Fighting Finagling in Financial Markets
It’s a new crime but it isn’t new. It has a silly name but it’s no joke. Spoofing, a way to manipulate financial markets for illegitimate profit, is blamed for undermining the integrity of trading and contributing to the scariest crash since the financial crisis. Spoofers trick other investors into buying or selling by entering their own buy or sell orders with no intention of filling them. That creates fake demand that pushes prices up or down. Long considered disreputable but rarely dangerous, spoofing has emerged in an era of computerized trading as a threat to market legitimacy. Regulators, lawmakers and market authorities are struggling to define and control it.
In November, a British futures trader, Navinder Sarao, pleaded guilty to spoofing charges in U.S. federal court in Chicago after losing an extradition battle. Sarao had been arrested in suburban London in April 2015 after U.S. authorities said his activities had contributed to the flash crash of May 2010, when almost $1 trillion was temporarily wiped out in the U.S. stock market. In July, high-speed commodities trader Michael Coscia, was sentenced to three years in prison by a U.S. judge in Chicago. It had taken a jury only an hour to convict him in November 2015. While reports of spoofing in U.S. stocks date to 1999, Coscia and Sarao were the first two people criminally charged under the 2010 Dodd-Frank financial reform law. Another trader was charged in a civil suit filed in October by the Commodity Futures Trading Commission. Bond markets are vulnerable too; that’s why guidelines for the $12.6 trillion U.S. Treasury market were changed to say that investors may not place trades “that give a false impression” of what’s going on. New York Attorney General Eric Schneiderman has also begun investigating possible spoofing in currency markets.
Traders have always used bluffs to gauge where prices are heading. What’s changed is that they no longer stand face to face, buying and selling with hand signals on trading floors. Now they watch numbers on a screen. When trading was done in a pit, bad behavior was easier to identify and avoid. In the electronic age, computer programs can flood markets with fake orders. For example, Sarao is accused of changing or moving futures contracts more than 20 million times on the day of the flash crash, while the rest of the market combined totaled fewer than 19 million actions. Rooting out spoofing is paramount for regulators and exchange operators to convince investors that markets are fair. In the U.S. stock market, the Securities and Exchange Commission has had the authority to punish spoofing as a civil violation since the 1930s. To help police futures markets, which are overseen by the CFTC, the Dodd-Frank Act defined spoofing and made it illegal in 2010. The currency investigation in New York involves a different form of spoofing, also known as ghosting, in which brokers may create and cancel orders to ramp up investor interest by making a market seem more active than it is.
Government regulators and operators of exchanges are outgunned by sophisticated and well-financed manipulators. CME spends $45 million a year to police traders, yet has been criticized by the CFTC for not doing enough to catch spoofers. CME says it has improved its software and in May suspended two traders it accused of spoofing gold and silver markets. Earlier that month, CFTC Commissioner Mark Wetjen said his agency should have access to real-time order and messaging data to better detect spoofing. That would be a big change, since it has always relied on CME to police its own market. Traders argue that the definition of spoofing remains too vague, making it hard to distinguish it from legitimate order cancellations. (It’s perfectly legal for a trader to change her mind.) Prosecutions of spoofing have to show that traders intended in advance to cancel their orders. In the Coscia case, for example, prosecutors said his intent was shown by computer programs written to cancel orders automatically. Some argue that the main victims of fake orders placed and withdrawn within milliseconds are high-frequency traders who have been blamed for a variety of market woes themselves, and many doubt that Sarao could have done more than contribute to the flash crash. Sarao gave his perspective in May 2015, when he shouted to a London courtroom, “I’ve not done anything wrong apart from being good at my job!”
The Reference Shelf
- A Bloomberg interactive graphic illustrates how regulators try to catch spoofers.
- Read the text of the Dodd-Frank ban on spoofing and the CFTC’s interpretive guidance.
- Read the CFTC complaint against Sarao.
- An article in the 2013-14 issue of the Review of Banking and Financial Law analyzed recent spoofing laws.
- Bloggers at Zero Hedge explain how some market participants try to root out spoofers.
First published June 23, 2015
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Matthew Leising in New York at email@example.com
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