Asset managers should consider the practical implications of these recent developments.
Signaling a new area of criminal and civil securities enforcement, federal regulators are flexing their newly acquired powers under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) to curb a trading practice known as “spoofing.” This enforcement push involves increased coordination with the futures exchanges that seems to herald a “task force” type approach to pursuing and sanctioning market participants that engage in spoofing at all levels. The government’s focus on this new area is yet another way that asset managers and other firms active in the derivatives markets are facing increased scrutiny and—by extension—greater compliance challenges.
This LawFlash provides an update on the government’s efforts in this evolving area and reviews the applicable regulatory context. We conclude with practical observations for firms to consider as courts and regulators continue to define the legal boundaries of spoofing.
WHAT IS SPOOFING?
“Spoofing” is a form of market manipulation in which sophisticated computer algorithms are deployed to rapidly place—and then cancel just before execution—hundreds or even thousands of large-volume trades. Dismissed by many as unprosecutable, spoofing failed to garner significant media or regulatory attention for years. Perhaps because of these prosecutorial obstacles, section 747 of Dodd-Frank amended the Commodity Exchange Act to add new section 4c(a)(5). This provision makes it unlawful for a person to engage in any trading, practice, or conduct on or subject to the rules of a registered entity (such as a futures exchange) that “is, is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).” With this change in law, civil and criminal enforcement authorities now have a clear mandate for pursuing this trading practice.
Less clear, however, is how firms should determine what conduct is specifically prohibited so that they can conform their trading practices to avoid sanctions. In an effort to address these challenges, the Commodity Futures Trading Commission (CFTC) has published interpretive guidance on spoofing and other disruptive trading practices. Among other salient points, the CFTC guidance clarifies that:
- The CFTC “interprets a [spoofing] violation as requiring a market participant to act with some degree of intent, or scienter, beyond recklessness” to violate the statute.
- “[L]egitimate, good-faith cancellation or modification of orders (e.g., partially-filled orders or properly placed stop-loss orders) would not” be considered unlawful spoofing.
- “When distinguishing between legitimate trading . . . and ‘spoofing,’ the [CFTC] intends to evaluate the market context, the person’s pattern of trading activity (including fill characteristics), and other relevant facts and circumstances.”
- The prohibition on spoofing covers “bid and offer activity on all products, traded on all registered entities” and is not restricted to “trading platforms and venues only having order book functionality.”
The CFTC also provided the following four “non-exclusive examples” of unlawful spoofing:
- Submitting or canceling bids or offers to overload the quotation system of a registered entity;
- Submitting or canceling bids or offers to delay another person’s execution of trades;
- Submitting or canceling multiple bids or offers to create an appearance of false market depth; or
- Submitting or canceling bids or offers with the intent to create artificial price movements upwards or downwards.
Finally, the CFTC cautioned that a “pattern of activity” was unnecessary, and that “even a single instance” of spoofing could constitute a violation of the statute.
Although the foregoing guidance sheds some light on the CFTC’s views on spoofing, it is not a binding limitation on the agency’s jurisdiction or enforcement authority. Nor does the CFTC’s guidance meaningfully restrict the power of prosecutors and regulators.
Recent enforcement actions brought under Dodd-Frank’s anti-spoofing provisions against two individuals and their respective firms—Michael Coscia, founder of Panther Energy Trading LLC, and Navinder Singh Sarao, founder of Nav Sarao Futures Limited—have brought this nascent offense into sharper and more immediate focus.
Key Legal Points
+ “Spoofing” is the entry of bids and offers with the intent to cancel them before execution.
+ Spoofing requires scienter.
+ Prosecutors and regulators may infer scienter from overall conduct and circumstances of the transactions, including fill rates and the specific algorithmic trading codes.
+ Federal prosecutors, the CFTC, and the derivatives markets have been collaborating to identify and pursue spoofing activity.
+ The recent spoofing prosecutions of Michael Coscia and Navinder Sarao reflect this trend.
RECENT SIGNIFICANT DEVELOPMENTS
Michael Coscia Case
On October 1, 2014, a grand jury sitting in the Northern District of Illinois returned a 12-count indictment against Michael Coscia, founder of Panther Energy Trading. The first spoofing case brought under Dodd-Frank, the indictment alleged that Coscia and Panther Energy Trading unleashed a sophisticated computer trading algorithm called “Flash Trader” to place (and then promptly cancel just before execution) virtually all trades to create the illusion of market interest (or disinterest) and thus artificially move prices in Coscia’s favor. Only after the market reacted to these spurious trades did Coscia place and fill real trades, reaping $1.5 million in profits. Each of the six counts of commodities fraud under 18 U.S.C. § 1348 is punishable by a maximum sentence of 25 years’ imprisonment and a $250,000 fine. Each of the six counts of spoofing under Dodd-Frank, 7 U.S.C. §§ 6c(a)(5)(C) and 13(a)(2), is punishable by a maximum sentence of 10 years’ imprisonment and a fine of the greater of $1 million or triple the violator’s monetary gain.
Coscia sought to have the spoofing charges against him dismissed on the grounds that Congress’s prohibition on spoofing was impermissibly vague. But Coscia’s motion was recently denied by US District Judge Harry D. Leinenweber. Deeming Coscia’s position unconvincing, Judge Leinenweber stressed the presumptive validity of Congress’s enactments and concluded that the statute fairly apprised Coscia that his specific trading activities were illegal. While recognizing the “contentious disagreement about the precise meaning of the term ‘spoofing,’” the court nonetheless accepted the government’s position that “there was never any serious debate” that the statute barred Coscia’s charged conduct—“offer[ing] non bona fide offers for the purpose of misleading market participants and exploiting that deception for [Coscia’s] benefit.” Further, the court clarified that the key question was really whether the statute was unconstitutionally vague “as applied to Coscia’s conduct”—not whether the conduct of “hypothetical legitimate traders” would constitute unlawful “spoofing.” Accordingly, any imprecision in the statute’s contours, in the court’s view, did not preclude the government’s prosecution of Coscia, who allegedly placed orders with the intent to “immediately cancel” and “fraudulently induce other market participants to react to the deceptive market information that he created.”
Coscia also sought to have the commodities fraud charges against him dismissed, but the district court rejected that demand as well, finding that even though no “false statement or material misrepresentation” was identified, the government adequately alleged a scheme to defraud. Indeed, Coscia allegedly (i) carried out his trading strategy “to create a false impression regarding the number of contracts available in the market, and to fraudulently induce other market participants to react to the deceptive market information,” and (ii)“intended to trick others into reacting to the false price volume information he created with his fraudulent and misleading quote orders.” This was enough, the court concluded, to sustain the government’s prosecution of Coscia for commodities fraud: “[F]alse representations or material omissions are not required under § 1348(1),” provided that there is “(1) fraudulent intent, (2) a scheme or artifice to defraud, and (3) a nexus with a security.” Last, because Coscia could reasonably anticipate that his scheme constituted commodities fraud, the court concluded that the applicable prohibition was not unconstitutionally vague.
Navinder Singh Sarao Case
In April 2015, the CFTC filed a civil complaint (complaint or “Compl.”) against London-based, high-frequency trader Navinder Sarao and his firm, Nav Sarao Futures Limited. The complaint alleges that Sarao manipulated the Chicago Mercantile Exchange’s (CME’s) E-mini S&P 500 futures contract by placing—and then promptly canceling or modifying just before execution—hundreds or thousands of “exceptionally large” trades. In so doing, Sarao was able to prime the market, artificially moving contract prices in his favor just before placing and filling real trades, in order to net millions of dollars in profits. The CFTC further alleges that Sarao’s “aggressive and persistent spoofing tactics” “contributed to an extreme order book imbalance in the E-mini S&P market” on May 6, 2010 (dubbed the “Flash Crash” day because of the market’s precipitous drop on that date), and that this “order book imbalance contributed to market conditions that caused the E-mini S&P price to fall 361 basis points.” Based on these alleged violations of the Commodities Exchange Act and the CFTC’s implementing regulations, the CFTC seeks monetary penalties and disgorgement of Sarao’s ill-gotten gains.
CHALLENGES AND IMPLICATIONS
The government is betting that its enforcement actions against Coscia and Sarao will send a strong message to would-be violators that spoofing will no longer go unpunished. Judge Leinenweber’s denial of Coscia’s dismissal motion should help reinforce the government’s message, but whether regulators can deter spoofing effectively may hinge on whether federal prosecutors and the CFTC are able not only to bring but also to prevail against Coscia and Sarao in this novel, largely untested area of the law.
To do so, federal prosecutors and the CFTC must clear a number of hurdles. The government must distill from reams of financial, market, and trading data evidence establishing that Coscia and Sarao deployed sophisticated computer algorithms to place and cancel the relevant orders—not for legitimate trading activities, but rather to manipulate market prices. The dearth of legal precedent interpreting Dodd-Frank’s anti-spoofing provisions only complicates the government’s task. Nonetheless, the government’s aggressive enforcement of Dodd-Frank’s anti-spoofing prohibitions suggests that firms should proceed with care in this evolving area of the law.
Although it is generally helpful to tackle a new compliance challenge head-on, spoofing can present special challenges. As explained above, the precise nature and scope of this offense remain ill-defined. Nonetheless, spoofing is a priority among prosecutors and regulators alike, and there is a general sense that brokers and exchanges are closely monitoring market participants for potential wrongdoing. For instance, brokers have asked firms to provide and substantiate their reasons for low fill rates during specific periods. Firms should assume that any response they provide to a broker will be shared with the exchanges and possibly law enforcement.
For these reasons and others, firms may find it prudent to review their trading algorithms and strategies with the CFTC’s guidance and recent court cases in mind. In our experience, firms that perform this review begin by focusing on trading strategies that deploy algorithms, involve a high overall volume of market activity, or have lower fill rates. Within that universe, firms should consider whether any activity could raise red flags for regulators, including, for instance,
- whether trading algorithms call for cancellation of bids and offers in all cases, even when prices move in a favorable direction;
- whether cancellation of bids and offers was meaningfully higher during closing periods;
- whether there is any potential connection between cancellation activity and market prices; and
- whether cancellations were driven by trading in other markets (i.e., where a strategy is pursued through both the futures markets and the securities markets).
In the table below, we identify other practical considerations for firms reviewing their trading activities.
Except in obvious cases, the specific types of trading activity prohibited by anti-spoofing provisions remain murky and will be the subject of ongoing debate. Accordingly, firms would be well-served by monitoring legal developments and following common-sense steps for reviewing their trading activities in this emerging area of criminal and civil enforcement.
Key Compliance Takeaways
+ Review trading strategies or algorithms to understand circumstances in which bids and offers may be canceled.
+ Evaluate historical fill rates and scrutinize periods with low fill rates.
+ Determine whether cancellations affected market prices of the underlying commodities or other relevant products.
+ Consider documenting the rationale for strategies or algorithms that generate disproportionate cancellations.
+ Evaluate potential modifications to strategies and algorithms as appropriate, in light of legal developments and new regulatory guidance.
+ Document the review process, relevant findings, and corrective measures, as appropriate.
+ Develop and deploy appropriate training and policy guidelines on spoofing and other proscribed trading.