The Dodd-Frank Act included a provision making “spoofing” a crime in U.S. futures markets, though not equity markets, curiously. Federal authorities lost no time in using this authority. In 2016, trader Michael Coscia was found guilty of the offense and sentenced to 3 years in prison. Last November, Navinder Sarao pled guilty to the offense and agreed to a $25.7 million civil penalty. He currently awaits sentencing on criminal charges and could serve as much as 30 years. In January, Citibank agreed to pay a $25 million civil fine for spoofing.
So what is spoofing, and does it warrant such aggressive targeting by regulators? Spoofing is basically a form of manipulation or disruptive trading that involves the placement of orders with the intent of fooling the market. For instance, at a point in time the best bid in the crude oil futures market may be $50.00, and the best offer to sell is $50.01. The spoofer places a bid at $50.00 (typically in a small quantity) and then enters a large number of sell orders at prices like $50.03, 50.04, and even higher.
The idea behind these off-market sales orders is to fool the market into believing that there is a lot of selling pressure, leading some traders to pull their bids and others to sell at $50: the spoofer hopes that his bid at $50 will be hit. When that happens, he cancels the big sell orders and reverses the process, placing a small sell order at the market and big buy orders below the current market. Wash, rinse, repeat.
Note that canceling a large number of orders is a crucial part of this strategy, and indeed Dodd-Frank defines spoofing as “bidding or offering with an intent to cancel before execution.” Therein lies the potential problem with aggressive prosecution of spoofing. Many legitimate trading strategies involve large numbers of cancellations.
In particular, market makers — who provide valuable liquidity to the market — cancel the vast bulk of their orders. The ability to cancel when new information arrives allows market makers to reduce the likelihood of making losing trades, and allows them to submit more aggressive quotes and supply liquidity more cheaply to the benefit of investors.
It can be very hard to discern the intent behind cancellations, and using high cancellation rates as the primary means for identifying spoofers runs the very serious risk of wrongly convicting market makers and others who cancel large numbers of orders as part of non-manipulative trading strategies.
Given the draconian penalties that have been assessed, even if the probability of a wrongful conviction is small, the cost to the accused can be large, which will raise the cost of supplying liquidity. Thus, aggressive policing of spoofing has the very real potential unintended consequence of reducing liquidity and harming market performance.
This cost might be worth paying if spoofing imposed large costs on the market, but this is unlikely. The government should focus on strategies that have large persistent impacts on prices, because these impose the largest economic harm: as a rule of thumb, the harm increases with the square of a price distortion.
But the price impacts of spoofing are trivially small. The government’s own expert in the Sarao case estimated that a large spurious order moved prices by just 0.003 percent. Moreover, since the strategy regularly reverses direction, spoofing causes oscillations of such tiny magnitudes, rather than persistent price dislocations.
Furthermore, spoofing is intended to be noticed, and market participants, notably high-frequency traders, can learn to discount obvious behavior that has little power to predict future price movements (because it is intentional noise): fool me once, shame on you, fool me dozens of times, shame on me (or high-frequency traders).
Thus, the market has self-correction mechanisms. This might explain why the government’s own expert found that a massive spoofing campaign had such little impact on prices. (The government also accused Sarao’s spoofing of causing the Flash Crash. This allegation is risible and inflammatory.)
In brief, aggressive enforcement of spoofing laws runs the risk of penalizing legitimate market conduct and reducing market liquidity, but provides little benefit in terms of reduced price distortions. In an era when enforcement officials (including the Commodity Futures Trading Commission’s ex-head of enforcement) complain of a lack of resources to police the markets, these scarce resources would be better employed to investigate manipulations that have far bigger impacts on prices.
Unfortunately, the checkered history of manipulation prosecutions has made enforcement authorities gun-shy. The checkered history is in large part attributable to vague and ill-conceived statutory language dating from the 1920s. Would that Congress had devoted more attention to this issue in 2010, rather than focusing on a peripheral form of financial misconduct like spoofing.
Craig Pirrong, Ph.D., is a professor of finance at the University of Houston’s Bauer College of Business. He has published 30 articles in professional publications and is the author of three books. His consulting clients have included electric companies and commodity firms around the world.
The views expressed by contributors are their own and are not the views of The Hill.