Spoofing and Price Manipulation in Order-Driven Markets

ABSTRACT

We model the trading strategy of an investor who spoofs the limit order book (LOB) to increase the revenue obtained from selling a position in a security. The strategy employs, in addition to sell limit orders (LOs) and sell market orders (MOs), a large number of spoof buy LOs to manipulate the volume imbalance of the LOB. Spoofing is illegal, so the strategy trades off the gains that originate from spoofing against the expected financial losses due to a fine imposed by the financial authorities. As the fine increases, the investor relies less on spoofing, and if the fine is large, the investor does not spoof the LOB. The arrival rate of buy MOs increases because other traders interpret the spoofed buy-heavy LOB as an upward pressure on prices. When the fine is low, spoofing considerably increases the revenues from liquidating a position. Spoofing increases the PnL because (i) the investor employs fewer MOs to draw the inventory to zero and benefits from roundtrip trades, which stem from spoof buy LOs that are ‘inadvertently’ filled and subsequently unwound with sell LOs; and (ii) the midprice trends upward when the book is buy-heavy; therefore the spoofer sells the asset at better prices.

KEYWORDS:

• Market making
• execution
• spoofing
• layering
• high-frequency trading
• market quality

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. See https://www.fca.org.uk/news/statements/statement-regarding-swift-trade-court-appeal-judgement .

2. See also the cases described in the U.S. Commodity Futures Trade Commission (www.cftc.gov) and the UK’s Financial Conduct Authority (www.fca.org.uk).