Something was amiss in the trading room at HTG Capital Partners. Namely, the market for U.S. Treasury bond futures seemed jinxed. Moments after traders confirmed a purchase, the price would suddenly fall, as hundreds of other supposed offers to buy disappeared. Likewise, within milliseconds of selling at what seemed like the going rate, the price would jump. They kept getting burned by minuscule fluctuations.
It turns out the Chicago trading firm was allegedly being “spoofed,” as they claim in a lawsuit filed last week in the U.S. District Court in Chicago. The case has reignited the contentious debate around high-frequency trading. The rival traders, known as “John Doe defendants” in filings, used lightning-fast algorithmic trades to carry out what HTG calls “egregious manipulation” in the market for U.S. Treasury futures.
The lawsuit is notable both for its uncommonly thorough documentation of the illegal practice known as “spoofing” – illustrated in 6,960 case studies included in the suit – and for the fact that the plaintiff is itself a player in high-frequency trading.
“It’s a little stunning,” says Eric Scott Hunsader, founder of the market research group Nanex. “High-frequency traders always say spoofing doesn’t happen, but here you have a high-frequency firm saying it happened thousands of times.”
Outlawed under the 2010 Dodd-Frank Act, spoofing is just one technique made possible by high-frequency trading, which comprises a whole universe of licit and illicit digital trading technologies. Brought to wider attention last year by Michael Lewis’s book “Flash Boys,” HFT has been criticized for creating what Lewis calls a “rigged" market that exploits ordinary investors and benefits insiders – all while creating unfathomable systemic risks.
High-frequency traders use highly complex algorithms to jump in and out of stocks and options at blistering speeds, far faster than any human trader could manage. Their strategies capitalize on minute fluctuations in prices, but they also take advantage of large investors like mutual funds, whose massive orders become the equivalent of slow-moving prey to algorithmic predators.
The dangers of HFT may tend to be exaggerated, while its benefits go unappreciated. When HFT first emerged, the technology was an underdog challenging entrenched Wall Street interests that were still using landlines as the Internet became ascendant. “It helps the overall marketplace become more efficient,” says Simon. What concerns him are the “niche strategies,” such as spoofing, that focus less on creating market efficiencies than on exploiting vulnerabilities.
Hunsader, whose firm attempts to uncover hard-to-detect algorithmic schemes, has a dimmer view of aggressive HFT tactics: “Whatever they’re earning is a tax on the market.”
HTG's case also shines an unfavorable light on the CME Group, the massive derivatives exchange where the alleged manipulation occurred. HTG hopes that in addition to winning $100,000, its lawsuit will force the exchange to identify the alleged culprits. “In the futures markets, the exchange is a trading facility, a clearinghouse and the so-called police at the same time,” says Matt Simon, a senior analyst at TABB Group.
“There are some inherent conflicts of interest between how their markets operate and where there could be potential for greater trading volumes," says Simon. Routing out high-speed corruption at CME also means decreasing profits derived from trading traffic.
The practice alleged in the suit involves a trader placing large numbers of orders to buy or sell, only to immediately cancel the orders and do the opposite. The false bids and offers create a market signal that moves prices, allowing trading algorithms to exploit the split-second changes that result.
Hunsader imagines a crooked used-car salesman: “You want to go and buy a car, but the sales guy hires a bunch of people to come in there and pretend they want to buy the car too.” You're willing to pay $10,000, but many other buyers are offering $10,500. The illusion of greater demand forces you to pay the salesman a higher price. As soon as the cash changes hands, however, the other supposed buyers vanish.
Or the reverse happens: You want to offload the car for $10,500, but a horde of phony sellers rush in saying they’ll sell the same car for $10,000. You have no choice but to mark your price down. Meanwhile, the salesman profits from the incremental changes induced by his decoys. “It goes back and forth and back and forth,” says Hunsader.
In the marketplace, these feints take mere milliseconds. Those on the other side are left buying for more and selling for less, often unaware they are doing so. This is just the part HTG found itself playing, according to its lawsuit, suffering an “unmistakable pattern of repeated build-ups, cancels and flips” over 20 months.
Reining In The Flash Boys
Only recently has spoofing come into the crosshairs of regulators. The FBI brought the first-ever spoofing prosecution last October against a trader who had netted $1.6 million from manipulating currency markets.
But the responsibilities of exchanges where high-frequency cheats might lurk aren’t so cut-and-dried. According to the lawsuit, the CME Group allowed nearly 7,000 instances of spoofing to slip by in less than two years – and those are just the instances that HTG identified. How could this all go unnoticed?
For one, these rapid trades involve mere “ticks” in market price, not vast swings. “This is very difficult to detect,” says Hunsader. “It’s not something that rocks the whole market.”
But it has been enough to rock HTG, which claims to have cut back its trading after getting scammed so often. The firm filed a separate arbitration case last August, asking the CME to sanction its rival Allston Trading for allegedly engaging in spoofing. That case is ongoing.
In September the CME issued new rules specifically barring “disruptive trading practices” like spoofing. Apparently that wasn’t enough for the Commodity Futures and Trading Commission, which two months later ordered the exchange to develop strategies to better detect and manage spoofing. Though it’s unclear what the CME has done in response, Hunsader argues it would be possible to program internal algorithms that automatically scan for the telltale signs of spoofing.
Though CME Group declined to comment on this story, the exchange has apparently attempted to remedy the issues. HTG’s lawsuit alleges wrongdoing only up until August 2014, a month before new rules went into place. The firm's lawyer has given the CME credit for boosting its controls.
“They have been on top of this issue over the last couple of months,” says Simon. Despite new rules, though, the CME remains largely its own watchdog. “There’s definitely a conflict there,” says Simon.