Prison sentence for spoofing highlights trading risks

Introduction

In November 2015, New Jersey trader Michael Coscia became the first person to be convicted of “spoofing”, a form of market manipulation, under the 2011 Dodd-Frank Act. A 12 member jury found that Mr. Coscia employed an illegal and fraudulent strategy to trade futures contracts on exchanges based in the United States and United Kingdom in 2011. On 13 July 2016, Mr. Coscia was sentenced in Chicago to three years’ imprisonment on six charges of spoofing as well as six charges of commodities fraud.

The sentence is a timely reminder to traders, hedge funds and brokers on both sides of the Atlantic that reckless trading may have a criminal consequence. It also highlights the need for firms providing clients with direct market access to put in place systems and controls to identify and prevent manipulative trading strategies.

Offences

The anti-spoofing statute criminalises the entry of bids or offers in the market with the intention of cancelling them before they are traded. At trial, US federal prosecutors successfully argued that Mr. Coscia’s trading algorithm repeatedly placed large “bait” orders for futures contracts that he had no intention of trading. These large orders nonetheless created a brief illusion of market activity - an illusion that moved prices and enabled his algorithm to fill smaller orders from which he profited. Over ten weeks, his “bait and switch scheme” netted Mr. Coscia roughly US$1.4m in profits across the CME Group, Inc. (CME) exchanges in Chicago and New York and the London-based Intercontinental Exchange (ICE) on which he traded.

Sentencing

At sentencing, federal prosecutors sought a prison sentence of 70 to 87 months, within the advisory guideline range, citing the sophistication of Mr. Coscia’s fraud, his false testimony at trial, and the need for general deterrence in the securities and commodities industries. Lawyers for Mr. Coscia, however, argued fervently for probation. They pointed to Mr. Coscia’s exemplary life, the penalties he had already paid, and the lack of interpretative guidance available to Mr. Coscia in 2011 about the “spoofing” offence.

Mr. Coscia was ultimately sentenced by Judge Leinenweber to three years’ imprisonment, to be followed by two years’ supervised release. This prison term will likely cheer federal prosecutors and regulators, who argued that a serious sentence would “require the industry to take more care in its trading strategies.” It is, nonetheless, a heavy price for Mr. Coscia, who had already paid US$2,787,800 in fines, disgorged US$1,715,376 in profits, and served a one year trading suspension as part of settlements with the exchanges, the US Commodity Futures Trading Commission (CFTC), and the UK Financial Conduct Authority (FCA).

Risks of criminal liability are not confined to the United States

The alleged architect of the 2010 “flash crash”, Navinder Sarao, is currently appealing extradition to the United States, where he has been indicted for “spoofing” as well as wire fraud, commodities fraud, and commodities manipulation. Westminster Magistrates Court rejected Mr Sarao’s challenge to the United States’ extradition request at a hearing in March this year. The Court found that, as a matter of English law, Mr Sarao’s spoofing activities would, if proven, have been capable of amounting to offences under s.2 of the Fraud Act 2006 and s.90 of the Financial Services Act 2012. In short, the judgment serves as a warning to traders in the UK - “spoofing” is a crime here too.

No criminal charges have been brought against Mr Coscia or Mr Sarao in the UK, although Mr. Coscia was fined £597,993 by the FCA pursuant to the UK’s civil market abuse regime. The success of US prosecutors in Mr. Coscia’s case, however, may well herald a shift towards criminal enforcement of “spoofing” in the UK.

Risks for firms providing direct market access

The FCA’s Final Notice to Michael Coscia explains that, like the traders in the Swift Trade spoofing case, Mr Coscia used the services of direct market access (DMA) providers to access the markets that he sought to manipulate. Regulators in the UK and US have made clear that DMA providers are required to have systems and controls in place to identify and prevent manipulative trading conduct.

In 2009 the FCA’s predecessor, the FSA, highlighted in its Market Watch newsletter the need for DMA providers to “ensure that they have appropriate systems and controls in place to identify and prevent layering and spoofing” and that “where these systems and controls are not deemed sufficient [the FSA might] consider supervisory or enforcement action”. This was followed by a letter to compliance officers in 2013 which reiterated that DMA providers are responsible for the trading of their clients and subject to suspicious transaction reporting obligations. When it comes into force, the Markets in Financial Instruments Directive II (MiFID II) will include an express obligation on firms that offer DMA to have appropriate risk controls to prevent trading that could be contrary to the Market Abuse Regulation.

In the United States, the Financial Industry Regulatory Authority (FINRA) has also been watchful of DMA providers, fining Newedge USA, LLC US$9.5m in July 2013 for failing to supervise trading by clients that used its DMA services. Newedge was found not to have sufficient procedures, adequate surveillance tools, or the necessary information to monitor DMA activity and to have failed to reasonably and effectively monitor for certain types of potentially manipulative trading.

Conclusion

The prison term handed to Mr. Coscia in US federal court yesterday will underscore to traders that manipulative strategies risk much more than a regulatory response. For DMA providers, the stern sentence is a reminder to remain vigilant for evidence of “spoofing.” The climate of intensified regulatory activity reinforces the importance of providing information and compliance training to traders and close scrutiny of trading strategies.