won’t be made public.

QuickTake Spoofing

Spoofers flood a market with fake orders that entice other traders to change their posted prices, then cancel their orders and profit by buying or selling at the artificially low or high prices they induced. Finra’s plan to write up report cards shows how deeply regulators fear the bait-and-switch has infected trading following high-profile cases such as that of London’s Navinder Sarao, who was arrested in April after authorities accused him of spoofing that contributed to the 2010 flash crash for U.S. stocks.

The report cards will flesh out cases in which Finra suspects a trader has spread their phony orders across different brokers, mainly to obscure the strategy from Wall Street firms and regulators. The assessments will focus on spoofing and another abusive practice known as layering, which also involves traders submitting orders that they have no intention of following through on.

“The persons that are doing this are becoming more sophisticated and they are using multiple firms to effect their strategy,” Finra chief executive officer Rick Ketchum said in an interview Tuesday.

Rigged Markets?

Efforts to reduce spoofing have gone global with both Chinese securities regulators and U.S. presidential hopeful Hillary Clinton proposing that traders pay a fee for habitual order cancellations. For every 27 orders placed on U.S. stock exchanges, about one is filled, according data from the U.S. Securities and Exchange Commission. In other words, approximately 96 percent of all orders sent to U.S. equity markets are never executed.

Finra’s responsibilities include monitoring trading and quote submissions across all U.S. stock exchanges for suspicious activity. The agency last year referred the largest number of incidents of suspected spoofing in its history to the SEC, Ketchum said. In 2014, Wedbush Securities Inc. admitted wrongdoing in agreeing to pay $2.44 million to settle SEC claims that it didn’t have policies to prevent customers from routing manipulative orders through the firm’s trading platforms.

“It’s a meaningful problem,” Ketchum said. “Our tools are more sophisticated now so we are identifying more of the actual efforts.”

Critics of high-frequency trading cite the high number of canceled orders as evidence that markets are unfair, or worse, rigged.

But some academics and financial firms argue that spoofing can actually be used as a defense against manipulation and that only traders using super-fast computers are hurt by it. Because spoofing usually happens in milliseconds, traders with longer time horizons usually can’t react to the rapid-fire price quotes.

Bond Markups

Some high-frequency traders have also said that restricting order cancellations might unfairly punish firms that are innocently using computer formulas to update the prices at which they offer to buy and sell securities. The firms argue that they have to withdraw orders because the speed at which stock markets now move makes many quotes irrelevant almost immediately.

The first report cards will be sent to brokers as soon as next month, Ketchum said. They will be sent to firms “where we are seeing a lot of this activity,” he added.

“The first line of defense is always the firms,” Ketchum said. “The best way to stop this is for the firms to refuse to do business” with traders trying to manipulate markets.

Finra also plans to continue examining price markups on corporate bonds sold to retail investors, Ketchum said. The effort focuses on instances in which bond dealers match retail buyers and sellers without assuming much risk themselves while extracting a commission that isn’t often disclosed to customers.

Finra plans to issue a related rule proposal for approval by the SEC within two months that would require disclosure of markups on customer documents, he said. The agency is trying to harmonize its proposal with one drafted by the Municipal Securities Rulemaking Board, which oversees trading rules for municipal bonds.