Finance Professor Warns Against Over Zealous Prosecution of ''Spoofing'' Cases
Commentary by Bob Zwirb
University of Houston Finance Professor Craig Pirrong analyzed the recent conviction of a commodities trader for engaging in "spoofing" (i.e., entering bids and offers with the intent to cancel before execution). In a blog post titled "I'm Not Spoofing You about Judicial Overkill," Professor Pirrong characterized the prosecution as "judicial overkill . . . that can do serious damage to the markets."
Professor Pirrong made three broad points in order to reinforce his argument that treating such activity as a criminal matter and imposing harsh sanctions is unwise.
First, Professor Pirrong observed that the amount of harm caused by spoofing is usually minor and involves "making a tick here and a tick there" - here, according to Professor Pirrong, in this instance involved only $1000 in the six episodes for which the trader was charged - and that such activity does not affect market prices in a meaningful way. "If spoofing works," he wrote, "the spoofer will repeatedly buy at the bid and sell at the offer, making the dealer's turn. This will not cause the price to diverge persistently from where it would be, absent this conduct."
Second, Professor Pirrong argued that spoofing is easily detected and even obvious. Ergo, "[i]f it [is] so obvious, nobody is fooled. If nobody is fooled, it can't affect trading behavior or prices. If it doesn't affect trading behavior or prices, there is no economic harm. If there is no economic harm, it shouldn't be prosecuted."
Third, Professor Pirrong noted that regulators and government prosecutors often find it difficult to distinguish between spoofing and "legitimate market making strategies involve large rates of order cancellation." As Professor Pirrong explained:
The . . . prosecution - and the popular condemnation of spoofing - focuses obsessively on the large rate of order cancellation. But perfectly legitimate market making strategies involve large rates of order cancellation, especially in volatile markets. They also involve buying frequently at the bid and selling at the offer. Given the Javert-like zeal of prosecutors, their dim understanding of trading, and the difficulty of explaining market making to a jury create the very real risk that a market maker could be charged, and convicted, and be punished severely, because he cancelled a lot of orders and made the dealer's turn all day long. This huge and very real risk will no doubt lead to less aggressive quoting (a market maker is less willing to quote aggressively if he is reluctant to cancel too often for fear of being accused of spoofing).
Professor Pirrong concluded by pointing out that prosecutors are ignoring more harmful forms of frequent manipulation than spoofing, and that their obsessive focus on order cancellations "threatens to demoralize legitimate, efficiency-enhancing trading."
Commentary
The problem with Dodd-Frank's codification of "spoofing" as a separate offense is that, like wash trading, it is vulnerable to overly literal interpretations by the government - interpretations in which the form of the transaction overwhelms the substance. Professor Pirrong's analysis is valuable because it reminds us that aggressively punishing an activity without understanding its underlying economic rationale runs the risk of harming legitimate market behavior; that sanctions must correspond to economic harm; and that prosecutors should focus on activities that cause real and substantial harm to the marketplace. That said, it behooves the accused parties in cases against such actions to present strong defenses showing that what looks bad really is not; they should not rely on platitudes. Judging from the content of press accounts on this matter, it appears that that didn't happen here.