Spoofing in the Financial Markets

Mar 10, 2022 05:32 PM ET
Spoofing in the Financial Markets

Speculative financial markets offer numerous opportunities for profit on a daily basis. However, no matter how experienced a trader is, they cannot predict with 100% certainty how a market will move in the future. Therefore, in a way, the outcome of each trade made in these markets relies on sheer chance. However, some traders find ways to manipulate an asset’s price, which gives them an unfair advantage over other participants. One such manipulation practice is called spoofing.

Spoofing explained

This is a market manipulation practice that involves placing fake buy or sell orders. When spoofing, the fraudster enters a large volume of limit orders, either long or short, with the intention of moving prices in a particular direction. However, before the orders can be executed, the trader cancels them since they had no intention of fulfilling them in the first place. Though most commonly found in the stock market, spoofing can happen to any financial asset, be it commodities, cryptocurrencies, or bonds. 

How spoofing works

Demand and supply are major moving forces behind the prices of speculative financial assets. Take stocks, for example. If demand grows for a company’s stock, the price will likely rally. Conversely, if the demand falls, prices will plummet. Therefore, if one could artificially induce this demand, they could very well influence the direction of price movement. This is the basic principle behind spoofing.

However, most of these financial markets feature a large number of market participants. Therefore, to effectively shift demand in any one direction, one has to place a large order in that direction. For that reason, spoofing is done using algorithms that are capable of placing hundreds of orders in a fraction of a second. Such algorithms are used in high-frequency trading (HFT). The same algorithm would then be used to cancel the orders before they are executed.

Example

Imagine a hypothetical situation where Randy, an affluent investor, owns the stock of company A to the tune of 150,000 shares, which he intends to sell.  At the time, the stock was bid at $130, with an asking price of $130.30. If he sells his holdings at this point, the price applicable to him would be $130. 

Instead, he places a spoof order to buy thousands of company A shares just above this bid price, say at $130.20. Since it is below the ask, the order won’t be instantly executed. However, Randy’s broker reports the $130.20 price as the National Best Bid and Offer (NBBO) best bid price. Other traders see a potential big buyer bids higher for the stock and take it as a sign that the stock is undervalued. This prompts them to enter their own buy orders, thus raising the asset’s price.  

Randy then makes another order to sell all his holdings at the inflated price while simultaneously canceling his initial pending buy order. In so doing, he obtained a higher selling price for his stock by using buy orders he had no intention of completing in the first place.   

Conditions that would hinder spoofing

Spoofing tactics may not work as intended when the market is choppy, or when unexpected volatility manifests. In our above example, let’s say the fake buy order Randy made at $130.20 was above a valid resistance point. If FOMO drives plenty of traders into buying the stock, its price may rise rapidly and fulfill Randy’s order before he has a chance to cancel it. In the same way, a short squeeze or flash crash can also fill pending orders that were not intended to be fulfilled. 

Therefore, spoofing works when demand is driven by the futures market of a particular asset. If a trend is caused by buying or selling on the spot market, then price movements may be rapid, rendering spoofing efforts ineffective.  

Legislation against spoofing

Spoofing is illegal and punishable by law in the US and UK. In the former, the Commodity Futures Trading Commission (CFTC) monitors and oversees the markets in an attempt to fish out any spoofing or other market manipulation activity. The Dodd-Frank Wall Street Reform and Consumer Protection Act has provisions that render spoofing unlawful. There are also laws and regulations banning spoofing and related activities from the Securities and Exchange Commission (SEC), as well as the Financial Industry Regulatory Authority (FINRA). 

In the UK, the Financial Conduct Authority (FCA) is mandated to oversee the markets to regulate manipulation activities. This body has been known to fine traders and institutions that were caught practicing spoofing. 

Ramifications of spoofing

Spoofing is one of the easiest ways of manipulating the markets, provided you have the means to make such large orders. For that reason, though it is illegal, it is a common practice among individual traders and institutional investors. 

In 2020, JPMorgan Chase was caught engaging in spoofing activities in the precious metals and US Treasuries futures and cash markets. As a result, the Department of Justice and CFTC fined the bank close to $1 billion. What’s more, the firm also was under investigation by the DOJ and the CFTC for manipulation activities that they allegedly undertook in 2015 and 2016.

In 2020, an individual trader was caught by the CFTC after carrying out a spoofing act that netted him more than $140,000 in profit. As a result, he was ordered to pay a fine of around $200,000.    

How to avoid falling prey to spoofing

Spoofing causes price movements that typically go against most investors’ analyses. However, due to the fear of missing out (FOMO), traders still buy into these fluke trends, only to fall prey to a spoofing scam. For that reason, the best way to avoid falling prey to this activity is to remain objective and avoid emotional trading. We live in a world where a single tweet can move certain markets significantly. Therefore, before buying into any trend, you best know what is causing that particular movement.

Conclusion

Spoofing is a popular method used to manipulate the prices of financial assets. It involves placing fake buy or sell orders in order to shift demand in a certain direction. However, just before the orders are fulfilled, the spoofer cancels them, leaving an asset significantly overvalued or undervalued. This practice is punishable by law in the US and UK. To avoid falling prey to it, always conduct your due diligence before buying into a market trend.


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