Spoofing is a quote driven manipulation which involves placing bid / ask orders, with an intent of cancelling the orders before execution, while simultaneously executing trades on opposite side of the order book. The side on which large orders are placed and cancelled is known as "spoof" side and the suspect trader involved in such an activity is called "spoofer".Spoofers are "persistent noise creators" (PNC), since the excessive orders may be attributed as "noise" in the market, with no intention to execute the trade by modifying or cancelling them. Spoofing creates misleading appearance of market depth or direction, to induce honest market participants by providing the spoofer with better execution of spoofer's orders on the opposite side of the order book.
Spoofer for example would place a buy order (non-bonafide) at less than the prevailing market price, forming substantial percentage of the pending order book. This is buy side spoofing and provides strength to the buy side book, with no intention of executing the orders.Other market participants observing this large buy order, perceive this as an indication of increased demand / supply and promptly react as if a genuine buy order has entered the market. This herd behaviour gives spoofers an opportunity knowing well that majority of the investors would act in the direction that the spoofer intends. Seeing the surge in demand of the scrip, traders who want to buy into the scrip, would start placing their bids either at the market price or above. This lends further strength to the buy side of the order book. Price is thus being influenced by artificial demand / supply created on the spoof side, and the spoofer than goes on the opposite side of the book and executes smaller orders, capitalising on the favourable price movement. Spoofer simultaneously starts placing smaller orders on sell side above the prevailing market price, which gets executed at a price favourable to the spoofer. Once the desired price movement is achieved, the original buy side order is cancelled within few seconds after the sale. The ultimate objective behind a spoof order is minimum risk of execution. Spoofer, thus profits from artificial price movements.
Spoofers trigger stop-loss orders placed by other traders and force them to sell/buy at disadvantageous prices by creating a false impression of the demand and supply in the market. Size and price aggressiveness are the two critical ingredients in case of a spoofing strategy, whereas a trader submitting a genuine limit order would always prefer to minimise the impact of size and price aggression to achieve trade execution at best price. Spoofing is a low cost and low risk strategy when compared to other manipulation tactics.
Over the years (since 2012), the Securities and Exchange Board of India (SEBI) and Indian stock exchanges have issued various guidelines to regulate algorithmic based manipulations such as "surveillance measure on order spoofing" - order to trade ratio. Intention is to deter PNCs - excessive order modifications / cancellations with an intent to avoid execution.It is applicable on daily trading activity at the client / proprietary account level in a security / contract (equity and equity derivatives segment1) based on prescribed parameters. Persistent noise results in an increase in overall "information asymmetry" for other algorithms and players in the market.
Stock exchanges have prescribed criteria based on which client orders (algorithmic and non- algorithmic) are short listed under PNC followed by corresponding surveillance action such as disablement of trading terminals for certain period and imposition of fines. The idea is to monitor trading behaviour of entities creating undesirable noise in the market and if any entity is found to be repeatedly modifying / cancelling the orders which results in non-execution of trades, such an entity may be liable for an action.
Analysis of order book for manipulation like spoofing, wash trading, iceberg orders, layering requires identification of complex patterns involving extensive analysis of the order book. Analysing the order book is particularly complicated and challenging as compared to analysing the trade book. Some examples of key data points to look for when analysing trading data are any size discrepancy between buy and sell orders on both sides of the market, the percentage of cancelled orders relative to the number of orders placed, the passage of time before large volume orders were cancelled, and the frequency of order patterns. High order cancellations are a crucial indicator of a potential spoofing attempt.
Spoofing often uses algorithmic and high frequency trading (HFT), which allows trading decisions to be generated quickly and transactions to be completed in fraction of seconds. For a spoofer it's easier to generate profit and may be go undetected when the market volatility and volumes are high, as it becomes easier for spoofer to hide their orders.
To prove spoofing, a regulator must show that the trader intended to cancel his or her orders before execution, because there can be number of trading strategies in which cancellation could be for legitimate reasons. Genuine traders would change their minds all the time and cancel orders as and when the economic conditions change, and that's not illegal. Stock exchanges monitor order to trade ratio (OTR) to detect and prevent potential market manipulation or excessive order volume. High OTR value can indicate a potential for market abuse, and stock exchanges have implemented measures to discourage excessive order placement without corresponding trades.
Traditional market surveillance methods often fail to identify and prevent order book manipulative practices effectively. Financial markets have evolved dramatically and with the rise of algorithms and HFT, most activity in today's market typically takes place via limit orders rather than via market orders and, it becomes extremely difficult to catch a spoofer amid the deluge of daily trades. An un-informed honest trader suffers as their trading strategy is based on deceptive information. Spoofing distorts market quality because a speculative un-informed honest trader would trade based on mis-leading information and will exhibit herd behaviour resulting in change in their price and order book.
From a risk management perspective, especially for stockbrokers, prevention and detection of spoofing includes conducting real time monitoring of the order book or as near to as possible, after the execution of the trade. Providing regular training to dealers or employees those who are in trade-related roles across the life cycle of a trade and/or officials from compliance teams with examples of data points [such as, any kind of specific trading trends, unusual volumes, checking of order identification2 to see if matching orders are placed by same trader, modifications or cancellations of quotes submitted without it culminating into a trade/transaction, time difference between order cancellation and subsequent order placement on the opposite side of the order book] to look for, while carrying out the analysis and risk assessment for discrepancies between buy and sell orders, should help mitigate the chances of spoofing and other market manipulations. This is also helpful, so that suspicious market abusing behaviour, if any, is promptly reported and escalated to the compliance team and comply with regulations governing prohibition of fraudulent and unfair trade practices. Trade surveillance systems of stockbrokers should therefore be able to effectively capture such manipulative activity.
Order book is a place where demand meets supply. Despite detection systems and regulatory enforcement efforts, spoofing is hard to eliminate due to the difficulty in determining the manipulative intent behind placement or orders.Intuitively, a spoofing strategy relies on frequent order cancellations and modifications, and hence the burden of proof on a regulator is high.
Spoofing leads to extra profit and typically tend to target stocks with lower market capitalisation or lower price level or thinly traded illiquid stocks or markets. Spoofing could also involve a genuine order in one asset and a spoof order in another asset [assets being positively correlated], and hence it is not always necessary that spoofing takes place in same asset. Likewise, it is also possible that a manipulator may submit a spoof order on a stock exchange where the security is more liquid and submit a genuine order on another stock exchange where the security is less liquid. Cross-market spoofing could be an even more complex trading strategy and therefore may present additional challenge to the regulator in detecting and proving the same.
With massive growth in market volumes, detecting all possible combinations of such a subtle behaviour and illicit design of manipulators, require enhanced surveillance infrastructure capabilities and is crucial for investor protection. While the Indian securities laws do not specifically define the term "spoofing", but the strategies employed by spoofers [layering, quote stuffing, order cancellation followed by actual trade] is substantially covered within the ambit of prohibited dealings as per SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.
Footnotes
1 Equity derivatives market is typically deeper and more liquid than the cash market. This enables a trader to submit a larger spoof order than what would have been possible in the cash market.
2 Tagging of orders with their corresponding algorithmic identification is mandatory since 2019.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
