The US federal court handling the civil case brought by the Commodity Futures Trading Commission against Navinder Sarao for alleged spoofing activity accepted the settlement agreement jointly submitted by the CFTC and Mr. Sarao two weeks ago. Under the terms of this agreement, Mr. Sarao will pay a fine of over US $25.74 million, disgorge profits of over US $12.87 million and be permanently barred from trading on CFTC-supervised markets, among other sanctions.
The CFTC filed its complaint against Mr. Sarao in April 2015, charging him and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing and layering activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange from April 2010 through April 2015 that netted him profits in excess of US $40 million. Mr. Sarao was specifically accused of having engaged in illicit trading that contributed to the May 6, 2010, “Flash Crash.” (The “Flash Crash” refers to events on May 6, when major US-equities indices in the futures and securities markets suddenly declined 5-6 percent in the afternoon in a few minutes before recovering within a similarly short time period.)
Two weeks ago, Mr. Sarao also pleaded guilty to criminal charges brought by the Department of Justice related to the same essential conduct; he awaits sentencing in connection with this matter. (Click here for further background regarding the resolution of Mr. Sarao’s criminal and civil actions in the article, “Alleged Flash Crash Spoofer Pleads Guilty to Criminal Charges and Agrees to Resolve CFTC Civil Complaint by Paying Over $38.6 Million in Penalties” in the November 13, 2016 edition of Bridging the Week.)
Separately, three judges of the US Court of Appeals for the Seventh Circuit heard oral arguments on November 10 related to Michael Coscia’s efforts to set aside his November 2015 criminal conviction on six counts of commodities fraud and six counts of spoofing in connection with his trading activities on CME Group exchanges and ICE Futures Europe from August through October 2011. During his presentation, Mr. Coscia’s counsel principally argued that the provision of law prohibiting spoofing under which Mr. Coscia was prosecuted had not given him adequate notice of what trading activity was precisely prohibited. This was because the relevant provision of law did not define spoofing and, prior to the time of Mr. Coscia’s alleged wrong conduct, the CFTC provided no guidance regarding what constituted prohibited spoofing.
The relevant provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act under which Mr. Coscia was prosecuted first became effective in July 2011, one month prior to the initiation of his alleged wrongful conduct. (Click here to access the relevant anti-spoofing provision, Commodity Exchange Act Sec. 4c(a)(5)(C), 7 US Code Sec. 6c(a)(5)(C).)
The judges hearing the case asked counsel for both Mr. Coscia and the United States to distinguish differences between contingent orders and orders that constituted spoofing, and to opine whether spoofing solely represented an evolution of market practices to address high-speed algorithmic trading. The judges appeared sympathetic to the fact that Mr. Coscia’s conviction was the first prosecution under the new Dodd-Frank provision outlawing spoofing. (Click here for background on Coscia’s sentencing and criminal conviction in the article, “Michael Coscia Sentenced to Three Years’ Imprisonment for Spoofing and Commodity Fraud” in the July 17, 2016, edition of Bridging the Week.)
My View: As I have written before, the anti-spoofing provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that prohibits trading activity 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)” is badly drafted because it uses a term that is assumed to be commonly understood and is followed by a parenthetical that is too broad in scope.
It may seem clear to many what is prohibited by this provision, but by its broad sweep, the provision technically makes illegal relatively ordinary trading conduct that no one – not even the Commodity Futures Trading Commission or any exchange – would likely consider nefarious.
For example, when a trader places a stop-loss order, he or she does not intend for the order to be executed, because presumably that would mean the market is trending in a direction opposite his or her view or expectation. However, he or she would accept an execution if the conditions of the stop-loss order was realized. The CFTC, in its May 28, 2013 Antidisruptive Practices Authority guidance (click here to access) seems to acknowledge this dichotomy. According to the CFTC, “a spoofing violation will not occur when the person’s intent when cancelling a bid or offer before execution was to cancel such bid or offer as part of a legitimate, good-faith attempt to consummate a trade. Thus the Commission interprets the statute to mean that a legitimate, good-faith cancellation or modification of orders (e.g., partially filled orders or properly placed stop-loss orders) would not violate [the spoofing prohibition].”
CME Group, in its interpretation of its rule related to market disruption, goes even further by suggesting there is a difference between intent and hope when placing an order. According to CME, “[m]arket participants may enter stop orders as a means of minimizing potential losses with the hope that the order will not be triggered. However, it must be the intent of the market participant that the order will be executed if the specified condition is met.” (Click here to access CME Group Advisory, RA-1516-5.)
Potentially, every individual that a regulator might seek to prosecute for spoofing will likely hope that some orders might not be executed, but is likely okay for the orders to be executed if they are — i.e., if the specified market conditions are met!
Moreover, in its Advisory, CME Group also provides a number of other examples where the intent of a trader is not necessarily to have all his or her orders executed at the time of order placement, but the consequence is not deemed impermissible spoofing — e.g., placing a quantity larger than a market participant expects to trade in electronic markets subject to a pro rata matching algorithm and placing orders at various price levels throughout an order book solely to gain queue position, and subsequently cancelling those orders as markets change.
Unfortunately, the statute prohibiting spoofing simply has it wrong. There is nothing automatically problematic about all spoofing as now defined under applicable law. Deception, to some extent, is part of smart trading. No trader knowingly reveals all his or her strategy or intent as part of an order placement. Using iceberg orders to disguise order volume is expressly legitimate, for example. As CME Group wrote in a comment letter to the CFTC about what should be deemed illegal spoofing, it is not the intent to cancel orders before execution that is necessarily problematic, it’s “the intent to enter non bona fide orders for the purpose of misleading market participants and exploiting that deception for the spoofing entity’s benefit” (emphasis added; click here to access CME letter to CFTC dated January 3, 2011).
The appellate judges hearing the Coscia appeal spent of lot of time listening to arguments regarding the distinction between hope and intent, the nature of algorithmic trading and how conduct characterized as spoofing might fit into modern markets. Until the law is clarified to reflect what truly is problematic, it will embrace both legitimate and illegitimate activity, potentially scare away bona fide trading and have a deleterious impact on market liquidity, and inadvertently cause some market participants to run afoul of the law for ordinary order placement activity.
No matter what the outcome of Mr. Coscia’s appeal, the law’s prohibition against spoofing should be amended to not capture commonly accepted legitimate trading activity and to more carefully capture solely what is wrongful conduct.