Exchanges must do more to oust tricksters

The renowned freewheeling and aggressive environment of futures trading is now firmly under the microscope with the industry keen to show it can still police itself.

The arrest of UK trader Navinder Singh Sarao for four years of alleged market manipulation of equity futures has shone a fierce spotlight on the dubious trading practices known as spoofing and layering, and done little to improve the reputation of markets.

The crackdown was reinforced last Thursday by the 60-day banning of two traders from the United Arab Emirates on the Chicago Mercantile Exchange for alleged gold futures manipulation.

Now traders are being reminded of the need to not only have adequate financial resources, but also exhibit "good moral character, a good reputation and business integrity," as the CME's rules state.

"Market developments [in recent years] both from the futures and equities market have opened the door for questionable market activities," says Matt Simon, senior analyst at Tabb Group, a US capital markets consultancy. "For others that follow Mr Sarao, there's likely to be a big legal fight over what constitutes spoofing."

A broader question for both futures and equity exchanges is whether dubious trading is isolated or far more prevalent, requiring a stronger response from these self-regulated entities.

As the world's largest futures exchange, the CME oversees trading across a range of contracts that provide hedge funds, banks, asset managers and others with an opportunity to buy and sell exposure to oil, agricultural products, interest rates and equity markets such as the S&P 500.

Like other bourses, it has had to adapt to the advent of sophisticated high-speed computerised trading systems allowing investors around the world to trade futures, cash equities, currencies and US government bonds.

The Department of Justice investigating Mr Sarao alleged he was able to manipulate the e-mini S&P 500 index futures contract from 6,000 miles away using tactics intended to draw out offers from other traders without showing one's own hand.

Spoofing is bidding or offering with the intent to cancel the bid or offer before execution. Layering is a more elaborate version, supplying the market with lots of orders that create the illusion of a healthy market. Without establishing intent, traders say it can make it difficult to distinguish it from legal tactics.

Others point out the structure of contract encourages certain types of trading. "What's key to this is that the e-mini market is a 'FIFO' market - 'first in, first out'," says one trading executive who declined to be identified. "It encourages you to put in orders when you're away from the market so that when the market moves closer to your price, you're closer to the front of the queue."

Indeed, traders' complaints about spoofing are legion. The customisation Mr Sarao asked for to his trading software "shouldn't be difficult to do", he wrote, "since there are people using these matrices in every market I have traded so it is fairly common."

Some argue that distinguishing from legitimate trading if difficult, especially when activity is dominated by rapid-fire computers that spit out numerous prices instantly.

For some, the main difference between Mr Sarao and other traders was not his tactics or technology, but the size of his trades and the risk he took that he would not be able to buy or sell in the market.

Regulators argue spoofing is a traceable crime. An academic paper from 2011, co-authored by the Commodity Futures Trading Commission's then chief economist, Andrei Kirilenko, argued it was a commonly observed form of manipulation used in high-frequency trading that existed in both equities and futures.

Earlier this year HTG Capital, a Chicago proprietary trading firm, sued an unnamed trader for spoofing the US Treasury futures market on CME, arguing his behaviour "eliminates the possibility that this pattern was anything other than orchestrated". HTG has also brought a CME arbitration case involving spoofing against rival firm Allston Trading.

The big US futures exchanges, CME and Intercontinental Exchangeimposed new rules banning disruptive trading. Both have brought punishments against recklessly disruptive conduct in the last three years.

Yet for all their efforts at enforcing discipline, questions are being asked about an exchange's dual role of running a profitable enterprise while also being responsible for making sure trading does not transgress acceptable practices. As a CME member, Mr Sarao had to meet certain criteria but in return he received price discounts for trading in volume.

But others say competition keeps them honest. "For-profit exchanges can lose customers and volumes - along with investor trust - by tolerating spoofing," says Neal Wolkoff, former chief executive of the American Stock Exchange and former chief operating officer of the New York Mercantile Exchange.

"In 2010 systems to detect spoofing, and even a definition of what it was, were in infancy. Looking back years to reveal practices and attitudes of exchanges today will give a skewed and inaccurate picture," he says.

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