Spoofers Keep Markets Honest
In financial markets, to “spoof” means to make a bid or offer for a security or commodity with the intent of cancelling the order before it is executed. It is designed to create a false sense of investor demand in the market, thereby changing the behavior of other traders and allowing the spoofer to profit from these changes. It is illegal under federal statute. In late 2014 and now this past week, federal prosecutors indicted traders for violating anti-spoofing laws. Both indictments include vivid portrayals of ostensibly deceptive practices that generated profits by “tricking” the market.
Until I retired in 2012, I was one of the largest traders of commodity futures. I am intimately familiar with every major commodities trading strategy and witnessed firsthand the evolution of these strategies in the course of my career. I was never a spoofer, nor was anyone in my firm. But I don't believe spoofing should be outlawed. Just the opposite: Given how markets now function, I believe that spoofers are beneficial.
As a threshold matter, it is important to address the confusion and negative perceptions surrounding high-frequency trading, which has been the subject of endless debate. High-frequency trading is simply the use of predetermined computer algorithms (as opposed to a human) to execute trades. HFT is a methodology for trading. It isn't a trading strategy. Some excellent trading strategies employ HFT, as do some exceedingly bad ones. Overall, most strategies that rely on algorithmic trading, including those that use HFT, increase market efficiency -- and they often benefit the market by adding liquidity.
There are, however, some trading strategies that use HFT in a manner that is disruptive and costly to humans trying to conduct real business in the markets. The most notable, and perhaps the most harmful, of these is what market players loosely call “front-running.” A front-runner profits by gleaning the intentions of legitimate market participants and jumping in front of their orders, thereby causing the original traders to buy or sell at a less favorable price. In my years running a hedge fund, I witnessed firsthand the effects of front-running. As more and more trading shifted from humans to algorithms, the amount of front-running, and the corresponding market disruption, increased dramatically. To limit the effect of front-running on my firm, I spent millions of dollars developing a proprietary order-entry system to disguise and conceal strategies from external algorithms. But most market participants don't have those resources or knowledge of market intricacies. They have no way to neutralize the front-runner.
Enter the spoofer. This person seeks to outsmart the front-running HFT algorithms. Take the example of Michael Coscia of Panther Energy Trading, one of the alleged spoofers indicted by the federal government last week. Coscia is accused of designing an algorithm that would enter two types of orders: a “buy” order for a small volume slightly lower than the best offer and then several “sell” orders for large volume higher than the market price. The front-running algorithms are designed to look for any sizable interest in trading and front-run that order. In this case, once the HFT algorithm detected the large volume on offer, it sent sell orders to the exchange, fulfilling Coscia’s buy order. Coscia’s sell order was then terminated and the process reversed, with the newly purchased lots offered for sale at a slightly higher price, intending to trick the front-running algorithms into buying them.
Front-running is profitable against traditional orders entered by humans. But with spoofers in the mix, the picture looks quite different: When the front-running HFT algorithm jumps ahead of a spoof order, the front-runner gets fooled and loses money. The HFT’s front-running algorithm can't easily distinguish between legitimate orders and spoofs. Suddenly the front-runner faces real market risk and makes the rational choice to do less front-running. In short, spoofing poses the risk of making front-running unprofitable. Because spoofing is only profitable if front-running exists, allowing both would ensure that neither is widespread.
Regulators have never described how spoofing harms market integrity or even legitimate traders. Instead, they condemn the practice because it involves deception (namely, entering orders that the spoofer never intends to fill) and summarily conclude that this deception is de facto harmful, without considering the broader context or its true consequence to the market. The battles between spoofers and front-runners are games being played between one computer and another in a tenth the time that it takes the human eye to blink. No human can see these trades, much less react to them in real time. The only party that is touched by the spoofer’s deception is the front-running HFT, whose strategies are harmful to every other market participant.
Anti-spoofing regulations not only fail to safeguard the integrity of the market; they exacerbate the very market instability that lawmakers sought to remedy by enacting the prohibitions in the first place. If front-running is allowed to exist, spoofing is its best remedy.
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