There’s a big trial going on this week that could reshape the law on market manipulation — and it’s all about “spoofing.”
But Sarao’s is not the only spoofing case.
Spoofing investigations have actually become quite a trend, and the Justice Department, the Securities and Exchange Commission, and other regulators have been investigating a number of alleged spoofing cases this year.
This week’s case is about a Chicago-based high-frequency commodities trader who prosecutors say defrauded the market to make some $US1.6 million in illegal profits.
That trader, Michael Coscia, was indicted last year and charged with multiple counts of commodities fraud and spoofing, which is forbidden under a new provision in the Dodd-Frank Act.
Now, the trader’s lawyers want to prove that the anti-spoofing law is “hopelessly vague, and its criminal enforcement would violate Michael Coscia’s right to due process of law.”
It could be a game changer.
So what is spoofing?
It’s all about intent
One person who would know is fraud attorney Celiza Bragança of Stoltmann Law, who worked on a spoofing case while at the SEC in the early 2000s.
Bragança told us spoofing goes like this:
- A trader makes a large bet on or against a security.
- The market reacts to that bet — sending the security’s price up or down.
- The trader cancels their bet once the market reacts.
- The trader takes advantage of other investors’ reactions by betting on or against the security for real.
Spoofing trades don’t make huge amounts of money every time they happen.
“No one’s going to make a million dollars on a trade,” said Peter Henning, a securities litigation professor at Wayne State University. “You’re going to make a dollar on a million trades. And of course, you’re not gonna make that same dollar from each person.”
When Bragança took day trader Stanley Awdisho to court for spoofing some 15 years ago, the practice, also known as a “pull and hit,” was little-known, and the term spoofing rarely used. But with the advent of high-speed trading technology, it’s become more prominent, and regulators are starting to take note.
Chicago trader Igor Oystacher of 3Red Group is under investigation by the Commodity Futures Trading Commission for spoofing in June of 2012. CME Group banned him from trading for a month last year and the FBI is also reportedly looking into the case.
The tactic was outlawed in the 2010 Dodd-Frank regulation, but, as with other forms of fraud, it’s hard to prove the trader’s intent — in this case, the intent to cancel the order. Prosecutors must prove the trader didn’t change his or her mind for legitimate reasons after placing the trade.
High-frequency trading technology has made it even easier than before.
“They are truly done in the blink of an eye, and it’s designed to take advantage of the algorithms that look for price disparities in the market,” said Henning. “Spoofing is signalling. I put in a small order and then a real big one, and I’m hoping the big one attracts you, and then you’ll throw my small one. And then I just dump the big one.”
Who does it hurt?
In Henning’s view, the fact that highly sophisticated technology is a necessary requirement for spoofing also means that the people who are most affected by it are other sophisticated, high-speed traders.
“This is Wall Street,” he said. “Everybody is trying to profit from everyone else.”
But he acknowledged that there is some impact on individual investors, mutual funds, pension funds, and other non-Wall Streeters, albeit small.
“It may push the price up a penny at which moment their order is executed. It could be that the price went up 2 or 3 cents… but they may be in there buying or selling at that moment,” he said.
Bragança foresees a wider impact. She worries that if pension funds and other investors cannot count on market regulation, they will take their investments to other markets outside of the US.
“It’s just like insider trading: it appears to be a victimless crime, but there is somebody on the other side who is selling, or buying, and that person is not getting the advantage of the market being able to reflect that information,” she said.
She expects to see more spoofing cases taken to court as the SEC and other regulators catch onto the activity.
“That’s just the nature of a financial market,” she said. “There’s a lot of money at stake and the regulators are always going to be a few steps behind. But the key is that they’re going to get there.”
Here’s Michael Coscia’s case.