Last Updated on 19 September, 2022 by Samuelsson
A silly name for serious market manipulation, spoofing is a new crime, but the practice has been around for a long time. In this era of computerized trading, spoofing has emerged as a threat to market legitimacy and was blamed for the 2010 Flash Crash in the U.S. market. But what exactly is trade spoofing?
Spoofing Trading, also known as bluffing, trade spoofing is a disruptive trading practice whereby a trader sends a large bid or ask order to the market, with the intent to cancel the order before execution, just to manipulate the market. The large order tricks other traders into thinking that there’s a huge demand or supply in the market and trading accordingly.
In this post, we will discuss the following:
- Spoofing definition: what is trade spoofing?
- How does spoofing work?
- Example of spoofing
- The position of the law: is spoofing illegal?
- Spoofing vs. layering: what is the difference?
Spoofing definition: what is trade spoofing?
Spoofing is a subtle but dangerous market manipulation that involves placing a huge bid order or ask order and subsequently canceling the order before it can be executed. This can be done in any financial market, including stock, bond, and futures markets, and the trader who does this is known as a spoofer.
The aim is to create a false picture of demand or false pessimism in the market. By creating a false sentiment in the market, a trader tricks other market participants to act in accordance with the sentient, thereby causing the price of the security to move as intended. Moreover, the trader already placed many smaller orders for the same security in that intended direction and thus, profits from the price movement, while the fake large order is canceled.
Spoofing is obviously manipulative because the trader would not have achieved the price on the actual orders without first triggering the price movement by virtue of the large bogus order. It is a disruptive practice employed by traders to outpace other market participants and to manipulate markets. In an order-driven market, by posting a relatively large number of limit orders on one side of the limit order book, spoofers make other market participants believe that there is pressure to buy (limit orders are posted on the bid side of the book) or to sell (limit orders are posted on the offer side of the book) the asset.
These activities can cause price movements to change as the market interprets the one-sided pressure in the limit order book as a shift in the balance of the number of traders intending to buy or sell the asset. If it gives the impression of more buyers than sellers), it can cause the price to increase, but if it gives the impression of more sellers than buyers, the price declines. The spoofer already knows the intended direction and has taken many positions to benefit from the price movement. Meanwhile, the large bids or offers are canceled before the orders are filled.
The practice has been around for decades as traders attempt to take advantage of other market players by creating an illusion of the demand and supply of the traded asset. However, it became more common with the rise of speedy, high-volume, and computer-driven trading systems, which makes it possible to execute large trade orders in a very short time.
Given the advantages of high-frequency trading (HFT), spoofing gains an immense scope that provides opportunities for moving the prices of the securities to a larger extent and earning higher profits. In 2010, it gained more notoriety with the Flash Crash, attracting the attention of securities regulators and law enforcement officials.
The official definitions of spoofing
The Dodd-Frank Act of 2010 under Section 747 defined spoofing as “bidding or offering with the intent to cancel the bid or offer before execution.”
In Australia, layering and spoofing were described in 2014 as: “the act of submitting a genuine order on one side of the book and multiple orders at different prices on the other side of the book to give the impression of substantial supply/demand, to suck in other orders to hit the genuine order. After the genuine order trades, the multiple orders on the other side are rapidly withdrawn.”
The Swedish Financial Supervisory Authority, in a 2012 report Finansinspektionen (FI), defined spoofing/layering as “a strategy of placing orders that are intended to manipulate the price of an instrument: for example, through a combination of buy and sell orders.”
How does spoofing work?
Before we consider how spoofing works, let’s try to understand the order flow in an exchange market. As you may already know, traders can place market orders or limit orders. While the market orders are executed at the bid or ask prices, the limit orders lie in wait in the market and form the order flow, only getting executed when the market gets to the levels specified in the limit orders. The lowest-lying sell limit order is called the “ask” (offer) price, while the highest lying buy limit order is called the “bid” price.
So, here is what a trader does when engaging in spoofing: the spoofer places large limit orders outside the current bid or ask level in order to change the reported price to other market participants. Meanwhile, the spoofer then places trades with market makers based on that impression of change in the price and subsequently removes the spoofing orders before they can be executed.
For instance, let’s say the share price of a stock is quoted as follows: bid price is $100.00, while the ask price is $100.20. With this, a market order to sell this stock would be executed at the bid price of $100.00, while a market buy order would be executed at the ask price of $100.20. Knowing this, the spoofer places a huge limit order to buy shares at $100.10, still some distance from the current ask price, so it won’t be executed.
Now, we have a new bid price of $100.10. These are reported as the National Best Bid and Offer best bid price. The spoofer then issues a sell order to a market maker for the shares of the stock at $100.10. The market maker fills the sell order at that price since that is the best-reported bid price. Meanwhile, the spoofer cancels the buy at $100.10, as he never intended it to get filled. The spoofer just created a fake price movement to profit from.
A real-life example of spoofing
Investigations revealed that the 2010 Flash Crash, which erased almost $1 trillion in market value from the U.S. stock markets, was primarily triggered by market manipulations using spoofing and layering schemes. It was learned that the scheme was perpetrated by a London-based futures trader, Navinder Singh Sarao.
Sarao was accused of manipulating the market by placing a large order for E-Mini S&P 500 stock index futures contracts with the intent to cancel the order before execution, and in 2015, he was charged by both the U.S. Department of Justice and the UK authorities for market manipulations and spoofing.
Here’s how Navinder Singh Sarao, dubbed the Hounslow day-trader, tricked the market participants: He employed the technique of dynamic layering, a form of market manipulation in which a trader places multiple large sell orders at different price levels for contracts tied to the S&P 500 Index. To intensify the manipulative effects of his dynamic layering technique, he applied a spoofing technique by placing some 188 and 289 lot sell contracts in certain instances. In today’s algorithm-based trading world, these actions triggered trading algos to short the hell out of the S&P 500 Index contract, leading to the market crash.
Analysts believe that spoofing has the potential to undermine confidence in the markets since it disrupts prices, making investors feel tricked. Some trading exchanges, such as the CME Group, have developed software to red-flag suspected spoofing, but the practice can be hard to define because trade orders can also be canceled for many legitimate reasons.
The position of the law: is spoofing illegal?
Spoofing is illegal in the UK; According to the Financial Conduct Authority (FCA), “Abusive strategies that act to the detriment of consumers or market integrity will not be tolerated.” Both the FCA and the courts are authorized to fine spoofers.
In the US, the Dodd-Frank Act of 2010 under Section 747, which defined the practice as “bidding or offering with the intent to cancel the bid or offer before execution”, designated it an illegal activity and a criminal offense. The U.S. Commodity Futures Trading Commission (CFTC) monitors such activities in futures markets and fines the offenders. The U.S. Department of Justice can also prosecute the offenders.
Why spoofing may be difficult to prove
Since the practice was outlawed in certain countries, spoofing charges have become more common, but they are not always easy to prove. The prosecutor must prove that the trader intended to manipulate market prices by placing and canceling orders; traders and investors cancel trades all the time for legitimate reasons, including that they simply changed their minds.
Spoofing cases that have been prosecuted
Apart from the Navinder Singh Sarao’s case in 2015, these are other major spoofing cases where the offenders were either fined or prosecuted:
In 2014, the U.S. Attorney’s office in Chicago charged Michael Coscia for an alleged spoofing offense, and was convicted on six counts of commodities fraud in 2015. In July 2016, he was sentenced to three years in prison. While the Securities and Exchange Commission (SEC) and CFTC have brought several civil spoofing cases since 2012, Mr. Coscia was the first person prosecuted under the CFTC’s 2013 guidelines.
The CME Group’s Comex division suspended two metals traders for 60 days for alleged spoofing violations in April 2015. In January 2017, the CFTC fined Citigroup $25 million for spoofing between July 2011 and December 2012 in the US Treasury futures, and in January 2018, the CFTC accused and fined three European banks — UBS, Deutsche Bank, and HSBC — of market manipulation using spoofing schemes.
Spoofing vs. layering: what is the difference?
Both spoofing and layering are forms of market manipulation in which a trader uses visible orders (that he intends not to execute) to deceive other market participants about the true levels of supply or demand in the market. While some regulators use both terms interchangeably, others, including FINRA, describe “spoofing” as entering one or more non-bonafide orders at the top of the order book and “layering” as entering multiple non-bonafide orders at different price levels.
Spoofing manipulation occurs if a trader enters a single visible order, or a series of visible orders, that either creates a new best bid or adds significantly to the liquidity displayed at the existing best bid or offer. Then, while that first order(s) was still open, or within a short time after it is canceled, the spoofer executes a trade on the opposite side of the market. Thus, the execution of the opposite order occurs at a more favorable price than the spoofer would have obtained in the absence of the first order(s) — regardless of whether the buy (sell) execution occurs at the pre-sequence best bid (offer) price, at the midpoint, or the new best offer (bid) price set by the spoof order(s). In any of those scenarios, the trade is executed at price better than if the spoofer had hit the pre-spoof bid or had taken the pre-spoof offer.
Layering, on the other hand, is a bit different. It is a variant of spoofing where the trader enters multiple visible non-bonafide orders on one side of the market at different price levels, causing the midpoint of the spread to move away from those multiple orders, and at the same time, the same trader executes a trade on the opposite side of the market. As with spoofing, this pattern is manipulative because the execution occurs at a more favorable price than the trader would have obtained in the absence of the first orders.
Trade spoofing is a disruptive algo trading practice in which a trader uses non-bonafide large bid or ask orders to manipulate the market. The large order tricks other traders into thinking that there’s a huge demand or supply in the market, so they trade accordingly while the spoofer gets a better price and makes illegal profits.