Spoofing in Commodity Futures Exchanges
The CME Group based in Chicago is the largest futures exchange in the world and operates the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT), the New York Mercantile Exchange (NYMEX), and the Commodity Exchange, Inc. (COMEX). CME Group's trading is diverse and occurs on everything from corn to Bitcoin futures with huge volume. This past May, CME Group reached its second-highest monthly trading volume ever, averaging nearly 24 million contracts daily.
Spoofing, which Congress criminalized in 2010 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, makes it illegal for "any person to engage in trading, practice, or conduct on or subject to the rules of a registered entity that –" "is, 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)." Title 7 of the United States Code, § 6c(a)(5)(C)
Spoofing is unlawful because it artificially moves prices, instead of taking advantage of natural market events. A spoofing trader can create artificial supply and demand by placing large and small orders on opposite sides of the market. An unscrupulous trader can shift the market downward through the illusion of downward market movement resulting from a surplus of supply by placing large, market-shifting orders that are never intended to be executed.
In Chicago, federal prosecutors charged Michael Coscia in the first spoofing case ever brought. Coscia, a veteran commodities futures trader, enlisted the help of a computer programmer to design two programs for several specific futures markets. Using this software, Coscia created an artificial supply and demand in the market by placing, and then cancelling, large-volume orders. In August of 2011, Coscia repeated this process tens of thousands of times resulting in over 450,000 large contract orders in two-thirds of one second, and earned profits of over $1.4 million.
Despite mounting a vigorous defense, Coscia was found to have "designed a system that used large orders to inflate or deflate prices, while also structuring that system to avoid the filling of large orders." Coscia essentially made, pumped, and then dumped the market in milliseconds while profiting enormously.
Spoofing has the potential to wreak havoc in commodity futures markets and has become an enforcement priority for federal regulators. The U.S. Department of Justice's Fraud Section announced a spoofing takedown last year that charged eight individuals in six cases across three federal districts. As the then-Acting Assistant Attorney General of the Criminal Division stated, "The Criminal Division’s message is clear. We are watching. We are closely monitoring the markets. And we will leave no stone unturned in our efforts to combat and eradicate illegal, fraudulent, and manipulative market conduct."
In the past five years, the Department of Justice has brought over a dozen spoofing cases with mixed results. The second spoofing trial involving a Swiss trader in the District of Connecticut resulted in six of the seven counts being dismissed for lack of venue and an acquittal on the remaining charge. This past spring federal prosecutors in Chicago dismissed spoofing charges against a software developer after his trial ended in a hung jury. But, in an August 20, 2019 press release for a trader’s guilty plea in the Eastern District of New York, the trader admitted as part of his plea allocution that he “learned to spoof from more senior traders, and spoofed with the knowledge and consent of his supervisors.” The release noted that the trader was “cooperating” and twice described the investigation as “ongoing,” suggesting that additional charges may be imminent.
In its annual review, the Fraud Section wrote that it “anticipates continuing to investigate and hold accountable individuals and institutions that undermine the integrity of the markets,” which suggested further spoofing enforcement in 2019. This appeared to be true last week, when the Fraud Section charged three traders in Chicago with a 14-count indictment that alleged a scheme to deceive other participants in the precious metals commodities markets via thousands of spoofed orders between 2008 and 2016. The government there alleged that the scheme violated six criminal statutes, including the Racketeer Influenced and Corrupt Organizations Act, a more aggressive approach likely designed for general deterrence and to avoid some of the complications in earlier cases.
Here are five takeaways for navigating these swift regulatory and enforcement currents:
- Spoofing will remain a high enforcement priority by the Department of Justice, U.S. Commodity Futures Trading Commission, and the U.S. Securities and Exchanges Commission’s efforts to combat market manipulation.
- What makes spoofing criminal is the trader's intent when placing the order. Prosecutors can charge only a person whom they believe a jury will find possessed the requisite specific intent to cancel orders at the time they were placed.
- Legitimate good-faith cancellation of partially filled orders does not violate the anti-spoofing statute, but is nonetheless potentially problematic in the high-volume commodity futures markets where cancelled trades can be as high as 90 percent. Prosecutors and regulators must be able to distinguish spoofing from legal trading strategies in this context.
- Investment firms and broker-dealers should be educated and trained about these offenses, indices of fraud, and have policies in place designed to prevent it so legitimate cancellations such as "stop-loss orders" (an order to sell when a certain price is reached), "fill-or-kill orders" (an order that must be filled immediately or it's fully cancelled), "partial-fill" orders (a pre-programmed order that cancels the balance of an order once a portion is filled), "Good-til-date orders" (orders that cancel with a defined period of time), "ping orders" (small orders used to detect trading activity), or "iceberg" or “hidden quantity orders" (orders designed to obscure the underlying supply or demand) are not mistaken for spoofing by regulators.
- Other statutes may come into play for similar market manipulation conduct such as 18 U.S.C. § 1348 (securities and commodities fraud), 18 U.S.C. § 1343 (wire fraud), and 7 U.S.C. § 13(a)(2) (commodity price manipulation). Knowledge about these types of offenses and countermeasures to prevent, detect, and deal with them is essential as technology continues to evolve high-frequency trading, presenting both challenges and opportunities.
For more information on market manipulation offenses, internal investigations, or compliance programs please contact your Quarles & Brady attorney or: