Contributed by Rootika Srivastava and Annika Mitthal

Introduction 

Spoofing, a sophisticated market manipulation tactic, is increasingly disrupting global trading systems by manipulating order books and creating artificial price fluctuations. Traders, generate a deceptive perception of demand and supply, leading to significant market instability. With the rise of High-Frequency-Trading (“HFT”), this practice has become more prevalent, adversely impacting the market and eroding investor confidence.

The United States (“US”) has addressed spoofing through the Commodity Exchange Act of 1936 (“CEA”) and the Dodd-Frank Act of 2010. India is still in the early stages of addressing this issue, with SEBI only enforcing civil penalties against such practices. In contrast, the US enforces both civil and criminal penalties, that raises concerns about the adequacy of India’s approach.

Spoofing Mechanism & Market Impact

Spoofing is a market disruptive practice under the CEA, which involves bidding and offering in securities with the intent to cancel the order before executing. Securities and Exchange Board of India (“SEBI”) defined spoofing for the first time in the NIMI Enterprise Order, stating that it is the activity of placing large orders with the intent of executing smaller orders while cancelling the bigger ones. Trader tries to manipulate the order book – which lists the current buy and sell orders in ascending price ranges by placing large fake orders. In India,  the order display only reflects the executed market orders, not the ones cancelled or incomplete, which allows the spoofers to manipulate the market undetected.

Spoofing occurs in two stages: firstly, spoofers place their fake orders to influence the market perception, creating an illusion of strong demand and supply. Once the false market perception is established, spoofers cancel their orders avoiding any real commitment. This leads to artificial price fluctuations that often result in losses for unsuspecting traders misled by the spoofers’ tactics. Spoofers often seek larger profits which requires higher volume of spoofed orders. To achieve this, they use HFT systems that allow them to place and cancel their orders in milliseconds.

The fraudulent practice of spoofing creates a ripple effect in the securities market impacting both the market and  its stakeholders. Retail investors often base their decisions on non-existent orders, leading to losses and forcing hasty adjustments. This increases  market volatility, making it hard to assess the market as fake orders can trigger a domino effect of buying and selling. The uncertainty  erodes the confidence of the investors, and forces the traders to adjust their strategies, leading to higher trading costs and lower liquidity.

The first known instance of spoofing was the 2010 U.S. Flash Crash, involving UK trader Navinder Singh Sarao. He placed thousands of S&P futures contracts but only executed 81. The Commodity Futures Trading Commission (“CFTC”) discovered emails between Sarao and a programmer discussing their market manipulation strategies. Sarao used both automated and manual spoofing methods to inflate securities prices and  cancel orders, causing significant order modifications and cancellations. The CFTC brought 22 criminal charges against him, to which he later pled guilty.

In contrast, SEBI’s response to its first potential spoofing incident in India, during the 2012 Flash Crash, was much lenient. The NIFTY Index dropped 15% within minutes due to rapid order cancellations, likely caused by HFT. While this situation resembled spoofing, SEBI attributed it to human error and only held the NSE responsible for negligence, letting them get away with a slap-on-the-wrist penalty as there is no regulatory framework to criminally prosecute such offenders in India. This reflects the weaknesses in India’s regulatory framework compared to other countries that are taking stronger measures to prevent spoofing.

Spoofing Loopholes in India – SEBI’s Struggle to Curb Deceptive Practices 

The SEBI Prohibition of Fraudulent and Unfair Trade Practices (“PFUTP”) Regulations, 2003 strictly prohibit any fraudulent or deceptive market practices, price manipulation and deceitful schemes. While the Act explicitly bans practices like insider trading, pump-and-dump schemes, the implementation of manipulative devices, it doesn’t explicitly ban spoofing and HFT Transactions. SEBI uses the broad scope of Regulation 4 to impose penalties for the latter.

SEBI recognized that such aggressive practices distort security practices and destabilize the market. To address spoofing amidst the rise of algorithmic and HFT trading, , SEBI issued a circular imposing penalties on traders engaging in such practices. It includes temprorary account suspensions (15 minutes to 2 hours) and fines based on high Order-To-Trade Ratio, frequent order modifications, or frequent delays/ changes in execution. Stock exchanges are mandated to implement  order-based surveillance system to detect and deter such malpractices. Further, the circular states that even if all the criteria aren’t met by the trades, they can be penalized if they cause repeated market disruptions.

SEBI issued an order against Nimi Enterprises for engaging in spoofing in the securities market, violating the SEBI Act and PFUTP Regulations. The company had deceitfully manipulated the appearance of supply and demand, by placing large orders at huge price differences and placing many small orders  at minimal gaps. Additionally, large orders were placed below market prices whereas smaller orders were placed at market rates. The investigation concluded that for several scrips, there were only minutes between execution of small orders and cancellation of large orders, indicating the manipulative trading strategy.

As per SEBI standards,  stock exchanges require dealers to either reveal their full order or at least 10% of it. In this case, the company only disclosed its smaller trades while hiding the larger ones, violating the regulations. As a result, they were banned from the securities market for 2 years and imposed a fine of  Rs. 2 Lakhs. 

United States Regulatory Framework against Spoofing

The US takes a different approach, with strict laws under the CEA and the Dodd-Frank Act. Enforcement agencies like the CFTC and the Department of Justice (“DOJ”) impose severe penalties including prosecuting the offender under criminal law. Intent plays a crucial role in US regulation i.e. the offender must have had the intent of cancelling the order.

Under the CEA, spoofing is defined as activity of bidding or offering with the intent to cancel the bid or offer before execution. The CFTC has issued a guidance statement outlining  specific spoofing cases, including obstruction of trade execution, false impression of market depth etc. The CFTC can take action against spoofing even if it involves just a single transaction and  seek interim relief on an Ex-Parte basis. However, spoofing requires intent not mere negligence, which cannot be solely proven by statistical data, as many traders cancel orders for legitimate reasons. Any person engaged in such practices faces civil penalties and administrative repercussions, including monetary penalties, suspension or revocation of enrolment and trading rights, restitution orders, asset freezing, and disgorgement of illegally gained benefits. 

The Securities Exchange Commission (“SEC”) can also take civil actions against spoofing under the CEA and Securities Act. The Securities Act of 1933 prohibits the deceptive sale of securities and forbids any person from trading while offering or selling securities/security-based-swap agreements through any means of communication.  This includes any trick, plan to commit fraud or omit vital information. No trader is permitted to use any facility of the National Security Exchange for deceptive and manipulative practices. 

The Dodd-Frank Act amended provisions of CEA, enabling the DOJ to prosecute spoofing offenses.In United States v. Coscia the trader used algorithms to manipulate the trades by cancelling them last minute, earning over $1 Million. The Seventh Circuit imposed criminal liabilities on him under the Dodd Act as the practices were carried out with intent. Further, the DOJ can file criminal prosecutions for “knowing” breaches of CEA rules, each with a 5-year limitation period. If found guilty, offenders face up to 10 years in prison and a one-million-dollar fine as seen in the case of United States v. Vorley. In this case, a trader was engaging in spoofing and wire fraud against financial institutions, enabling the DOJ to impose harsher penalties. These precedents in the US clearly indicate that such manipulative tactics are not merely met with minor bans in the securities market, rather they are subjected to criminal penalties that effectively deter such deceitful practices.

Conclusion 

The difference between the regulatory framework for spoofing in India and the US highlights a pressing need for India to strengthen its measures against spoofing. While the US has established comprehensive laws that impose both civil and criminal penalties on offenders, effectively discouraging spoofing in the market, India’s approach remains rather limited. The recent actions taken by SEBI indicate a growing awareness of the challenges posed by spoofing, but without effective enforcement mechanisms and stringent penalties, the Indian securities market may continue to be vulnerable to spoofing. India must adopt stringent regulations, transparency and accountability to protect its investors, restore confidence in the market, and ensure a fair-trading environment.