01 Mar 2016
In this article, Greg Brandman and Shibani Kapur of Eversheds’ Financial Services, Disputes & Investigations group consider the US and UK definitions of spoofing, review the relevant enforcement outcomes including the landmark decision in Coscia (relevant to both sides of the Atlantic) and provide some key takeaways for firms arising from an analysis of these enforcement actions and incoming regulation at the European level
The UK Position
The UK FSA formally expressed its concerns about the practice of “spoofing” or “layering” to UK regulated firms for the first time in 2009 in its Market Watch newsletter, where it described the activity as that where a trader submits multiple orders at different prices on one side of the order book (‘layering’ the book) slightly away from the “touch”. The trader then submits an order to the other side of the order book and, following execution, rapidly cancels the multiple orders that he initially placed. This has the effect of creating a false or misleading impression of supply and demand in the market leading to a movement in the price of the relevant investment, which the trader can then take advantage of.
“Spoofing” as a manipulative trading strategy is not formally defined under UK law or regulation. But it has been deemed by the FCA to fall within the market abuse provisions of the Financial Services and Markets Act 2000 (“FSMA”) in several civil enforcement actions (such as the Coscia and Da Vinci cases discussed below). “Spoofing” falls within one of the definitions of market manipulation under FSMA, the relevant provision being section 118(5), which describes the following activity as being a type of market abuse:
‘effecting transactions or orders to trade (otherwise than for legitimate reasons and in conformity with [accepted market practices] on the relevant market) which (a) give or are likely to give a false or misleading impression as to the supply of, or demand for, or as to the price of one or more [qualifying investments] or (b) secure the price of one or more such investments at an abnormal or artificial level.’
Further guidance for firms seeking to understand what conduct may captured by section 118(5) can be found within the Code of Market Conduct (“MAR”) in the FCA Handbook, which again focuses on the ‘misleading impression’ created by the activity within the market. Under MAR1.6.2E(4) of the FCA Handbook, the analogous description refers to:
‘entering orders into an electronic trading system, at prices which are higher than the previous bid or lower than the previous offer, and withdrawing them before they are executed, in order to give a misleading impression that there is demand for or supply of the qualifying investment at that price.’
In contrast to the UK, the US formally defines “spoofing” as ’bidding or offering with the intent to cancel the bid or offer before execution’ in the Commodity Exchange Act (“CEA”) and the Commodities and Futures Trading Commission’s (“CFTC”) interpretative guidance issued in 2013.
A Question of Intent
The US spoofing offence under the CEA requires intent, beyond mere recklessness, to cancel the order before execution. In contrast, under the UK’s civil market abuse regime, there is no requirement for intent for any of the market abuse offences under section 118 FSMA to have been committed. It remains to be seen whether the FCA will use the misleading impressions offence contained in section 90 of the Financial Services Act 2012 (which does require an element of intent) to prosecute “spoofing” on a criminal basis in the future. Traditionally, the FCA has preferred to use the civil provisions under section 118 FSMA to investigate and “prosecute” market abuse, except in the most egregious cases of insider dealing, where it considers that the test under the Code for Crown Prosecutors has been satisfied.
Coscia – US and UK Cooperation
In a landmark case in November 2015, the Illinois courts convicted Michael Coscia (founder of Panther Energy Trading) of six counts of spoofing and six counts of commodities fraud. This case was the first criminal conviction in the US under the anti-spoofing law that was added to the CEA by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act and followed civil penalties already imposed on Coscia and his company by both the CFTC and the FCA for engaging in market abuse in 2013.
It should be noted that although Coscia was based in the United States, he submitted orders to a UK-regulated market which led to enforcement action being pursued in the UK as well as the US. The coordinated CFTC/FCA civil enforcement actions reflect the willingness of financial services regulators to bring enforcement action, even where the perpetrators are geographically located outside their own jurisdiction.
The FCA Enforcement Action Against Michael Coscia (2013)
Coscia’s trades used an automated algorithm which involved placing a small order on the order book, typically around the best price level (‘the touch’), and when the small order was in place, placing several large orders on the other side of the order book. This gave the appearance of a large number of orders having entered the market, moving the price in the direction of the resting small order. The false impression of liquidity created by the large orders induced market participants to trade on the opposite side of the order book so the small order would be executed. On execution of the small order, the algorithm was designed to cancel all other orders. Remarkably, the use of algorithms meant that Coscia could buy and sell 17 lots and realise a profit of US$ 340 in less than one second. This he did repeatedly; sometimes hundreds of times in one day.
As part of its findings in respect of market abuse, the FCA relied upon the fact that Coscia’s large orders were unlikely to be executed in practice because of the speed at which they were placed and cancelled. This gave rise to a false impression of liquidity rather than reflecting any genuine market supply and demand. The orders were also unusually large in that market, which meant they had a significant effect on the impression of the level of supply and demand within the order book (market depth) and had a detrimental impact on the market as a whole because there was no genuine intention to execute them.
One of the interesting aspects of the Coscia case was that it represented the first time a penalty for market abuse was imposed against a high frequency trader by the UK regulator. The FCA’s findings focused largely on the negative impact of the speed and size of Coscia’s manipulative orders. Although the FCA recognised in its Market Watch Newsletter of August 2013 the benefits of algorithmic trading, which provides a very important source of liquidity to financial markets, it has also expressed concerns that algorithmic trading strategies can be used with an abusive intent, (as with Coscia’s) and that the speed at which such abusive strategies can be implemented can have a very significant impact on market integrity.
The nexus between the use of spoofing to manipulate the market and its degree of impact is further illustrated by the charges brought by the CFTC and the DOJ against another trader, the UK resident Navinder Singh Sarao, whom the DOJ alleges contributed to the 2010 ‘Flash Crash’. Sarao has been accused of using layering algorithms to rapidly place and cancel orders on the Chicago Mercantile Exchange.
The potential for algorithmic trading to cause market volatility and distortion is expressly acknowledged by MiFID II, which is introducing much closer regulation of algorithmic traders and the venues on which they trade, including significant additional monitoring obligations.
Da Vinci Invest Ltd
Another recent example of an enforcement case in the context of “layering” or “spoofing” came about in April 2015 when for the first time the FCA asked the English court to impose a permanent injunction restraining market abuse on three individual traders, Da Vinci Invest Ltd and Mineworld Ltd. The FCA also persuaded the court to impose substantial civil penalties on the defendants, four of whom were incorporated or resident abroad, although their abusive conduct related to UK-listed securities..
The traders in the Da Vinci case engaged in spoofing by placing large orders for shares (through contracts for difference with a Direct Market Access Provider rather than placing the orders directly on the market themselves) with no intention to execute in order to create a false or misleading impression of the supply and demand of the shares. They proceeded to place small orders to improve the price, then placed large orders at the best bid or offer price, repeating the process again. The traders were able to take advantage of the improved share price by entering the market on the opposite side to gain from the artificial uplift, with the initial layered orders then being cancelled.
Although the Court held that the individual traders appeared to know that their actions constituted improper conduct, the finding of market abuse against the firms was made on the basis that they had not done all that they could have reasonably done to prevent market abuse from occurring, for example checking the background of the traders or monitoring trading strategy. The case provides a further reminder to firms of the importance of ensuring that they maintain effective market abuse systems and controls so as to enable appropriate monitoring of suspicious trading activity, including monitoring for potentially manipulative strategies that could constitute spoofing or layering.
Enforcement and Incoming Regulation – Points To Note
There are several points to note for firms on an analysis of recent FCA enforcement activity relating to layering and spoofing and relevant incoming regulation at the European level:
- Regulators are increasingly willing to take draconian action to address the perceived risks to market integrity arising from high frequency algorithmic trading.
- Further regulation will be coming into force in 2016 (pursuant to the Market Abuse Regulation (“MAR”)) and in 2017/2018 (pursuant to MiFID II), which will significantly increase the monitoring, reporting and compliance burden on high frequency traders and the venues on which they trade. Firms will want to consider the most effective means by which they can design and monitor trading strategies so as to ensure that they comply with the new rules.
- The implementation of MIFID II will be particularly significant in this regard. This will impose additional requirements on firms and trading venues, including in particular, the obligation to disclose prescribed information to regulators about algorithmic trading and record-keeping in respect of placed and cancelled orders.
- MAR will also place additional reporting burdens on firms, including a requirement to report suspicious orders (such as those that may have been placed and then cancelled in support of a layering strategy) in addition to the existing obligation to report suspicious transactions.
- Further, using algorithmic or high frequency trading strategies to disrupt trading systems or to obscure genuine orders or otherwise create false/misleading signals about supply/demand/price of financial instruments will be an offence under MAR where this has not previously been the case in certain EU jurisdictions:
- Under MAR, there will be a presumption of market manipulation where orders are sent to a trading venue by means of algorithmic or high frequency trading without an intention to trade and where they have the effects referred to above; and
- under MAR it will also be an offence to attempt to manipulate the market.
- Firms should have regard to comments and guidance from regulators in the enforcement of layering and spoofing cases; including in relation to the effect of such activity on the market and the historic pattern of activity, including the size, duration, price and time priority of the orders. The FCA and US regulators in the Coscia cases were particularly focused on the duration and cancellation rates of the underlying orders and whether the large orders were placed systematically on the opposite side of the order book. It would therefore be prudent for firms to monitor cancellation rates in particular and the comparative size of such orders with respect to traditional, established trading patterns in relevant markets.
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