• Brett Friedman

Spoofing: The Trials of Deutsche

September 24, 2020

Brett Friedman

Managing Partner

· The criminal trial of two former Deutsche Bank precious metals traders by the Department of Justice began recently.

· A few key legal decisions emanating from this case could fundamentally change the way electronic markets work in the US.

· The DOJ is alleging fraud, not price manipulation. This will be a much higher bar to prove.

· Having reviewed all the public information, I am not sure the DOJ has enough evidence to prove that, at the time of the alleged spoofs, the defendants placed those orders with the intent to spoof.

· My colleague Jack Yeager explains the case – it’s not that straightforward!

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Given all the recent easy wins by the CFTC in spoofing cases, it is easy to assume that the DOJ case against James Vorley and Cedric Chanu that is going on now in Chicago will be more of the same. That would be a mistake. I am not saying the DOJ will lose. I am just saying that it will be harder for them to win than it has been for the CFTC.

First, let’s talk about why the DOJ will have a difficult time in this case.[1] In every trial, the accuser must prove certain things (“elements”) to win their case. Sometimes these are well defined by law, but in cases involving new regulations, they may not be well defined. The law also specifies how convinced a judge or jury must be about these “elements” to find the accused guilty. In a nutshell, the DOJ has a more difficult job because they must both prove more elements than the CFTC and prove them more convincingly.

This case is a criminal trial, while CFTC cases are civil trials. In a civil trial, the CFTC must prove that the accused is guilty “based on the preponderance of the evidence.” In layman’s terms, the jury only needs to be convinced that it is more likely that the accused is guilty than not guilty. In a criminal trial, the DOJ must prove that the accused is guilty “beyond a reasonable doubt.” The DOJ must convince the jury that there is no other reasonable explanation for the accused’s action other than that they are guilty.

The essential element the CFTC must prove in a spoofing case is that the trader knew, when they placed orders that they intended to cancel these orders. Not just that the trader might cancel the orders, but that they definitely would cancel them.

In a civil trial, the CFTC could present evidence about the size, price, and timing of order entry and cancelations, and the fact that this same pattern happened hundreds of times. They could then assert that this pattern was consistent with spoofing and rest their case. The defense could then present evidence that this pattern was consistent with other completely legal strategies and argue these are just examples of those strategies. Neither has presented any evidence about the trader’s intentions at the time the “spoof orders” were placed. The jury would then decide whether it is more likely the trader is guilty or innocent based on the evidence presented. At this point, there is probably a 50/50 chance of guilt or innocence. The balance would tip to favor guilt if the jury had any suspicion that the trader might be cheating. The fact many people view traders as cheaters may explain why most traders choose to settle cases against the CFTC.

In a criminal trial, the DOJ would have to convince that same jury that there is no possibility that these were legal strategies. Otherwise, the jury must find the defendant innocent. The DOJ has a more difficult job in this instance because they must disprove the explanation offered by the defense rather than offering up a more convincing alternative. While I have not seen all the evidence the DOJ will present about the traders’ intentions at the time they are placing each alleged spoof order, what I’ve seen so far has lots of holes that the defense can use to create doubt.

Assuming the DOJ does convince a jury that the defendants spoofed, they can still lose this case because they are alleging fraud here, not spoofing. The judge for this case has made it clear that to prove a spoof rises to the level of fraud the DOJ must both prove spoofing and something else. The judge gave some hint about at least one of the things he thinks might be included as “something else” in an earlier ruling in the case.

“Whether there was anything false or misleading about the communications the defendants made when they placed Spoofing Orders will depend on what their bids and offers meant to other market participants. What, if anything, beyond commodity, price, and quantity an order conveys is plainly a question of fact and the defendants’ arguments about whether their Spoofing Orders carried any implied misrepresentations are arguments about the sufficiency of the evidence that will be presented in the case and have no place in assessing the adequacy of an indictment. Perhaps the defendants are right, and traders do not, as the government alleges, expect that their counterparts necessarily intend, at the time they place an order, to fill that order. Or, perhaps, understanding that Spoofing Orders are criminal under the Commodities Exchange Act and prohibited on the COMEX, traders do understand that the placement of an order carries with it an implicit statement that the party placing the order intends to fill the order. Perhaps there is no consensus as to the import of an open order on the market. Perhaps traders recognize that unusually large orders may be outliers that cannot be relied upon as indicators of market forces. Given the permitted use of iceberg orders, perhaps traders routinely assume that order volumes are generally understated. Perhaps their own trading strategies are designed to exploit what they perceive to be unusually large orders (perhaps, for example, they try to inject themselves into the spoofing process). Perhaps differences between high frequency programmed trading and manual trading affect the understanding of what the placement of an order conveys. Perhaps manual trading strategies are independent of micro-changes in the market price or available volume of a commodity. The answers to these questions are neither self-evident nor undisputed."[2]

The judge also indicated that the accusers might need to prove other things as well. For now, let’s focus on the market participants’ expectations. This seems straightforward enough, right? Wrong! We need to know which market participants we are talking about. Is it anyone, some of them, certain of them, or something else? This is a legal question. It is also a question that has not been addressed by the law or any prior cases. That means the judge gets to decide. He will then communicate his decision by telling the jury what facts they must believe to be true to find the defendants guilty.

At one end of the spectrum, the judge could instruct the jury to consider how most market participants view limit orders. The defense is hoping the judge gives these instructions. By doing so, the judge allows the defense to point to the testimony of other traders about how long they expect limit orders to remain in the market before being filled or canceled[3]. They can point to the fact that there is already a means for traders to place orders that they want filled with certainty. It is called a market order. They can point out that in futures markets it is much more common for limit orders to be canceled than it is for them to be filled. Simply put, given this instruction, there are many things the defense can point to that the jury must consider.

At the other extreme, the judge could instruct the jury to consider whether the limits orders deceived ANY "reasonable" market participants. This would be bad news for the defense. We already know that Citadel and Quantlab are going to testify that they were deceived by the limit orders (or at least their algorithms were). So, if the DOJ can prove the traders spoofed, such a decision by the judge may ensure they are also found guilty of fraud. Such a ruling almost ensures that anyone found guilty of spoofing is automatically found guilty of fraud, and thus can serve jail time. As if that is not bad enough, such a precedent could then be used by the CFTC or DOJ to add fraud to other charges such as disruption, deceptive practices, or manipulation. It also allows trading firms to “weaponized” the regulators by crying foul (or in this case deceit) every time a competitor makes a shrewd move.

I am hoping the judge instructs the jury to consider the opinion of the masses, not the few. If not, he would be setting a precedent that would redefine the meaning of limit orders in every market, and in so doing, redefine the micro-structure for all markets that make use of a visible limit order book. This could result in some markets doing away with visible limit order books altogether.

We may find out what he has decided early on in the trial, or we may not find out until just before he dismisses the jury to deliberate, but either way, he will set a precedent. Once he does, the jury must apply this standard in determining guilt or innocence. In yet another weird 2020 twist, the judge may instruct the jury to pay attention to the few (and in so doing, basically burns down the electronic trading markets), and the jury still finds the defendants not guilty, in which case Vorley and Chanu walk free. Stay tuned.

© 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.

[1] I am not a lawyer, and this is not legal advice. I reserve the right to be completely wrong, as usual. [2] Memorandum Opinion and Order in response the defendants’ Motion to Dismiss; USA v James Vorley and Cedric Chanu; IN THE UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF ILLINOIS EASTERN DIVISION, Judge John J. Tharp, Jr, Filed 10-21-2019. [3] Hint: I have begun an informal survey, and more than 90% of those responding so far have indicated that they fully understand that any limit order can be canceled at any time for any reason

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