He was manipulating the market by generating large sell orders. This would drop prices (because others can see that some stock is being rapidly sold off -- especially by high-frequency traders or other automated programs who will also start selling). He would then cancel these orders to buy at the new low prices. This is called spoofing orders.

It was a large reason for the crash (though not the only component in my opinion) because these orders amounted to $200 million worth of bets that the market would fall and they were replaced or modified 19,000 times. And of course this is just one person. The market involves multiple people so you can imagine how much money was at stake here.

Of course investment banks do this sort of thing all of the time, this guy's crime is that he wasn't associated with one of the big incumbents.

HFT generates and cancels orders on magnitudes like this all day long, but they have to be allowed to do so because it "creates markets", whatever that means.

> HFT generates and cancels orders on magnitudes like this all day long, but they have to be allowed to do so because it "creates markets",

No, they are allowed because HFT firms have the intention to (and in fact, will gladly) trade.

Sort of true. They will do the trade, but only if there was already someone in the system willing to make the same trade. HFT firms don't hold positions at the end of the day.

AIUI, the difference is that, at the moment the HFTs place the order, they have every intention of filling them. Just because they might change their mind a fraction of a second later and modify their orders isn't particularly relevant.

Whereas spoofing is placing orders that you don't have any intention of filling. The only point of the orders is to move the market, rather than to actually make trades. And that's the thing that's illegal.

Therein lies the rub. How can regulators or prosecutors discern after the fact that a canceled order was one you intended to have filled?

I don't think the intention matters if the result is the same.

Well, the law doesn't really say anything beyond "manipulative devices" and "contrivances," but right now, judges have kinda ruled that intention matters. But we don't know much, because most of these cases get settled out of court, so we don't have a robust case law to base any of this off of. Basically, if you participate in a financial transaction in any way, be prepared to be accused of a crime.

Intention mostly matters, sometimes doesn't. Sometimes the left arm doesn't talk to the right arm and conflicting orders go out. Technically this could be construed as spoofing, but sometimes it's business unit A not talking to business unit B, because A isn't in the same location as B, or there's a Chinese Firewall between A & B. It might not be intentional spoofing, but it can happen, anyway.

The law strongly disagrees, and for good reason. See: manslaughter vs murder.

it matters because the law says it matters.

I also don't understand why this is illegal. The markets should not be predictable.

People like that guy should be rewarded financially for making it unpredictable.

You don't want to have an economy where only a tiny group of powerful people understand what's happening while 99.99999...% of the population are at in the dark and at their mercy.

A fair system should be simple enough to be understood by everyone or complex enough to be understood by no one - Anything in-between is not a fair system.

> The markets should not be predictable.

Uh, yeah they should. To someone with perfect knowledge, a proper free market should be 100% predictable. It's only unpredictable if other people know things that you don't (and the market itself is the vehicle by which that knowledge is disseminated). Introducing uncertainty into the market without introducing knowledge into the market is a bad thing. And spoofing trades in order to move the market isn't providing any knowledge, and it is in fact making the market less efficient because it no longer matches the knowledge of the participants.

I don't think it's fair that people can make money from having 'perfect' knowledge of the market. I don't buy into the efficient market hypothesis.

I can point out many significant inefficiencies in the system - E.g. Nepotism (allocating employee rank and pay based on social connections instead of skills/results), executive bonus structures which favor short-term gains over long-term gains, monopolies which make companies complacent and employees less productive, other anti-competitive behaviours - These factors allow large, inefficient companies to beat competitors in the market in spite of significant internal inefficiencies.

Anti-competitive behaviour will probably always exist in the markets; it's part of human nature and it's basically universally accepted except in the most extreme cases (E.g. antitrust cases).

Maybe if humans become smarter and more psychopathic (like in the novel 'Atlas Shrugged'), then we could have an efficient market, but right now, I think it's very far from efficient.

Maybe it's efficient on a human psychological level (from the perspective of an average trader/investor) in that there is some sort of universal consensus about the value of everything. The problem is that this consensus is not rooted in reality but on a superficial, socially-constructed representation of it - That means it's not necessarily efficient in terms of maximizing the output of companies and the happiness of their customers.

> I don't think it's fair that people can make money from having 'perfect' knowledge of the market. I don't buy into the efficient market hypothesis.

These two statements don't seem related. And I don't understand the first one anyway. Where does "fairness" come in? It doesn't seem unreasonable to me that one person who has perfect knowledge about a financial market would be able to make money that someone who doesn't have perfect knowledge wouldn't. And it seems quite "fair" to me that this would be so; why should the person with better knowledge not be able to benefit from their better knowledge?

shouldn't a spoofer's action just be an opportunity for someone who has said knowledge to exploit the spoofter's enhanced liquidity?

Well, I'm not really sure how exactly to exploit this (I'm not a trader, all I really know about this is what I've read in all of the previous discussions about this), but that's really besides the point, because nobody has perfect information. In any case, I suspect the only real way to take advantage of this situation is to determine the orders that the spoofer actually does intend to make (e.g. spoofing to depress the price and then buying low) and making those trades first yourself. But you're not actually harming the spoofer in that case (except in that they didn't get to make the trade they wanted), because the spoofer won't actually have executed any trades, they'll have simply attempted (and failed) to execute them.

Which is to say, if you have perfect knowledge, you might be able to prevent the spoofer from reaping the benefits of their spoofing, but you won't actually have harmed them, and of course the effect on the market is just as bad as if you let the spoofer spoof in peace.

spoofing is largely defined in its relationship to people submitting large orders that they intend to cancel for the purpose of moving the market. so, while the rest of the market thinks there is buying or selling pressure coming from the spoofer's large order, the spoofer has private information that he does not intend to actually trade that large order. he simply wants to move the market towards one of his much smaller orders, and get it filled instead. then, he cancels the large order, and the market in theory should revert back to its old price, because the information that a large order will be moving the market has been taken away. now, what's important is that the spoofer actually has to send a large order. and even if he has no desire or intention of getting it filled, it's still available to be filled. so, if someone thinks a market is going up, but there isn't enough liquidity for him to express his opinion, he could wait for a spoofer to come along to inadvertently provide liquidity with a large offer, and trade with that offer before the spoofer has time to cancel.

What you describe isn't someone taking advantage of the spoofer's intention not to actually trade, though. Or rather, it's not someone who has perfect information using that information to understand that the spoofer's order does not represent actual knowledge. It is, in fact, someone who has limited information and believes the market does not reflect reality, and then using that to place an order that just happens to use the spoofer's order. So in this case, it's no different at all from them trading with a market maker.

Also, I would assume spoofers don't typically place orders in illiquid markets, precisely because they risk having someone use their new order as a source of liquidity. I mean, spoofers don't actually want their orders filled. Plus, the whole point of the spoofed order is to trick market makers into moving their positions, and if the market isn't liquid then clearly there's no market makers (because if there were market makers, then the market would be liquid), and if there's no market makers then spoofing isn't going to work to begin with.

Markets already are unpredictable. Spoofing is the equivalent of running an auction on ebay and submitting bids yourself under fake accounts to drive up the price to trick the one person who actually wants it into paying more.

Market makers do this sort of the thing all the time in trading stocks.

There is a difference between unpredictability and instability. Things like this cause instability and can destroy the market altogether.

What happened if someone took him up on an order before it was cancelled?

He got some partial fills.

And he had a separate account that would trade the market distortion.

His big orders weren't the best bid or ask. They were a few orders deep in the market.

Basically people and machines would jump further in front of the big buy or sell order with their own orders, and move the price in a direction. His smaller account would make profits from those trades.

Yes you could affect trillions of dollars of derivatives and the sentiment of the entire market with just a few dozen millions.

It is still a widespread practice and tough to prove. But spoofing was made illegal in the Dodd Frank Act. So if the government can nail some easy cases and create case law, then they could think about going after the banks that do it. Emphasis on think.

Should it be illegal for s man to shout SELL! on a crowded trading floor?

If he has no intention of selling, yes.

But he did. He just shouted, "nevermind," a few milliseconds later.

>on a crowded trading floor?

does such a thing even exist anymore?

Yes just not for many products. You can tour it in Chicago.

Your question is exactly correct. As long as they are real orders, with real risk of being executed, there should be nothing at all wrong with this behavior. If people are so stupid as to move their orders trivially based on others' actions, they deserve what they get.

The reason this gets prosecuted is that it's an easy target for the exchanges to make it look like they care. They are now publicly-traded companies interested in profits first and foremost--not market integrity (which maybe used to be the case--different discussion).

source: 25-year vet of futures markets, the last 10 in HFT; many many millions of orders and executions

> they deserve what they get.

what about buy-and-hold investors who don't do anything to deserve that ? Why should they get unnecessary volatility in their portfolios just because some get-rich-quick kids want to treat NYSE like its Mortal Kombat?

> if people are so stupid as to move their orders trivially based on others' actions

Then why show level 2 quotes at all ? Isn't your argument equivalent to "level 2 information is useless"? If not, then people wouldn't be stupid for using it, would they ? Would you trade in a market that only had level 1 quotes ?

They don't get unnecessary volatility unless they're paying attention to the order book all the time. Realized equity volatility is MUCH MUCH MUCH lower in the era of HFT.

Yes, "flash crashes" exist, and normally because of liquidity disappearing. Yes, algos are basically sheep that all bail at the same time. But overall, the net effect is massively beneficial to everyone except lazy traders (which include fund managers who miss the days of getting lots of steak dinners from their favorite brokers).

I'm not arguing against algos or HFT, just spoofing. also I updated my comment to ask about level-2 quote information. If people are stupid for acting on perceived intention of other market participants, wouldn't that make the case that L2 quotes are entirely garbage and should just be removed from the exchange ?

You're conflating two things (in my mind). L2 is very useful to people like me. If it's useful to you, you should be able to handle spoofing.

The "average investor" doesn't need L2, and doesn't care what it says, including flashing "fake" orders.

HFT doesn't really do anything for markets since they take very little risk, and that is the purpose of a market... the magic coil will kill your business anyway

I thought true HFT (not short-term momo, etc. where the intention is to actually take risk) had essentially died already, Virtu aside

True HFT is not in any sense dead, it's just matured so only those with deeper pockets can compete.

Flash crashes have no effect on buy and hold investors. You're holding, there's a crash, you're holding, bounces back, you're still holding.

Not remotely true, many buy and hold investors have stops to limit their losses and/or exit their positions at certain levels. Flash crashes hurt them greatly.

Which part of "buy and hold" includes "sell when it goes down"?

It's called cutting your losses. Buy and hold isn't "buy and go down with the ship".

No in fact that is the opposite of buy and hold. If you are selling as it goes down you may as well just light your money on fire.

So you'd rather ride the sinking ship and lose all your money as the company goes bankrupt? Are you saying you'd never exit any of your positions no matter how much money you lost?

Correct and correct.

The stock market cannot go to 0. It is literally impossible. If you are invested in the fortune 500.. and the value went to literally 0.. we are in a zombie Apocalypse. Money no longer has value. So yes I lost all my investment, but I also don't have a job, and a gun is my most valuable asset.

Buy and hold = Buy big index funds (i.e. Fortune 500), and then never ever ever ever sell, until you are ready to spend the money (i.e. draw-downs in retirement).

Trying to go "oh the market lost 20% this week, it is going to 0 soon" is a fools investing.

The market itself cannot go to zero, but individual stocks can. If you're of the view the market can't be beat and investing in index funds is the way to go then your position is fine. If you're of the view where you select the stocks you want to invest in, as a great number of market participants are, then your position if flawed because stocks do go to 0 and as such exiting losing stocks makes sense. Tossing all your money into an index fund is not trading, so you're not even talking about the same thing I am.

Flash crashes massively hurt people who invest in particular stocks because they do often have exit points which get triggered by those crashes. The advice you're giving doesn't apply to these people, they're not the ones just dumping everything into an index fund.

Also known as a make loss order. :(

Better to have a loss limiter, than lose it all. Without a stop loss, you can't limit your risk. And yes, exiting at a small loss is the point, it prevents a much bigger loss. Refusing to exit with a loss is how the market takes it all from you.

Retirees might need to liquid a percentage of their portfolio each month to pay their bills. Getting caught in a flash crash can have an effect on them.

In a general sense though I agree that the behavior shouldn't be illegal but am fine with exchanges implementing rules about it. For a trade to occur both the buyer and the seller are getting what they want at a price they both deem acceptable. Phantom orders does not inherently change that.

Keep in mind that you're talking about getting caught in a window that was 34 minutes long. So you'd have to be pretty unlucky, not to mention oblivious, to push through a market sell order at that time.

Here's an analogous situation - let's suppose you are a buyer in an auction for a car. You're competing with all other interested buyers to get the car, and after a bunch of back and forth, you win the auction.

Later, you find out that one of the most aggressive bidders in the auction was actually just a buddy of the seller, trying to increase the price in his/her favor but avoid at all costs actually winning the auction.

You'd probably rightfully think this was unfair, and this is exactly what spoofers are doing in an electronic market. They are generating the illusion of interest to buy or sell, without the intention to actually do so, in order to move the market in their favor.

I don't see a problem with this. At any time, I could stop bidding and the buddy would be left with the car and the fees from the sale.

I'm not going to bid more than the car is worth to me.

The idea is, the seller just buys the car back off his buddy.

It's annoying, but I wouldn't consider it unfair. In the end, nobody forces you to pay more than you are prepared to pay.

this is not an accurate analogy. a spoofer's order is legitimate. if someone buys or sells it, the spoofer made a transaction.

No, only one order was legitimate. They placed an ask at the top level and then placed 3 bids below the top level. As soon as someone hit the ask, they cancelled the bids. The bids made it look like the market was going up. If the top level bid had been hit first, they still would have cancelled

Why is that illegal? Why doesn't it just get you kicked from the market if you do it?

Because it's financial fraud, and it harms the legitimacy of the market itself and it harms the other people participating in the market. It's not like banning a cheater in a video game, there are real world stakes.

If video games have real world financial stakes(say, for professional eSports players like Dota/LoL), should cheating be punishable by jail time?

Maybe.

If we are playing poker, and you cheat, you have stolen my money through fraud.

Certainly if I cheat at a casino, I'm likely going to jail.

Bluffing in poker is not cheating, is it? This guy bluffed that he want to sell when he did not.

I believe if you cheat at a casino, you are just banned and kicked out.

Also, perhaps there is a differentiation between working within the mechanics of a system to cheat, and going around a system to cheat. An example from the esports league would be the difference between using a corner case to shoot through a wall, versus hacking into the server and modifying the code.

If you don't cheat, but do something the casino doesn't approve of you are kicked out. If you actually cheat, and the casino decides it is worth it, you'll have the government come down on you too.

It actually is.

It kicks you out of the market by sending you to prison.

It's a scheme to get money by being dishonest; so it's stealing.

>get money by being dishonest; so it's stealing.

That isn't the definition of stealing. In fact I would argue, while it is dishonest, it isn't stealing in slightest. Stealing means you took something, without agreement, that rightfully belongs to someone else. The scheme is more accurately described as fraud than stealing.

I was an intern at Goldman Sachs in 2007 working in IT and my boss was explaining to us how market making works and he described this exact phenomenon - how banks, hedge funds, HFT trading outfits spoof orders constantly so you cannot rely on the order book to determine direction / intent of other traders in the market. Apparently this guy's crime was not being part of a hedge fund or large bank.

That isn't true. Making an order with an intent to cancel is a crime. Hedge funds routinely cancel orders, but they do not necessarily make them with the intent to cancel them from the beginning.

Insider trading is also a crime yet it is widespread on wall street, like snowflakes in a blizzard.

Perhaps the most routine trade I see is with a Time in Force of Immediate or Cancel. Fill or Partial Fill if you can, cancel the remainder. Happens millions of times a day.

Market makers have special privileges. That's why they abuse with spoofing, boxing, jumping, etc using offshore entities.

Many hedge funds do the same thing. This guy's crime is doing it without being associated with the in-crowd.

No they don't. The very big difference is intent and actual behavior. Sarao was blatantly not following through on any of his spoofing, which is where the intent is derived based on pattern of behavior.

If a hedge fund behaved the exact same way, they'd get in trouble for it. That is, if Renaissance Technologies decided to do spoofing on 99.999% of its market action, they'd get in trouble for it. Hedge funds doing high frequency trading, is not the same as spoofing.

The SEC is fine with HFT traders executing less than 1/10th the orders they place so the rules are not that clear cut.

Yes but canceling a lot of your orders is not necessarily indicative of spoofing. In fact it's kind of the crux of market making. These are ver different behaviors.

https://www.bloomberg.com/view/articles/2015-10-08/why-do-hi...

Honest questions from someone who is only slightly educated on market making:

Is there a law that stated/states all trades need to be with real intention to buy?

How can they prove that intention? Even if an indicator is actually having the amount of cash to finance the trades, that could be covered as well.

Lastly, is it not the responsibility of the people receiving the trade orders to not let the new trade information out or do anything with that information themselves which would affect the market until the actual trade takes place?

> Is there a law that stated/states all trades need to be with real intention to buy?

We're not talking about trades, but rather the illusion of an intent to trade, when really there is no intent, and pushing that illusion onto the world to give the market the impression you will trade that amount, causing other market participants to react accordingly, which causes the market to move in the direction you wanted. Then you cancel your planned trade and profit off the move you manipulated.

That's the gist of it, and yes there are laws against it.

You didn't answer the Parent Poster. He's asking how can the law determine if the trader was spoofing or legitimately trading. What are the criteria for that.

Repeatedly following through with a second batch of orders just right after cancelling a large batch of offers in the opposite direction will do wonders to put the sincerity of the first batches into question.

I think it's safe to assume that this is not a "one daring bet" kind of manipulation, like e.g. badly disguised insider trading could be, it is rather wealth by a thousand papercuts. The pattern is very unlikely to be worthwhile without excessive repetition and there are only so many million times where you can believable claim that you wanted, then you didn't, and than you wanted the opposite, all in carefully timed lockstep.

What if what you described was done by an algorithm rather than by human trickery? What if that action was discovered "per chance" through machine learning? I myself don't feel there is anything morally wrong with that. Why should I feel differently when a human does it rather than an algorithm at an HFT firm?

Genuinely curious of your thoughts!

Late reply, but the question is too interesting to resist:

Posting an order is a statement of intent. If you allow a machine to post those in your name you take responsibility for the claims made by that machine. Discovery of that "one magic trick" by ML reminds me of the way toddlers learn all kinds of mischievous "life hacks" like "I can reach goal X by dropping object Y" before they start to respect more cooperative forms of interaction. I am skeptical of allowing toddlers on the trade floor. And if you did allow then, you would want to have mechanisms to make their parents take responsibility while their children are not yet able to.

If the decision-makers at the exchanges running the show were not so much closer with those trading for trade than with those trading for actual ownership, they would have curbed this abuse very early. Maybe by introducing a sufficiently low upper limit to the volume of offers that can be cancelled (relative to the volume of offers that are followed through), or some form of progressive cancellation fee that would protect the market from this form of abuse. The observation that only external supervision put an end to it (instead of the "house rules" of the exchanges) makes it difficult for me to dismiss as paranoid the claims made in the discussion here that he just lacked the right friends to pull this off.

Same way we decide everything, a sitting judge or a jury of your peers.

I know it's a common sentiment that "You can sue anyone for anything".

But is it a common sentiment that you can be charged with anything by a district attorney?

>But is it a common sentiment that you can be charged with anything by a district attorney?

Pretty much. If you piss them off enough, or if they are trying to get elected to something else and think you are a good way to do it, then yes, they will charge you with something and keep going at it. (See: Aaron Schwartz).

It's not "anything", it's "intent to defraud". The prosecutor needs to provide a minimum standard of evidence to bring charges, they don't need to prove intent (to hear the case). The rest is like I said.

AIUI the answer is basically "it's very hard to prove", which is why very few people actually get punished for it. IIRC in the flash crash trader's case he actually had emails that made it very clear what his intentions were with the orders he placed (but I could be misremembering).

A spoof is about orders, not trades. Those are two very different things.

I thought it is called negotiation.

Note that intent is a necessary component of many (most?) crimes. For example, if you accidentally get someone killed, with no intent, you haven't committed murder. If you try to kill someone but fail, you've still committed attempted murder even if the target is untouched.

Reliably determining intent is just about impossible, but it doesn't stop the courts from trying.

> How can they prove that intention?

Obviously they cannot. It's basically subjective, and it looks like Sarao just got too greedy.

The CME does enforce rules about trade executions, that the ratio of orders placed to orders executed does not get too low (like 1/30 or something.) I'm guessing Sarao just placed a small amount of large-size orders to get around this.

The whole thing kind of surprises me as I think it is well known that there are plenty of algos that place orders with the sole intent of enticing/manipulating the market. But as I said, it's not really something you can define objectively.

EDIT: I did a bit of reading, yes, Sarao placed orders for massive size on CME. Big kahoonas for sure.

The purpose of markets is taking risk. Any participant whose intention is not to take risk is a parasite

Like many things in life, there are complete bullshit situations where some people get a better deal than others simply due to some arcanery. Are doctors in America 4x better than European ones, or are residency spots artificially restricted to keep salaries high?

The world has less and less parasites every day because technology allows us to see them for what they really are. This is just one of the many

The purpose of blackjack tables is taking risks. The purpose of markets is to determine a price that is fair to both sellers and buyers. Risk-taking intermediates are just a possible building block for coming up with a solution to that goal.

I don't consider arbitrageurs parasites. They ensure that I am paying a fair price for my SPY shares.

Arbitrage that only exists due to the technicalities of market microstructure is parasitic to me. True HFT identifies trades with no risk; a long and a hedge at the same microsecond. That's just fractions of pennies that true risk takers lose, every day. They don't care at all about the intrinsic value of the security

The order book is public. Anyone can go look at the outstanding orders (offers really) for any stock.

It is market manipulation. Placing a big order would signal to other traders that there is someone who wants to buy/sell a lot of the stock and therefore the stock's price would change accordingly. But then the trades are never actually executed, therefore he intentionally manipulated the price of the stock.

The game is only fair if you play to outsmart the other animals in the herd. Not if you actively harm them by misdirecting them with false signals.