September 14, 2020
Brett Friedman
Managing Partner
The CFTC is coming down hard on spoofers -- and they are just getting started.
Based on how the CFTC has described spoofing in past cases, there is still a lot of activity that will likely trigger CFTC actions.
In many cases, the traders and compliance groups either don’t know what the CFTC considers to be spoofing, or don’t know enough about the current enforcement regime to realize why they should even care.
This path leads to only two possible outcomes: either shareholders demand their traders and compliance groups do more to protect themselves, or they will become the next Scotiabank. Time is ticking!
The SEC, in conjunction with the DOJ, is getting more aggressive in pursuing spoofing in non-futures markets.
Recently, I wrote about the orgy of spoofing in the precious metals markets that has been going on for about the last 10 years. All the usual bank suspects were involved: JPM, Scotia, UBS, HSBC, etc., etc. Keep in mind that all this wasn’t going on in a vacuum but during the same period in which FX and LIBOR fixes were being manipulated at many of the same banks. Of course, the traders supplied the usual chatroom banter to hang themselves and their employers. Criminal (i.e. jail time) and civil sanctions and settlements were handed down by the authorities; the banks made solemn and vaporous promises to do better.
But here’s the shocker: all this blatantly illegal activity occurred in institutions with well-developed compliance and legal teams, all supposedly beefed up post-2008. Needless to say, Board conversations must have been “candid” after they found out that they had taken yet another hit to their reputation due to trading activities that they barely understood.
And yet, despite all the prosecutions, fines, and criminal sanctions, traders are still engaging in what the CFTC calls spoofing.
How do we know? After all, the law defines spoofing based on the trader’s intentions, something we cannot possibly know. Over the past several years the CFTC has described specific examples of spoofing in its public and non-public filings. Only a handful of those examples come with any discussion or other evidence about the trader’s intentions. The remaining examples are woven into a simple legal argument that boils down to this: “if it quacks like a duck, smells like a duck…” So, we are not saying the traders are spoofing, only that what they are doing will likely be called spoofing by the CFTC.
So what exactly does a spoof “look like” in the eyes of the CFTC? When we describe spoofing, we know it is spoofing because we know the “why” behind the activity. But what if we don’t know the “why,” only the “what”? What should we look for? Without knowing this, we can only detect spoofing when a trader decides to boast about it in chatroom. Alternatively, compliance could approve activity that we know is not spoofing, only to learn later that the CFTC thinks it is. As if in one voice, the trading industry asked the CFTC this question several years ago as part of the process to finalize spoofing enforcement rules. Unfortunately, in the view of most, the CFTC’s “clarification” was as clear as mud.
After more than a year of digging through hundreds of public and non-public documents from the dozens of CFTC spoofing actions taken so far, my colleague, Jack Yeager, thinks he now knows what’s tipping off the CFTC. His approach to figuring this out was simple. Spoofing is whatever the CFTC says it is, and the CFTC has described hundreds of incidents over the past few years. Here is one example, as described by the CFTC:
At 8:26:48.474, [Trader] placed a 55-lot Spoof Order to sell December-delivery Gold Futures contracts at a price of $1285.10 that he intended to cancel before execution. At the time he placed this 55-lot Spoof Order to sell, it was two ticks from the best offer, and there was a total volume of 89 lots visible on the sell side of the Order Book at this price level or better, including this order. This order constituted over 60% of the total market at this price or better and significantly shifted the book pressure on the bid side toward the front of the book. During the time it was on the market, prices dropped up to three ticks and bid orders were filled at more favorable prices. At 8:26:52.720, less than 5 seconds later, [Trader] canceled the 55-lot Spoof Order to sell in its entirety.[1]
You might say “Wait, what about the order on the other side, the one where they make money?” Here’s the deal. That other order is not the one that results in charges. In fact, the CFTC refers to those as the “genuine” orders. Even so, there are many instances where the CFTC alleged spoofing when there was no order on the other side. In every instance, they found something else to point to as the reason for the spoof. It could be a position in another market, or in a spread or option position, or to game a customer on an order, or to earn a fee, or get others to modify a quote on an OTC position, or as part of a conspiracy with another trader or even another counterparty, or something else. In short, they were willing to stretch as far as necessary to find something. Even after stretching, they sometimes found nothing, at which point they describe it as a “failed attempt” to spoof.
To try to answer the question of whether or not this kind of thing is still going on, Jack analyzed the publicly available market data from CME for some of the more actively traded futures contracts during the summer of 2020, looking for things that resemble the CFTC examples. Here is an example he found from May 1, 2020:
At 11:30:04.758700, [Trader] placed a 21-lot Spoof Order to buy June-delivery Gold Futures contracts at a price of $1691.20 that he intended to cancel before execution. At the time he placed this 21-lot Spoof Order to buy, it was two ticks from the best bid, and there was a total volume of 34 lots visible on the sell side of the Order Book at this price level or better, including this order. This order constituted over 60% of the total market at this price or better and significantly shifted the book pressure on the bid side toward the front of the book. Almost immediately after it was placed on the market, prices began to rise, climbing over 5 ticks, and offer orders were filled at more favorable prices. At 11:30:10.291260, just over 5 seconds later, [Trader] canceled the 21-lot Spoof Order to buy in its entirety.[2]
It is difficult to deny that this thing walks, quacks, and smells like a CFTC spoofing duck. In all, he found 106 such instances on this one trading day and in this one gold futures contract. He found the same thing in the most actively traded gold futures contract for every trading day during the months of May and June 2020. He also found similar activity on every trading day during the two-month period in the most actively traded Natural Gas and WTI Crude futures contracts. So when you ask, are traders still spoofing, we are confident that the CFTC would say, “Yes, of course they are.”
This leads to the obvious question: Why? Why, after all the actions and sanctions, some criminal (i.e., actual jail time), are traders still doing this? Why aren’t compliance functions or trading management stopping it? According to Jack, the answers to these questions seem to boil down to one of two reasons. They either don’t know or don’t care.
Jack does training on spoofing for traders and compliance groups. Here is how he describes it:
“We always start by asking the room if they know what spoofing is. Everyone says they do, that they understand it is illegal, and that they don’t do it. Then we start describing to them some of the examples the CFTC has pursued as spoofs and the room erupts. Some have actually boasted that they do this kind of thing all the time. They reason that it must not be spoofing, because they have never gotten a call from compliance about it. I have usually prepped compliance beforehand, so they are ready. They explain that this is a gap in their monitoring that they are just learning about, and that they are working to fix. At that point many begin to panic, starting to describe their recent activity and asking how that might be viewed. These are the ones that didn’t know.”
So what about the ones that don’t care? Jack explains it this way:
“Occasionally we run into someone who just doesn’t care. It is not that they don’t care about breaking the law. They just don’t care what the CFTC thinks. They reason that, if the CFTC ever comes after them, they will simply explain why they did what they did, and the whole thing will go away. After all, who is the CFTC to tell them what their intentions are? There is a whole lot of legal stuff to explain here, but at the end of the day it comes down to this: the trader’s testimony about what why they did what they did will likely be ruled hearsay and will not be allowed into evidence. Simply put, they will likely not be allowed to testify about why they did what they did. A long silence usually follows this little tidbit. Then some choice words about the legal system. Eventually though, we get back on track. Now, the trader who didn’t care suddenly cares more than anyone else in the room about what the compliance group is doing to protect the traders. Honestly, I have never run into someone who still does not care once they learn that their entire defense is going to be shut down without ever getting a chance to testify.”
And for those of you smugly dismissing this because you are an equity investor, don’t get too comfortable. While the SEC does not have specific rules prohibiting spoofing in security markets, they have successfully pursued spoofing charges in the past. They now seem to be taking a page from the CFTC playbook, and are becoming much more aggressive in pursuing these charges, both alone and in conjunction with the DOJ. So, consider this:
If spoofing is still rampant in a market where the regulators have been aggressively pursuing charges for the past 3-4 years, how rampant do you think it is in a market where it has largely been ignored?
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[1] Excerpt from CFTC complaint redacted to hide the name(s) of the trader(s) involved. [2] Excerpt from CFTC complaint, redacted to hide the name(s) of the trader(s) involved.
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© 2020. all rights reserved, Winhall Risk Analytics. The contents of this website are intended to convey general information only and not to provide legal advice or opinions. The contents of this website, and the posting and viewing of the information on this website, should not be construed as, and should not be relied upon for, legal or tax advice in any particular circumstance or fact situation. The information presented on this website may not reflect the most current legal developments. No action should be taken in reliance on the information contained on this website and we disclaim all liability in respect to actions taken or not taken based on any or all of the contents of this site to the fullest extent permitted by law. An attorney should be contacted for advice on specific legal issues.