Spoofing and Price Manipulation in Order Driven Markets

38 Pages Posted: 2 Aug 2019 Last revised: 30 Jan 2020

See all articles by Álvaro Cartea

Álvaro Cartea

University of Oxford; University of Oxford - Oxford-Man Institute of Quantitative Finance

Sebastian Jaimungal

University of Toronto - Department of Statistics

Yixuan Wang

University of Oxford

Date Written: August 2, 2019

Abstract

We model the trading strategy of an investor who spoofs the limit order book (LOB) to increase the revenue obtained from selling a position in a security. The strategy employs, in addition to sell limit orders (LOs) and sell market orders (MOs), a large number of spoof buy LOs to manipulate the volume imbalance of the LOB. Spoofing is illegal, so the strategy trades off the gains that originate from spoofing against the expected financial losses due to a fine imposed by the financial authorities. As the expected value of the fine increases, the investor relies less on spoofing, and if the expected fine is large enough, it is optimal for the investor not too spoof the LOB because the fine outweighs the benefits from spoofing. The arrival rate of buy MOs increases because other traders believe that the spoofed buy-heavy LOB shows the true supply of liquidity and interpret this imbalance as an upward pressure in prices. When the fine is low, our results show that spoofing considerably increases the revenues from liquidating a position. The PnL of the spoof strategy is higher than that of a no-spoof strategy for two reasons. First, the investor employs fewer MOs to draw the inventory to zero and benefits from roundtrip trades, which stem from spoof buy LOs that are ‘inadvertently’ filled and subsequently unwound with sell LOs. Second, the midprice trends upward when the book is buy-heavy, therefore, as time evolves, the spoofer sells the asset at better prices (on average).

Keywords: Market making, Spoofing, Layering, High-frequency trading, Market quality

JEL Classification: F0, G14, G18, G10, C61, C02

Suggested Citation

Cartea, Álvaro and Jaimungal, Sebastian and Wang, Yixuan, Spoofing and Price Manipulation in Order Driven Markets (August 2, 2019). Available at SSRN: https://ssrn.com/abstract=3431139 or http://dx.doi.org/10.2139/ssrn.3431139

Álvaro Cartea (Contact Author)

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

University of Oxford - Oxford-Man Institute of Quantitative Finance ( email )

Eagle House
Walton Well Road
Oxford, Oxfordshire OX2 6ED
United Kingdom

Sebastian Jaimungal

University of Toronto - Department of Statistics ( email )

100 St. George St.
Toronto, Ontario M5S 3G3
Canada

HOME PAGE: http://http:/sebastian.statistics.utoronto.ca

Yixuan Wang

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

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