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Spoofing, Market Manipulation, and the Limit-Order Book

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Spoofing, Market Manipulation, and the Limit-Order Book INSIGHTS Spoofing, Market Manipulation, and the Limit-Order Book JOHN D. MONTGOMERY, ANKURA1 I MAY 3, 2016 INTRODUCTION are willing to buy or sell the instrument, may influence assessments of the value of the instruments. This article provides an overview of legal and enforce- ment actions relating to “spoofing” and related allegations An array of laws and rules governs this process. Each of disruptive or manipulative trading. It also provides an financial exchange has its own set of rules governing overview of several economic issues: how spoofing might the submission of orders, trading, and other topics. work; whether it provides any benefits to, or harms, mar- Government regulatory bodies in turn govern the ex- ket participants; and how a trader’s intent regarding spoof- changes. In the United States, the Securities and Ex- ing might be analyzed. The Dodd-Frank Wall Street Reform change Commission oversees trading in stocks, bonds, and Consumer Protection Act of 2010 (Dodd-Frank Act) and options on those securities, while the Commodi- added statutory language explicitly outlawing spoofing, ty Futures Trading Commission (CFTC) takes respon- defined as “bidding or offering with the intent to cancel the sibility over trading in futures and similar products. 2 bid or offer before execution” in the commodities and fu- Rules govern how trading is done. Laws prohibit manipu- tures markets. Recent years have seen both criminal pros- lative trading practices on both securities and futures ex- ecutions and regulatory enforcement actions involving al- changes. These laws generally require that the practices legations of spoofing and similar behavior. As such legal be intentional and that they be successful in influencing activity proceeds, courts will likely benefit from analysis of prices or other trading on exchanges. In addition to these how spoofing might operate, how it might affect markets, longstanding rules, the Dodd- Frank Act added prohibi- and how a trader’s trading patterns might provide evi- tions against particular “disruptive” trading practices in dence regarding his or her intent. futures markets, with somewhat reduced requirements What is the right price to pay for a security or a futures regarding intention and success. These new restrictions in- contract? It is possible to buy or sell many securities and clude a specific prohibition against spoofing. The CFTC has futures contracts on well-developed exchanges. A simple begun enforcing its anti-spoofing authority, leading to sev- view would be that transaction prices should reflect all eral settlements, and at least one ongoing lawsuit. Federal publicly available information. But even in that situation, prosecutors have initiated criminal proceedings in several different investors will have different opinions about the cases, with the first conviction in November 2015.3 value of the instruments, and prices will be affected by Enforcement proceedings and criminal prosecutions re- the range of different opinions. Moreover, investors take garding manipulation and disruptive practices such as their cues from one another, so the price at which the in- spoofing raise important issues for economists to ana- strument is trading, or the price at which other investors lyze. Both manipulation and spoofing require a degree of 1. Mailing address: Ankura Consulting Group, 685 Third Ave., New York, NY 10017. Telephone: (646) 227-4277. E-mail: [email protected]. 2. Commodity Exchange Act 7 U.S.C. § 6c(a)5 (2014). 3. Press release, United States Attorney’s Office,High-Frequency Trader Convicted of Disrupting Commodity Futures Market in First Federal Prosecution of ‘Spoofing’, (N.D. Ill., Nov. 3, 2015). INSIGHTS intent – either to create an artificial price in the case of by the use of any means or instrumentality of interstate manipulation or to cancel orders before they are execut- commerce, or of the mails or of any facility of any na- ed in the case of spoofing – and this is likely to require an tional securities exchange, analysis of economic rationale for the defendant’s trading (a) To employ any device, scheme, or artifice to defraud, activities. Such an analysis needs to be embedded in an understanding of the dynamics of the relevant markets. (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make In the rest of this article, I cover the following subjects. I the statements made, in the light of the circumstances begin with a review of U.S. statutes, regulations, and reg- under which they were made, not misleading, or ulatory guidance covering manipulation and disruptive trading practices. I discuss recent criminal and civil cas- (c) To engage in any act, practice, or course of business es involving market manipulation and spoofing. Finally, which operates or would operate as a fraud or deceit I review economic aspects of these issues, starting with upon any person, in connection with the purchase or 5 an overview of the structure of financial exchanges, the sale of any security. impact that orders have on the markets, possible mech- Similar language for futures market was included in the anisms for spoofing behavior to affect the markets, and Dodd-Frank Act: some issues related to proving intent in spoofing cases. (1) Prohibition against manipulation It shall be unlawful for any person, directly or STATUTES, REGULATIONS, AND indirectly, to use or employ, or attempt to use or REGULATORY GUIDANCE employ, in connection with any swap, or a contract of sale of any commodity in interstate commerce, U.S. financial law has both general rules prohibiting ma- or for future delivery on or subject to the rules of nipulation in financial markets and, for futures markets, a any registered entity, any manipulative or deceptive section that specifically prohibits spoofing. device or contrivance, in contravention of such rules Separate federal laws govern securities and futures mar- and regulations as the [Commodity Futures Trad- kets. The Securities Exchange Act of 1934, among other ing] Commission shall promulgate by not later than statutes, covers conduct in securities markets. A key pro- 1 year after July 21, 2010, provided no rule or regu- vision of this act is Section 10(b), which makes it unlawful: lation promulgated by the Commission shall require To use or employ, in connection with the purchase or any person to disclose to another person nonpublic sale of any security registered on a national securities information that may be material to the market exchange or any security not so registered, or any se- price, rate, or level of the commodity transaction, curities-based swap agreement any manipulative or de- except as necessary to make any statement made ceptive device or contrivance in contravention of such to the other person in or in connection with the 6 rules and regulations as the [Securities and Exchange] transaction not misleading in any material respect. Commission may prescribe as necessary or appropriate The CFTC’s rule covering this issue reads in part as follows: 4 in the public interest or for the protection of investors. Prohibition on the employment, or attempted employ- Based on this statutory language, the SEC created Rule ment, of manipulative and deceptive devices. 10b-5: (a) It shall be unlawful for any person, directly or ind Employment of manipulative and deceptive devices. rectly, in connection with any swap, or contract of It shall be unlawful for any person, directly or indirectly, sale of any commodity in interstate commerce, or 4. Securities Exchange Act of 1934, 15 U.S.C. §78j(b) (2014). 5. General Rules and Regulations, Securities Exchange Act of 1934, 17 C.F.R. § 240.10.b-5 (2015). 6. Dodd-Frank Wall Street Reform and Consumer Protection Act § 753 (Anti-Manipulation Authority) 7 U.S.C. § 9.1 (2016). INSIGHTS contract for future delivery on or subject to the rules es of each particular case, including a person’s trading of any registered entity, to intentionally or recklessly: practices and patterns.” The statute provides no specific (1) Use or employ, or attempt to use or employ, any ma- definition for spoofing, other than the statutory language nipulative device, scheme, or artifice to defraud… that connects to the submission of orders with the intent to cancel those orders before execution. In its guidance, §180.2 Prohibition on price manipulation. the CFTC also provided some examples of behavior that It shall be unlawful for any person, directly or indi- could qualify as spoofing: rectly, to manipulate or attempt to manipulate the The Commission provides four nonexclusive exam- price of any swap, or of any commodity in interstate ples of possible situations for when market partici- commerce, or for future delivery on or subject to pants are engaged in ‘‘spoofing’’ behavior, including: (i) 7 the rules of any registered entity. Submitting or cancelling bids or offers to overload the In addition to these general prohibitions on manip- quotation system of a registered entity, (ii) submitting ulation, Dodd-Frank also introduced specific lan- or cancelling bids or offers to delay another person’s guage regarding spoofing and other practices on execution of trades, (iii) submitting or cancelling mul- futures and commodities exchanges: tiple bids or offers to create an appearance of false In addition to these general prohibitions on manipu- market depth, and (iv) submitting or canceling bids or lation, Dodd- Frank also introduced specific language offers with intent to create artificial price movements 9 regarding spoofing and other practices on futures and upwards or downwards. commodities exchanges: All four of these examples add to the general language in (5) Disruptive practices the statute (“bidding or offering with the intent to cancel the bid or offer before execution”) specific intended ef- It shall be unlawful for any person to engage in any fects of the spoofing.
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