The government won its first victory in prosecuting a high-frequency trader under the anti-spoofing law that stemmed from the Dodd-Frank Act. It took a Chicago jury about an hour to find Michael Coscia of Panther Energy Trading guilty, a surprisingly short amount of time for a verdict that might result in a remarkably long prison sentence.
Busting a high-frequency trader is good news, right? Fairness has been restored to markets, "regular" investors can play again with confidence that Uncle Sam will keep them safe from predators, and Michael Lewis can go back to writing about baseball and football and other stuff that's way more interesting than trading in nanoseconds. Right?
Well, not so fast. Focusing on "spoofing" in this case, and two more waiting in the wings, shows the government indeed has set its sights on high-frequency traders -- but as the victims, not just the criminals. "Spoofing," to those who haven't kept up, is when traders place orders to buy or sell that they don't intend to honor. The idea is that if spoofers want to buy something, they can push the price lower by first placing a bunch of offers to sell at prices slightly higher than the best price on offer. If they want to sell, they can push the price higher by doing the opposite.
These bogus orders are quickly canceled, like within a fraction of a second, but that's long enough for certain traders to adjust their price quotes in response to what they see as a change in the supply-demand dynamic in the market. Who adjusts quotes so quickly that they are victims of spoofing? Why, you guessed it: High-frequency traders! (Or automated electronic market markers, or proprietary trading firms or whatever they want to be called this week.)
In fact, that lightning-fast change of quotes in response to new information is exactly what many critics of high-frequency trading think is the real crime. They call it "front-running," in a modern adaptation of a term originally used to refer to brokers who hear of a big client order that may move prices and rush to trade ahead of it for their own accounts. It's much more of a concern in the stock market than the commodities markets where Coscia operated because equities trading is spread out over a larger number of venues.
It's worth reading, or re-reading, John D. Arnold's take on spoofing for Bloomberg View back in January. The founder of hedge fund Centaurus Energy made a rather extreme argument: spoofing is the natural defense of front-running and actually makes markets more honest. He concludes:
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.
While convincing others that spoofers are beneficial to the market is a tough sell, his view gets to the heart of the issue. Under the current rules of engagement in the algorithm wars, spoofing is outlawed but rapidly changing price quotes in response to new information isn't -- no matter how much critics complain about it. Rubbing salt in the wounds is how high-speed traders thrive best when prices are moving rapidly and trading volume is frenzied. Look no further than the results reported on Wednesday from Virtu Financial after the wild ride in markets in the third quarter: adjusted Ebitda surged 52 percent, to $100.7 million, with a margin of more than 71 percent. As CEO Douglas Cifu put it: "Virtu has the capacity to thrive in high-volume environments with increased volatility. Our overall performance in the third quarter reflects this favorable environment.”
IEX Group's stock-trading platform, made famous in Lewis's "Flash Boys," offered a refuge to those who felt victimized by the fastest traders by coiling miles of fiber optic cable in a "magic shoe box" to slow speed traders down a bit. Now that IEX is seeking to upgrade from a dark pool to an official exchange, however, the propriety of the magic shoe box is being called into question. Bats Global Markets, one of the Big Three exchange operators, argues that delaying quotes may be fine for a dark pool like IEX. But for official exchanges it raises all sorts of concerns because they benefit from a law that forces competitors to send orders their way if they have the best quotes, known as "protected" quotes. Bats calls it a "critically important issue" because intentional delays in gaining access to protected quotes could hurt the accuracy of the National Best Bid and Offer and the price discovery process for everyone in the market.
That curve ball being thrown by Bats may prove to be a tricky one for the Securities and Exchange Commission to handle because Bats is essentially calling into question the propriety of the feature that makes IEX stand out as the haven from high-frequency trading.
It all results in a situation in which critics of high-speed trading may find themselves in a familiar position: being frustrated with the status quo. IEX's private-sector solution is meeting resistance as the company pursues ambitions to be a stock exchange. And regardless of how many spoofers the government prosecutes, it won't solve the bigger issues that have drawn criticism to high-frequency trading in the first place.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Michael P. Regan in New York at firstname.lastname@example.org
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