September 30, 2020

Gaffes and Spoofs

You all remember the Fat Finger?

It’s a gaffe, trading-style.  In one 2014 instance, if the record can be believed, somebody in Japan accidentally tried to buy $700 billion of stocks including more than half the total outstanding shares of Toyota.

The trades occurred outside hours and were cancelled but the embarrassment lingers.

Do you know of Harouna Traoré?  A French day trader learning the ropes, Mr. Traoré plunked down twenty thousand euros at online platform Valbury Capital and, thinking he was in simulation mode, began trading futures contracts.

Racking up a billion euros of exposure and about a million euros of losses before he realized his error, the horrified trader said, according to CNBC, “I could only think of my family.”  But the intrepid gaffer – so to speak – soldiered on, turning one billion and losses into five billion and profits of about twelve million euros.

I don’t know how it turned out but not well, it appears. The Chicago Mercantile Exchange sanctioned Mr. Traoré in June 2020 for exceeding credit thresholds, and banned him from trading for two years.

The Fat Finger has become reliably rare in US markets, thanks to security protocols.  It’s improbable we’ll again see a Knight Securities buy $4 billion of stock in 45 minutes and be forced to liquidate to Getco as happened in 2012 (Getco is now Virtu).

That’s the good news. The bad news is bizarre moves in equities such as we’ve seen in 2020 are therefore not due to gaffes.

But they could be spoofs, legal or otherwise.  JP Morgan yesterday agreed to a $920 million fine related to spoofing in futures contracts for metals and US Treasurys.  I can’t recall a larger trading fine.

Spoofing is the deliberate act of entering orders to trade securities and then cancelling them, creating, at least momentarily, the artificial appearance of supply or demand.  Dodd-Frank outlawed spoofing after tumult in the 2008 crisis, and regulations for commodities and stocks have subsequently articulated guidelines.

Investors and public companies alike don’t want fake liquidity in markets. As gaffes do, it’s what causes unexpected lurches in prices – but on purpose.

We can all sleep well, then?

Nope.

Turns out there is illegal spoofing, and legal spoofing.  The SEC’s Midas data platform shows trade-to-cancel ratios for stocks in various volume and market-cap tranches.  Generally, there are about 15 cancellations for every executed trade in stocks.

In Exchange Traded Funds (ETFs), the ratio explodes. The gaps or so severe between quartiles and deciles that an average is difficult to find. But the rate ranges from about 100 to nearly 2,000 cancellations for every completed trade.

Well, how is that not spoofing?

Answer: If you use order types it’s legal. It means – broad definitions here – that Fill or Kill (do it at once or don’t do it at all), Limit/Stop-Loss, All or None (no partial fills, the whole thing or nothing), Iceberg (just a little showing and more as the order fills) or Passive (sitting outside the best prices) orders are sanctioned by the government.

Tons are cancelled. Layer your trades with a machine instead, and it’s illegal.  Spoofing.

Wait a minute.

Order types through a broker are trades in the pipeline. Systems know they’re there. Risk-management protocols require it.  If the orders are at retail firms that sell their trades, then the high-speed buyer sees every layer before it reaches the market.

See the issue?

The market is stuffed with legal cancelled orders – that somebody else can see before the trades execute and who will therefore clearly know what the supply/demand balance is, and what gets cancelled.

I’m not sure which is worse, a fat finger, or this.  The one is just an accident.

Now, why should you care?  Because stocks are awash in compliant spoofs.  Regulators are trying to sort, one from the other, the same kind of activity, except one lets somebody else know ahead of time that it’s there. And that’s fine.  Sanctioned.

If you trade on inside information, data you obtained that others don’t know, in exchange for value, it’s illegal. Well, trades sold to high-speed firms are exactly that, if only for a fraction of a second.

If ETFs are peppered with cancellations at rates dwarfing trades, and money is piling into ETFs, would it be good for the public to know? And why mass cancellations?

Because ETFs are legally sanctioned arbitrage vehicles. That’s another story.

The good news is we track the behavior driving arbitrage.  Fast Trading.  We know when it’s waxing and waning. It imploded into today’s futures expirations – where much spoofing occurs, legally – and just as Market Sentiment turned dour.

I hope there are no gaffes.  Spoofs will abound.  Authorities will pat themselves on the back.  It’s a weird market.

***

By – Tim Quast, President and Founder, ModernIR

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