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High-Frequency Trading and Spoofing   

Six years ago Michael Coscia placed orders through the CME Group’s Globex platform via a trading algorithm that amounted to “spoofing.” He placed both large and small orders in the copper market, for example, with the large orders (cancelled within milliseconds) designed to create the illusion of market movement in order to create the reality of movements, whence the small order would reap its profits.

In November 2015 a jury convicted Coscia of commodities fraud and sentenced him to three years in prison.

At trial, Jeremiah Park, a software designer, testified that Coscia had commissioned him to create the programs at issue, telling Park that he wanted such a program as a “dcoy” to “pump [the] market.”

After the trial, Coscia appealed his conviction to the 7th Circuit Court of Appeals, and that court has now (as of August 7, 2017) issued an opinion affirming the judgment.

Coscia argued on appeal that Congress’ language on spoofing is void for vagueness, that is, that it fails to provide traders with clear notice of what they are and aren’t allowed to do, and thus is inconsistent with due process of law.

Not Vague, Not Void

The relevant statute says that it is “unlawful for any person to engage in any trading, practice or conduct on or subject to the rules of a registered entity 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).”

The void-for-vagueness argument sought to make use of the quotation marks around the word “spoofing” in the statute. Congress thereby signalled that it believed that this is a term of art in the industry. That belief was a mistake (ran the argument), hence the law fails.

The 7th Circuit rejected this reasoning because, it said, the term “spoofing” as Congress understood it was then defined in a parenthesis. Congress was, then, clear what it meant by the term – what if anything it thought the industry meant is irrelevant for judicial construction. The statute has clarity enough for Coscia’s obedience.

Coscia had argued, in anticipation of such reasoning, that the material in the parenthesis was merely intended as an illustration, not as a definition, so the word “spoofing” is left undefined.

The court’s opinion replies that Coscia’s actions clearly come within the meaning of the words “bidding or offering with the intent to cancel the bid….”, so it doesn’t really matter whether those words were meant as an illustration or as a definition. They were clearly meant to describe prohibited behavior, and Coscia engaged in that behavior.

The New York based law firm Cleary Gottlieb has made public a memorandum on the case.

The view from Cleary Gottlieb.

Cleary Gottlieb calls the decision a helpful one for the government.

“[N]ot only has the criminal anti-spoofing provision survived its first constitutional challenge, but the court’s opinion provides a blueprint the government can use to rebuff legal challenges to future spoofing and market manipulation prosecutions in other courts.”

For example, other market participants might want to invoke the supposedly unique nature of algorithmic and/or high-frequency trading in order to justify potentially suspicious trading. This opinion is going to prove an obstacle for such a tactic.

Further, the 7th Circuit (the circuit that includes the city of Chicago after all) has a lot of experience with cases that arise out of derivatives trading, and this decision is likely to prove persuasive even where it is not dispositive.

But the Clearly Gottlieb memo does point to some continuing issues raised by the Coscia case. The opinion describes the intent to evade execution of the orders as the key feature separating Coscia’s use of Park’s algorithms from legitimate traders, and stop-orders or the like. But … “both parties acknowledged during oral argument,” the memo says, that “any number of acceptable algorithms and trading practices are designed to avoid execution for reasons unrelated to manipulation of the market.”

Future decisions might make it clearer that intent to have an artificial effect on supply and demand is required, along with intent to avoid execution, for spoofing to be spoofing.

In a footnote, the memo mentions that the CFTC has a rule making process underway concerning pre-trade risk controls and it suggests that the Coscia court’s analysis might affect that rulemaking going forward.