Potentially abusive trading algorithms, such as algorithms that purportedly engage in “spoofing” or “layering” are the subject of considerable regulatory interest. However, in an interesting complaint filed on October 19, 2015, the CFTC alleged that a firm manually entering futures orders engaged in illegal spoofing that appears to have lured algorithmic traders into the market.
The CFTC charged Chicago-based trader Igor B. Oystacher and his proprietary trading company, 3 Red Trading LLC (“3 Red”), with spoofing and employment of a manipulative and deceptive device while trading on four different futures exchanges in violation of Dodd-Frank. The statute defines “spoofing” as bidding or offering with the intent to cancel the bid or offer before execution.
According to the civil complaint, defendants manually placed large passive spoof orders on one side of the market at or near the best bid or offer price. Defendants then would flip their position with aggressive orders on the other side of the market, at the same or better price, and “virtually simultaneously” cancel the spoof orders in order to trade with market participants that had been induced to enter the market by the now-cancelled spoof orders. The CFTC alleges that the spoof orders were only displayed to the market for milliseconds before they were cancelled, and the purpose of the orders was to lure other traders into the market at the same side by providing a false sense of market interest and a deep book on that side of the market.
According to the CFTC, defendants were able to accomplish the scheme by using the “avoid orders that cross” functionality on a commercially available trading platform, which is intended to prevent a trader’s own orders from matching with one another. When defendants placed aggressive orders on the other side of the market from their spoof orders, the “avoid orders that cross” function automatically cancelled the spoof orders. As explained in the complaint, “the Defendants use of the avoid orders that cross functionality not only prevented the flip orders from matching with the spoof orders, but also allowed Defendants to cancel the pending spoof orders and place aggressive order(s) on the other side of the market at the same or better price before other market participants could assess and react to the disappearance of the false market depth and book pressure the spoof orders had created.”
As a result of defendants’ activity, the CFTC charges that they were able “to maximize their opportunities to trade in quantities and/or at price levels that would not have otherwise been available absent the appearance of false market depth and book pressure, and the resulting joinder by other market participants.” While the complaint does not identify the “other market participants” who were affected by the spoof orders, those orders were left pending for only a matter of milliseconds – 400 to 750 milliseconds in two examples cited by the CFTC – suggesting that high-frequency algorithmic traders may have been the only market participants having the ability to react to spoof orders displayed for so short a time.
As evidence of the defendants’ intent to cancel the orders prior to execution, the CFTC alleges that 98% to 99% of the alleged spoof orders were cancelled, and less than two percent of those orders received a fill. By contrast, there was a much higher fill rate for the non-spoofing orders. Firms are reminded that regulators may well look to fill rates to identify potential spoofing, and firms’ internal surveillance programs may be designed to do the same.