Spoof regulation

Wall Street is finally acknowledging that bogus trades are a problem… in its own way

January 3, 2014
January 3, 2014

Wall Street has never been very good at regulating itself. For example, the market for over-the-counter derivatives (interest-rate swaps, credit-default swaps and so forth) was, up until recently, largely self-regulated, and we all know how that worked out (paywall).

But for the big banks and brokerage houses, self-regulation is vastly preferable to onerous and costly government regulation. That’s why Wall Street’s own self-appointed regulator, the Financial Industry Regulatory Authority (FINRA), is keen to show that it is alert to any new risks that might threaten the financial system. FINRA released its regulatory priorities for 2014 yesterday (Jan. 2), and it’s keeping an eye on everything you’d expect it to: insider trading, complex structured products, funds investing in opaque and politically unstable “frontier” markets, and brokerages staffed by people who have already been busted by authorities.

But one area of focus that piqued our interest was FINRA’s concern about the abuse of algorithmic and high-frequency trading. FINRA highlighted the use of “momentum ignition strategies,” also known as “spoofing” or “layering.” Essentially, these are when a high-frequency trading system floods the market with buy orders above the current price or sell orders below it, in an attempt to make it look like there is buying or selling interest and induce others to trade at the artificially high or low prices. When the market price accordingly moves up or down, the trader quickly takes the other side of the spoof order, at a (slightly) better price than it would otherwise have achieved.

There has been a lot of concern about spoofing among traders. The practice is, of course, illegal, but FINRA said it continues to see variations of spoofing strategies, with different prices and sizes of fake orders, which is worrying in itself. The Commodity Futures Trading Commission laid its first charges for the activity in June last year, and the Securities and Exchange Commission also clamped down on the practice in 2012.

It’s good to know that America’s financial regulators are concerned about market-distorting behavior like spoofing. But the alarming lack of co-ordination and persistent turf wars among America’s disparate financial regulators are also a problem. Maybe if they spoke to each other, bogus trades would be less of an issue.

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