On Nov. 3, 2015, a federal jury in Chicago found commodities trader Michael Coscia guilty on six counts of commodities fraud and six counts of spoofing, the first criminal conviction for that offense under the Dodd-Frank Act.
This conviction could set a precedent for aggressive prosecutions in this area. Asset managers, proprietary trading firms and others active in the derivatives markets should have no doubt that their trading activities will come under scrutiny, both for spoofing and other types of disruptive and manipulative trading. A transaction that is questioned by a broker, other traders or an exchange could become the basis for a government investigation, as exchanges, the Commodity Futures Trading Commission (CFTC), the Department of Justice (DOJ) and foreign regulatory authorities collaborate. It should also remind firms that a careful review of their trading programs and algorithms is in order.
What is spoofing?
Spoofing is a form of market manipulation using trading strategies that are designed to rapidly place, and then quickly cancel, orders before execution with the intent that the original order be canceled for non-bona fide purposes.
Section 747 of Dodd-Frank amended the Commodity Exchange Act (CEA) to make spoofing illegal. Specifically, Section 4c(a)(5) of the CEA makes it unlawful for a person to engage in any trading, practice or conduct on or subject to the rules of a registered entity (such as a futures exchange) that “is of the character of, or is commonly known to the trade as, ‘spoofing’ (bidding or offering with the intent to cancel the bid or offer before execution).”
While this change in law gives civil and criminal enforcement authorities a clear mandate for pursuing this manipulative trading practice, it has remained uncertain what specific conduct would qualify. In May 2013, the CFTC published guidance on spoofing and other disruptive trading practices. The CFTC guidance clarifies that:
- The CFTC “interprets a [spoofing] violation as requiring a market participant to act with some degree of intent, or scienter, beyond recklessnes.”
- “[L]egitimate, good-faith cancellation or modification of orders (e.g., partially-filled orders or properly placed stop-loss orders) would not” be considered unlawful spoofing.
- “When distinguishing between legitimate trading … and ‘spoofing,’ the [CFTC] intends to evaluate the market context, the person’s pattern of trading activity (including fill characteristics) and other relevant facts and circumstances.”
- The prohibition against spoofing covers “bid and offer activity on all products, traded on all registered entities” and is not restricted to “trading platforms and venues only having order book functionality.”
The CFTC also provided four “non-exclusive examples” (see “What is spoofing?” below).
Additionally, the CME Group and ICE Futures U.S. have issued guidance offering their interpretations as to what constitutes disruptive practices.
United States v. Coscia
In October 2014, Coscia was indicted on six counts of commodities fraud and six counts of spoofing by a federal grand jury sitting in the Northern District of Illinois.
Coscia was accused of utilizing sophisticated computer trading algorithms called “Flash Trader” and “Quote Trader” to manipulate futures market prices. The Flash Trader algorithm allegedly placed a small order on one side of the market, and the Quote Trader algorithm would place large orders on the opposite side at the same time. The large orders were then promptly canceled just before execution, creating the illusion of market interest, or disinterest, in different commodities to artificially move prices in Coscia’s favor. Only after the market reacted to these spurious orders did Coscia place and fill “real” orders, allegedly reaping $1.4 million in profits.
Judge Leinenweber of the U.S. District Court for the Northern District of Illinois denied Coscia’s motion to dismiss in April 2015, holding that Congress’s prohibition on spoofing was presumptively valid and that Dodd-Frank fairly apprised Coscia that his specific trading activities were illegal.
Coscia’s trial began on Oct. 26, 2015 and concluded in six days (see “Key points,” below).
The jury deliberated for a little more than one hour before finding Coscia guilty on all 12 criminal counts. Coscia is scheduled to be sentenced in 2016. Each count of commodities fraud carries a maximum sentence of 25 years and a $250,000 fine. Each count of spoofing carries a maximum sentence of 10 years and a $1 million fine.
In addition, in 2013, Coscia settled civil claims brought by the CFTC by paying a $2.8 million fine and consenting to a one-year trading ban. Coscia also settled with the CME in 2013 by paying a $200,000 fine, consenting to a six-month trading and membership ban with the CME, and disgorging more than $1.3 million. Coscia also settled charges with the UK Financial Conduct Authority (FCA). He did not admit or deny the CFTC, FCA or exchange charges.
The Coscia guilty verdict is significant for several reasons. The verdict, and particularly the short length of the jury’s deliberation, demonstrates that spoofing prosecutions are viable and are not too complex for a jury to understand. Criminal authorities and the CFTC may be emboldened to bring more of these cases as a result.
Also, it was difficult for Coscia’s defense team to convince enforcement authorities, and ultimately a jury, about the economic rationale of placing and canceling orders—and particularly large orders—within milliseconds. Finally, an automated self-canceling trading algorithm can be seen as market-manipulative under Dodd-Frank’s anti-spoofing provisions.
With the DOJ’s victory in Coscia, and after more than three years of heightened civil enforcement by the exchanges and CFTC, expect aggressive enforcement of the anti-spoofing provisions to increase. To this end, the CFTC filed a civil complaint in April 2015 against London-based high-frequency trader Navinder Sarao and his firm, Nav Sarao Futures Ltd. The agency alleges Sarao manipulated the CME’s E-mini S&P 500 futures contract by placing—and then promptly canceling or modifying just before execution—hundreds of thousands of “exceptionally large” trades. The agency further alleges that Sarao helped to cause the “flash crash” of 2010. In addition, on Oct. 19, 2015, the CFTC filed suit against Chicago-based trader Igor Oystacher and his firm 3Red Trading LLC on charges of spoofing. The complaint alleges that Oystacher and his firm carried out more than 5,000 spoof orders from December 2011 to January 2014, involving nearly 360,000 underlying contracts—orders that were usually canceled in less than a second.
With Coscia and the CFTC’s earlier guidance in mind, it is prudent for traders to review their trading strategies and algorithms. Firms should consider the following factors when evaluating if their trading strategies and algorithms lead to higher cancellation rates:
- Do trading algorithms call for cancellation of bids and offers in all cases, even when prices move in a favorable direction?
- Are cancellation rates of bids and offers meaningfully higher during contract closing periods?
- Are there differences between fill rates for large vs. small orders?
- Is there a potential connection between cancellation activity and market prices?
- Are cancellations driven by trading in other markets (such as where a strategy is pursued through both the futures markets and the securities markets)?
Firms should also be mindful of order-fill rates generally and have a legitimate rationale for all orders and cancellations. Indeed, firms should evaluate any coding instructions or other computer programming direction to ensure there is a legitimate rationale for the instructions. Finally, traders should be aware of the aggressive push by civil and criminal authorities, often working in tandem and with overseas regulators, in this emerging area of enforcement.