INTRODUCTION 400 II. BACKGROUND 400 A. The Futures Markets 401 B. What Are Spoofing and Layering, and How Common 402 is Such Conduct? C. Are Spoofing and Layering Harmful? 406 D. Spoofing, Layering, and High-Frequency Trading 411 E. How Do Spoofing and Layering Differ from Other Similar 414 Forms of Trading? III. SPOOFING ENFORCEMENT IN THE FUTURE MARKETS 417 A. Pre-Dodd-Frank Act 417 B. Post-Dodd-Frank Act 418 1. The CFTC Obtains New Authority 419 2. The CFTC Issues Interpretive Guidance 422 3. The CFTC Retains its Former Authority 423 4. The CFTC Exercises its Authority in 424 Combination with the DOJ IV. SPOOFING AND LAYERING IN THE SECURITIES MARKETS 429 A. Exchange Act Section 9(a)(2) 430 B. Exchange Act Section 10(b) 431 V. SPOOFING, LAYERING, AND CRYPTOCURRENCY 433 VI. THE SPOOFING PROHIBITION IS NOT 437 UNCONSTITUTIONALLY VAGUE VII. LIABILITY FOR FAILURE TO SUPERVISE 440 VIII. DO THE PROHIBITIONS ON SPOOFING AND 443 LAYERING APPLY ONLY TO TRADERS? IX. DETECTING AND PROVING SPOOFING AND LAYERING 444 A. Evidence of Spoofing and Layering 445 B. The National Exam Analytics Tool and the 448 Consolidated Audit Trail C. Regulation A-T 449 D. Industry Software 450 X. CONSTRAINTS ON THE CFTC 450 XI. CFTC ENFORCEMENT TOOLS 452 A. The CFTC's Cooperation and Self-Reporting Program 452 B. The CFTC's Whistleblower Program 456 XII. THE ROLE OF SROS IN REGULATING SPOOFING 458 AND LAYERING A. The Current Multi-Tiered System of Regulation 458 B. The Exchanges Adopt Express Anti-Spoofing Rules 461 C. Enforcement by the NFA and the Exchanges 462 XIII. A PRIVATE RIGHT OF ACTION 464 XIV. CONCLUSION 468 I. INTRODUCTION
This Article examines a broad range of issues associated with spoofing and layering in the futures and securities markets and proposes a set of recommendations to resolve them. Spoofing and layering are forms of market manipulation or fraud, whereby traders place orders or bids in a commodity or security on an exchange or other trading platform with no intent to execute, primarily to deceive other traders as to the true levels of supply or demand. While the terms are sometimes used interchangeably, layering is best understood as a specific form of spoofing, in which traders place orders at multiple price tiers, with no intent to execute. (1) Spoofing was expressly prohibited by an amendment of the Commodity Exchange Act in 2010 and such conduct is proscribed--albeit not expressly--by the federal securities laws. Spoofing has also been prosecuted as commodity, mail, and wire fraud by the Department of Justice. Regulatory and criminal anti-spoofing enforcement has sharply accelerated in the last few years, and that enforcement has spawned numerous novel unresolved issues which are addressed herein. (2)
This Article begins by examining the futures markets, the significance of spoofing and layering, the harm associated with such conduct, the connection between spoofing, layering, and high-frequency trading, and the essential differences between spoofing, layering, and other forms of trading--some of which are disruptive and proscribed under federal law and some of which are not.
The Futures Markets
Spoofing and layering take place primarily, but not exclusively, in the futures markets. Futures are a major subset of the larger market for derivatives, which are financial products that derive their value from the change in value of underlying assets or the occurrence of external events. Derivatives played a central role in the 2008 financial crisis, (3) but they also play an essential role in economic growth, by pricing commercial risk and "transferring it in efficient ways." (4) Derivative prices reflect price discovery--"the aggregate opinions of market participants about the present and future values" of commodities. (5) Derivatives have become commonplace. Derivative instruments include futures, as well as swaps and options on commodities. The derivatives markets are governed by the Commodity Exchange Act (CEA), (6) which very broadly defines "commodities" to include "all services, rights, and interests... in which contracts for future delivery are presently or in the future dealt in." (7) In effect, a commodity is any product which is or may in the future be traded on a futures exchange. (8) The CEA thus governs commodity futures contracts, which are executory contracts for the purchase or "sale of a commodity executed at a specific point in time with delivery of the commodity postponed to a future date." (9) The current version of "[t]he CEA governs the trading of [such] contracts and grants to the Commodity Futures Trading Commission [(CFTC, Commission)] the authority... to implement the regulatory regime established therein." (10)
The CFTC has regulated commodity futures markets in the United States since 1974, when the Commodity Futures Trading Commission Act (11) was enacted to amend the CEA. (12) Subject to a few limited exceptions, futures contracts are within the exclusive jurisdiction of the Commission, (13) notwithstanding the continuing convergence between the securities and derivatives markets. (14) The futures industry traces its origin to agricultural commodities trading in the 1860s, primarily in wheat, corn, and cotton, but it has become increasingly complex since the creation of the CFTC more than a century later. (15)
Congress enacted the CEA for the purpose of preventing, deterring, and redressing price manipulation of commodity futures and options contracts. (16) The statute had a generic anti-manipulation provision (17) and an anti-fraud provision, (18) both of which have been amended since enactment. Because conduct involving manipulation in a commodity futures market takes numerous forms, it was left undefined when the CEA was enacted. (19)
What Are Spoofing and Layering, and How Common is Such Conduct?
There is no universally accepted definition of the term, but some conduct is commonly recognized as spoofing. (20) A basic spoofing scheme involves a trader entering a large order on one side of the market that the trader intends to cancel prior to execution and contemporaneously entering one or more small orders on the other side that the trader intends to fill. The large order creates an illusion of market depth and generates a response from other market participants that together benefit the trader's small positions. (21) A response is generated because many participants base their market strategies on their perceptions of supply and demand at various price levels. These responses are often automated and virtually simultaneous, given the widespread use of trading algorithms.
Spoofing and layering are rarely isolated events. The schemes often extend for many years and include the placement of thousands or millions of spoof or layered orders. (22) In August 2019 a former J.P. Morgan Chase precious metals trader pleaded guilty to spoofing thousands of times during the period 2007 to 2016. (23) A 2018 CFTC enforcement action concerned more than 36,000 spoof orders and an earlier enforcement action by the Securities and Exchange Commission (SEC) involved more than 325,000 layered transactions that corresponded to the entry of more than eight million layered orders. (25)
The results can be major losses for spoofed traders. In one case in which co-defendants pled guilty in october 2018, market participants who traded futures contracts in the spoofed markets during the period that prices were distorted incurred losses in excess of $60 million, according to the DOJ'S calculations. (26) In a separate spoofing case, which Merrill Lynch Commodities, Inc. settled in June 2019 with the CFTC and Department of Justice (DoJ) for a combined $36.5 million, the settlement included both disgorgement and restitution. (27) The non-prosecution agreement (NPA) Merrill Lynch entered into with the DOJ identified negative effects of the spoofing scheme that included exposing market participants to a risk of loss, unwinding precious metals futures positions at a loss, investigative and litigation costs and expenses, and reputational harm. (28)
Layering is a more sophisticated version of spoofing. In a common layering scheme, multiple limit orders (29) are entered on one side of the market at various price points, with no intent to execute. Again, the usual objective is to create the appearance of a change in the levels of supply and demand, thereby artificially moving the price of the commodity or security. An order is then executed on the opposite side of the market at the artificially created price, and the multiple prior orders are cancelled.
Spoofing and layering rest on the fundamental microeconomic principle that increased supply drives prices down and increased demand drives prices up, (31) but the trading techniques have evolved and become more complex in recent years. More refined versions include spoofing with vacuuming, collapsing of layers, flipping, and the spread squeeze. (32) Still further sophistication is provided by cross-market schemes that play out across highly correlated markets. (33) Increased complexity has magnified the detection problem.
The trader's motivation in a spoofing or layering scheme is usually, but not always, to manipulate the market for profit. A secondary motivation is to test the market's reaction to certain types of orders. A recent example of the latter occurred in September 2018 when Mizuho Bank agreed to pay a civil penalty of $250,000 to resolve allegations that it engaged in multiple acts of spoofing on the Chicago Mercantile Exchange (CME)--the world's largest futures exchange--and Chicago Board of Trade (CBOT). (34) The CFTC alleged that Mizuho's trader placed spoof orders to test market reaction to his trading in anticipation of having to hedge Mizuho's swaps positions with futures at a later date. (35) The CFTC did not allege that the trader executed or even placed genuine orders that benefitted from the spoof large orders. In all...
Spoofing and Layering.
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COPYRIGHT GALE, Cengage Learning. All rights reserved.
COPYRIGHT GALE, Cengage Learning. All rights reserved.