Giving a crime a catchy moniker is a good way to get attention when prosecutors pursue a new form of misconduct. There is, for instance, a type of money laundering called “smurfing,” named for the cute blue cartoon characters, that involves runners for a drug organization making small cash deposits at various banks to avoid the currency transaction reporting rules.
Now there is “spoofing,” a form of market manipulation. Last week, the Justice Department filed charges against Michael Coscia in what it said was the first criminal indictment for spoofing. While not quite as evocative as smurfing, spoofing involves an effort to fool market participants into believing there are large orders for futures contracts to draw them into making trades. Mr. Coscia is accused of placing orders that he planned to cancel to induce others to buy or sell in response, thereby artificially driving prices up or down so that he could then trade.
Regulators have begun focusing on spoofing because of the rise of high-frequency trading firms, which now account for as much as 50 percent of stock trades. The firms use computer programs to buy and sell securities and futures contracts that react almost instantaneously to small movements in the market. In July, Reuters reported that the Securities and Exchange Commission was looking at 10 brokers for possible spoofing, along with a related form of manipulation called “layering,” which involves placing multiple orders at different prices to give the appearance of significant trading interest.
Mr. Coscia operated a high-frequency trading firm, Panther Energy Trading, that used computer programs called Flash Trader and Quote Trader to enter large orders that were quickly canceled; the intention was to move the price to where he wanted an order executed. In 2013, he settled civil charges filed by the Commodity Futures Trading Commission by paying $2.8 million in penalties and disgorgement, along with a $900,000 penalty to the Financial Conduct Authority of Britain for violations in London. The Dodd-Frank Act specifically gives the commodity commission the authority to pursue spoofing of futures contracts, which is defined as “bidding or offering with the intent to cancel the bid or offer before execution.”
The criminal charges raise spoofing to a new level. Mr. Coscia now faces a potential prison sentence of more than five years under the advisory federal sentencing guidelines, based on the claim in the indictment that his trading strategy earned nearly $1.6 million in profit. The Justice Department’s prosecution also poses a threat to other high-frequency trading firms that may employ a trading strategy using a high volume of orders that are quickly canceled.
In this case, it is interesting to note, the profits from the six trades cited by the government were tiny, and the victims were not sympathetic characters like individual investors or pension funds.
The indictment describes how Mr. Coscia’s programs would enter small buy or sell orders for future contracts that he wanted to have filled. He then placed large orders on the other side of that trade at a higher or lower price to entice others to enter the market on the belief that the larger order would affect the price. Once the price moved so that his small order was filled, the program canceled the large orders. The program would then do the same transaction in reverse by entering another round of large orders that would move the price up or down to allow for Mr. Coscia to exit the position at a profit.
The price differences were small, sometimes fractions of a penny, so that the profits were quite modest on an individual set of trades. The indictment sets out 12 charges against Mr. Coscia, six counts of commodities fraud and six counts of spoofing, based on trading in September 2011. The total profit from those transactions amounted to about $1,070.
Mr. Coscia’s firm engaged in thousands of trades to generate the estimated profits of nearly $1.6 million. But prosecutors needed to narrow the charges to just a few transactions if they hoped to obtain a conviction because introducing evidence of every trade would risk putting the judge and jury to sleep. But with just a limited number of trades, there is also the danger that Mr. Coscia’s lawyer will question why such small amounts are worthy of a federal prosecution and try to portray the trading as innocuous.
As is usually the case in a white-collar crime prosecution, the Justice Department’s biggest hurdle will be proving intent. The government must show that the design of the computer program is circumstantial evidence of Mr. Coscia’s intent to defraud other traders by misleading them with the large orders that he planned to cancel before they could be filled.
It is not a defense to argue that “everyone else was doing it” — a point that our mothers and kindergarten teachers drilled into us. But Mr. Coscia can offer a good faith defense, which is available for any crime requiring proof of fraudulent intent. He may try to show that other high-frequency traders routinely cancel orders, with estimates of as many as 90 percent of all orders being canceled before they are executed. It is not a matter of claiming that what he did was right because everyone else did it, but rather that there was no intent to defraud when traders know that most orders quickly disappear and are never filled.
The victims of Mr. Coscia’s trading strategy may not be appealing to a jury either: other high-frequency trading firms. The indictment describes in detail how a set of trades and canceled orders took place in less than a tenth of a second. Only firms using computer programs to buy and sell in the blink of an eye could respond to the type of spoofing the Justice Department is prosecuting. So it would not be a surprise if Mr. Coscia argued that these sophisticated firms engaged in similar conduct through their own trading strategies and were not defrauded by orders entered by his program.
The indictment seeks to hold Mr. Coscia liable for trades executed in milliseconds by a computer, including one trade at 4:54 a.m. when he was probably asleep. The spoofing charges may send a chill through the high-frequency trading world because the evidence of fraudulent intent will come from a program that uses rapid-fire orders and does not depend on humans for its execution. So finding that Mr. Coscia engaged in spoofing may come down to a jury deciding whether one computer fooling another is a crime.