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What is Spoofing/ Layering? How can Spoofing/ Layering Be Monitored?

What is Spoofing/ Layering? How can Spoofing/ Layering Be Monitored?

Spoofing and layering are forms of market manipulation that can get a firm or a trader into trouble. A simplified version of what might trigger a regulatory action goes something like the following:

  1. A trader has some inventory they would like to sell at a good price, better than the best bid in the market right now.

  2. The trader places a sequence of buy orders to try to move the spread, making it look like there is a lot of sincere interest in buying. Some of these might be below the current best bid, some above. The intent is to trigger an algorithm or another trader into thinking that they should get ahead of this wave of interest.

  3. The algorithm or other human trader (the “mark”) falls for it, placing a new bid above the current best bid.

  4. Trader cancels all the buy orders and hits the new high bid by the mark.

After this sequence of events, the trader has managed to exit the position at a better price than otherwise available.

The problem is that the bids placed by the trader were not actually intended to execute, but put there to send false information into the market in an attempt to manipulate the price. Moreover, someone lost money because of it.

There are a lot of subtleties here, not least because the activity of placing and canceling orders on both sides of the market is not inherently manipulative or problematic, but a fundamental part of many legitimate trading strategies. Market making, in particular, involves doing this frequently.

Thus the distinction between problematic behavior that can trigger sanctions, fines, and even prison and normal market-making type behavior comes down to a combination of repeated actions over time, trader intent, and the statistical properties of the pattern of orders a trader makes, relative to the background of order flow in the market. These patterns and statistical properties can be subtle. Still, we have clues as to the most important patterns and properties to look for because we can examine the sequence of events that led to regulatory action in the past.

The trader and anyone responsible for supervising the trader (like the trader’s firm, introducing broker, or the exchange) has some compliance obligations to monitor and prevent such behavior. There are three times this monitoring can happen:

  1. Retrospectively: during regular compliance reviews.

  2. Live: alerting a monitor to a manipulation attempt in process.

  3. Preventatively: blocking an order from being sent or at least warning a trader that the order could be flagged.

It’s worth noting that the trader being monitored here might be a person or an algorithm. In the case of an algorithm, intent becomes even more subtle. Past cases have looked at things such as the high-level direction given to a programmer in creating the algorithm.

Traders, firms, and regulators can use TradeLlama to monitor markets for this kind of manipulation and meet their compliance obligations. Contact us to learn more about our spoofing and layering solution.