Market abuse is like theft. And, there are many shades of abuse in the securities trading world – from the outright prohibited to the downright frowned upon. At least a dozen different abuse scenarios have been identified under the Market Abuse Directive (MAD) in Europe, with many colourful labels used to describe a plethora of trading transgressions.
‘Spoofing’ and ‘Layering’ are just two among the list and have been hitting the headlines of late with cases involving Navinder Singh Saroa, a 36-year old British trader dubbed the ‘Hound of Hounslow’, who is alleged to have triggered a massive £350 billion ‘Flash Crash’ in the US by making 7.4 million (m) trades a day from his bedroom in west London.
But one might have thought there would have been many more cases of such abusive trading practices over recent years given how much media coverage they actually garner when cases come to court, prosecutions are made and fines are levied. Cases can also take a long time between abuses being identified, examined and the final court hearings.
In actual fact, over the past two or so years there have been just three cases brought by the UK’s Financial Conduct Authority (FCA), the UK’s main financial regulator. And, in the US around four cases have been prosecuted over a similar period of time by the Commodities Futures Trading Commission (CFTC).
First Case Of Spoofing
The first spoofing case in the US, which was prosecuted under section 747 of the Dodd-Frank Act, was the case of Michael Coscia, a futures and high frequency trader who allegedly manipulated commodities futures prices gaining illegal profits of nearly $1.6m. In the UK, the FCA imposed a financial penalty on Mr Coscia for ‘layering’ a specific form of spoofing under section 118(5).
In August 2015, the FCA secured a secured High Court judgment against Da Vinci Invest Ltd, Mineworld Ltd, Mr Szabolcs Banya, Mr Gyorgy Szabolcs Brad and Mr Tamas Pornye for committing market abuse.
Specifically, the defendants – four of whom were incorporated or resident abroad in Switzerland, the Seychelles and Hungary – were found to have committed market abuse in relation to 186 UK-listed shares by using a manipulative trading strategy known as ‘layering’.
The court awarded an injunction and over £7.57m in penalties against five defendants in the case. So, it can hit firms and individuals heavily in the pocket. It was the first time that the FCA had asked the High Court in the UK to impose a permanent injunction restraining market abuse and a penalty.
Highlighting the lengthy nature of bring cases to court, in relation to this particular case the FCA took action to stop the abuse as far back as July 2011.
Over in the US, attention has now turned to a case where the CFTC, which is based in Washington DC., is suing Red 3 LLC, a Chicago-based high frequency trading (HFT) firm and its owner-broker Igor Oystracher.
This case, which was to be heard on 23 February 2016 in a court in Chicago, Illinois, centres on the firm allegedly engaging in spoofing on some of the largest exchanges in the world over 51 days (between 12/11 and 1/14) on the Chicago Board Options Exchange, the New York Mercantile Exchange, the Chicago Mercantile Exchange, and the Commodity Exchange.
According to the general description of ‘layering’ or ‘spoofing’ offered by the FCA, which was accepted by the Upper Tribunal in 7722656 Canada Inc. (t/a Swift Trade) v FSA , “layering consists of the practice of entering relatively large orders on one side of an exchange’s electronic order book without a genuine intention that the orders will be executed.”
In essence the term ‘layering’ refers to the placing of multiple orders that are designed not to trade on one side of the order book. And, the term ‘spoofing’ refers to the fact that by the placing such orders creates a false impression as to the true trading intentions.
The accepted definition of layering in the above mentioned case states: “The orders are placed at prices which are (so the person placing them believes) unlikely to attract counterparties, while they nevertheless achieve his objective of moving the price of the relevant share as the market adjusts to the fact that there has been an apparent shift in the balance of supply and demand.”
The subsequent movement is then followed up by the execution of a trade (and often multiple trades) on the opposite side of the order book, which takes advantage of, and profits from, that movement. In turn this is followed by rapid deletion of the big orders that had been entered for the purpose of causing the movement in price, and by repetition of the behaviour in reverse on the other side of the order book.
In other words, individuals engaged in layering attempt to ramp up the price in order to benefit from a sale at a high price, then attempt to move it down to buy again – but at a lower price. And, typically they repeat the process a number of times.
In the United States, spoofing under a 2012 Act (Section 4c(a)(S)(C)) of the Dodd Frank Act is explained as “bidding or offering with the intent to cancel the bid or offer before execution.”
However, layering can sometimes be legitimately undertaken provided trades are executed when the price of a particular security reaches a certain price floor or ceiling.
Therein lies part of the problem in bringing successful prosecutions. Parties suspected of such illicit trading behaviour will likely face consequences – fines or worse – if they are not able to provide a legitimate explanation for such strategies.
What is fundamentally key in all this and very difficult to prove either way is ‘Intent to Cancel’. Trading algorithms will have high order placement and cancellation rates as they seek liquidity.
Here the scenario would be where an order is put into one venue but achieves no immediate successful fill, it is then cancelled and the order goes to another venue, and again achieves no fill, is cancelled and goes on to the next venue before achieving a fill. Thereafter , the process starts all over again in the same manner. And, this cycle can potentially be run hundreds of times in a matter of seconds.
Michael Potts, managing partner at London-based Byrne and Partners, a legal firm specialising in civil and criminal litigation in financial crime, points out that: “It is not illegal to engage with high frequency trading and neither is the cancellation of trade.”
Given that the spoofing offence in the US is described as “bidding or offering with the intent to cancel the bid or offer before execution”, Potts explains that: “The prosecution must prove “intent to cancel the bid” at the time of bidding or offering.”
He adds: “When trading is executed by automated software this may be achieved by using the programming of the software. The instruction of experts on both sides is likely because of the complexity of trading and the automated software used.”
Proving a person’s or indeed electronic strategies ‘intent’ can therefore be a difficult proposition. While in certain cases it is clear cut that such abuse has occurred outside court using market surveillance technology to go over the trading pattern(s) and the alleged misbehaviour, proving it in front of a presiding judge is another matter.
With the spoofing offence in the US being described as “bidding or offering with the intent to cancel the bid or offer before execution”, here Potts explains: “The prosecution must prove ‘intent to cancel the bid’ at the time of bidding or offering.”
He adds: “When trading is executed by automated software this may be achieved by using the programming of the software. The instruction of experts on both sides [prosecution and defence] is likely because of the complexity of trading and the automated software used.”
Under English law, if the prosecution charge a trader with market abuse, the prosecution does not need to prove intent to cancel the bid as in the US – but “behaviour” which gives or are likely to give a false or misleading impression or secure the price of an investment at an abnormal or artificial level.”
He adds: “The burden of proof is not as in criminal cases “beyond reasonable doubt”, but the lower civil burden of proof of “on the balance of probabilities.”
Potts commenting in respect of the nature of nailing spoofing and layering abuse case says: “The complexity of trading, the witnesses to be heard, the instruction of experts on both sides and indeed extradition proceedings that may take place before the substantive case starts, all add to the length of any such cases.” He added: “Given the increased monitoring of regulators, it is not unlikely that more cases will follow.”