How Spoofing Works & Why It is Illegal

Elise Fleischaker Industry News, Neurensic Blog

The law of supply and demand is taught in every economics class. My children learned it in high school. It is simple to understand; yet it isn’t something we think about often. We don’t think about how it applies to our stock and commodity markets.

The law of supply and demand is a theory that states that when something is in demand, and supply is lower than demand, then the price will rise. Conversely, when there is more supply than demand, then the price will decrease.

In electronic trading the supply and demand is represented by the trading book. Consider the following Jelly Bean futures contract electronic trading market.

spoofing-1

In this market the supply and demand is equally balanced. If one wants to buy 100 Jelly Beans, he or she will have to buy it at $76 because that is the lowest price at which anyone else willing to sell Jelly Beans. Likewise, if one wants to sell Jelly Beans they will need to drop their price to $74 because that is the highest price at which anyone is willing to pay for Jelly Beans.

What Happens if Supply Increases?

Supply increases in the following market ladder. 1,000 new contracts is immediately seen by all market participants. The buyers know that the increase in supply will drive down market prices because there is now more jelly bean contracts being offered for sale. Therefore, the buyers anticipate being able to purchase their jelly beans for a lower price and drop their price by $1.

spoofing-2
Supply & Demand with Spoofing

Spoofing is entering orders into the market without the intent of actually having those orders filled. Dodd-Frank section 747 expressly prohibits spoofing, the CME Group does as well with rule 575 and so does ICE. (See Neurensic’s Spoofing Similarity Model for quick references to these rules.)

Spoofing exploits the law of supply and demand. The following is an example of one of the many ways that a trader could potentially spoof the market:

Time 1: Trader enters a small order to Buy 10 at $74. This is the real order that the trader wants filled.

spoofing-3
Time 2: Trader enters a large order to Sell 1,000 at $76. This is the spoof order that the trade has placed into the market to drive the price down by dramatically increasing market supply.
spoofing-5
Time 3: The result of the large order causes other market participants to change their prices in hopes of being able to buy their futures contracts at a better price.

spoofing-6

Time 4: Supply side traders, anticipating dropping prices will rush to decrease their prices. Moving the market price down. Because the market manipulator’s price on the Bid (Demand) side is now the top of the book, the trader will be filled as the prices drop.
spoofing-7
Time 5: Now that the spoofer has been filled on his 10 lot order, he will cancel the 1,000 lot order allowing the market to return to equilibrium.
spoofing-8
As the price rises without the additional supply the trader receives an immediate unrealized profit.

Why is this market manipulation illegal?

Our trader in the above example has tricked the marketplace into thinking that a market move is starting. Sellers are tricked into to lowering their prices because of the additional supply. Buy-side traders have retreated from where they actually were willing to invest based on false market supply signals.

The key is that many participants have been tricked to do something by order actions that were never intended to result in a trade. CME’s rule 575 statess, All orders must be entered for the purpose of executing bona fide transactions. Additionally, all non-actionable messages must be entered in good faith for legitimate purposes. ICE explicitly communicates that disruptive trading practices occur when the market participant’s intent was to induce others to trade when they otherwise would not.  

Tricking market participants to trade when they normally wouldn’t is market manipulation, and repeating this type of pattern over and over again is drawing the attention of regulators.  

The Long Term Effect

In the long term, market participants may consider the price volatility to be too risky and not participate in the market. Aitan Goelman, the CFTC’s Director of Enforcement, once said,”  “Spoofing seriously threatens the integrity and stability of futures markets because it discourages legitimate market participants from trading.”

Market Spoofing – The Regulator’s View

Regulators work to keep the markets fair, competitive, transparent, and sound. It is their intention to protect all market participants from fraud and manipulation. Trade spoofing undermines these principles. Therefore, it is illegal. The regulators are holding traders, investment firms, chief compliance officers and officers accountable for market manipulation.