On October 1, 2014, the U.S. Attorney’s Office in Chicago brought criminal charges against Michael Coscia for “spoofing.” United States v. Michael Coscia, 14-cr-551 (N.D. Ill.). Each count of the indictment relates to a different futures contract Coscia traded (namely, Euro FX, Pound FX, soybean meal, soybean oil, gold and copper). Each spoofing count carries a maximum sentence of 10 years in prison and up to a $1 million fine; each commodities fraud count carries a maximum sentence of 25 years in prison and up to a $250,000 fine.
The indictment alleges that Coscia designed and utilized algorithmic trading programs through which “he entered large-volume orders that he intended to immediately cancel before they could be filled by other traders.” These are referred to as “quote orders” – as distinguished from “trade orders,” which were placed on the other side of the market, and which Coscia intended to be filled. This type of spoofing is commonly referred to as “layering,” which involves placing a bona fide order that is intended to be executed on one side of the market (buy or sell), and entering numerous non-bona fide orders on the opposite side of the market to attract interest to the bona fide order and artificially improve or depress the bid or ask price. Immediately after execution of the bona fide order, the open non-bona fide orders are cancelled, and the strategy is repeated on the opposite side of the market to close out the position. According to the indictment:
COSCIA designed his programs to cancel the quote orders within a fraction of a second automatically, without regard to market conditions, even if the market moved in a direction favorable to the quote orders. COSCIA programmed the quote orders to cancel quickly and automatically because he did not intend for the quote orders to be filled when he entered them, but instead intended to trick other traders into reacting to the false price and volume information he created with his fraudulent and misleading quote orders.
While regulatory scrutiny of “spoofing” – generally viewed as the entry of a bid or offer with the intent to cancel the bid or offer before execution – predates Dodd-Frank’s enactment, federal focus on and enforcement tools relating to this and other trade practices in the futures and derivatives market have been given a significant boost by that statute. First, Dodd-Frank added a provision to the Commodity Exchange Act (CEA) that specifically prohibits on CFTC-regulated markets any trade practice or conduct that violates bids or offers, demonstrates intentional or reckless disregard for the orderly execution of transactions during the closing period, or constitutes spoofing. Second, Dodd-Frank greatly expanded the fraud and manipulation authority of the Commodity Futures Trading Commission (CFTC) by adding a provision to the CEA modeled on Section 10(b) of the Securities Exchange Act, which for the first time allows the CFTC to charge manipulation based upon reckless conduct, not just intent.
The CFTC has already brought cases utilizing these provisions, imposing substantial sanctions. And it intends to ramp up its use of them. As reported in the Wall Street Journal on November 9, Aitan Goelman, the Director of Enforcement at the CFTC recently gave a speech in which he said that:
He wanted the agency to work with the criminal authorities to achieve more prosecutions of market manipulations and other complicated frauds that lie within the CFTC’s area of responsibility. He cited as one example “spoofing” . . . . The CFTC can impose civil penalties, such as fines, for such manipulative practices, Mr. Goelman said. But to deter others from future misconduct, there is “no substitute for putting actual human beings in jail,” he said. “We want to put the word out that if you violate the Commodity Exchange Act, you have a real chance of facing time in prison.”
The exchanges are also ramping up their attention to so-called disruptive or anti-competitive trade practices. In September, the CME Group Exchanges put into effect new Rule 575, entitled “Disruptive Practices Prohibited.” As explained in Market Regulation Advisory Notice RA1405-5 (the MRAN), Rule 575 codifies “particular types of disruptive order entry and trading practices” that “have historically been prohibited by and prosecuted under other Exchange rules . . . .” The 12-page MRAN provides guidance on various types of prohibited disruptive order entry and trading practices that the CME Group Exchanges consider to be abusive to the orderly conduct of trading or the fair execution of transactions. A list of examples of conduct prohibited by Rule 575 includes, among other things, trading practices that create a misleading impression of buy or sell pressure, entering orders to identify and then “ignite” algorithmic trading activity in order to create “momentum” in a particular market (referred to as “momentum ignition”) and entering and canceling orders during a pre-opening period to gauge depth of book, identify hidden liquidity, or to artificially increase or decrease the indicative opening price. Order entry and related activities conducted with reckless disregard for adverse impact on the orderly conduct of trading and fair execution of transactions is sufficient to cause a violation. In that regard, the MRAN cautions: “Market participants should be cognizant of the market characteristics of the products they trade and ensure that their order entry activity does not result in market disruptions.”
In light of all these changes and activity, market participants need to examine carefully their trading practices and assess the risks they may face from SROs, federal regulators and even criminal prosecutors. It is critical that participants in these markets not only evaluate their practices to identify clearly improper conduct, but to consider carefully from a risk management perspective the much wider swatch of trade practices that could trigger scrutiny because they fall in the gray areas under vague legal concepts like “manipulation,” “spoofing” and “disruptive practices.” Continuing analysis of trading and the consideration of various risk management techniques over time and as enforcement focus and case law develops will also be crucial.