Sunday, February 08, 2015

Is order spoofing ok?

Spoofing is the act of generating orders to buy or sell something on an electronic market, but to then immediately cancel these orders in order not to trade. Spoofing is used to generate a burst of activity with the hope that it will cause other algorithmic trading systems to react in a sub-optimal manner, allowing the spoofer to follow through with profit making trading activity. Spoofing happens when you enter orders with no intention of letting those orders trade. Which is different from entering orders in to a market and to then cancel them because you have changed your mind. There is no change of mind in spoofing, and therefore it might be seen as a form of deception. Spoofing works because other trading systems are waiting to see certain market prices before they change their behavior. Spoofing can also slow down the market as it may overload the exchange’s network or matching engine, such a slowdown may put at disadvantage other market participants. The question is: is spoofing ok?

Deception is never far from risk taking in business. Taking risks implies building a mental abstraction that works out the pros and cons of future scenarios, and that concludes that certain actions are more profitable than others. Sharing this understanding with others, might well affect negatively your future outcomes. A first form of deception is to avoid public debate around subjects that would develop information that would be against your interests.

An example of such a business deception is the communication around “phone screens that break”. Looking around, and by my own experience, the number one issue for mobile phone owners is that their phone falls and the screen breaks. I still remember my Note II slipping from my hand and shattering on the pavement, and I sadly remember dropping it again after having fixed the screen. From a phone vendor perspective, broken screens drives profits as it creates a continuous demand for replacement phones. Therefore there is no incentive for the vendors to fix the issue. To the contrary, the bigger the phone and the closer the glass to the edge, the more chances that a phone will break on fall. The consequence is that phone vendors build larger and more elegant phones, which just so happen to break more easily. Making fragile mobile phones is business deception at its best!

Is business deception morally wrong?

The simple answer is yes, if only because I am “pissed off” with mobile phone makers. This emotional state is a sign that a part of me thinks that these companies are behaving badly. Yet the full answer is less obvious.

All companies that take risks are potentially being deceptive. Again the issue is that minimizing risk and maximizing profit leads to minimizing information disclosure. And keeping information “quiet” is a form of deception. The issue is that business is not possible without taking risks or making profits. In fact the whole economy is built on embracing risk and profit, and therefore also built on embracing certain forms of deception.

That our way of life leads to deception and that deception can hurt people, is a reality we would be happier without. And yet as the issue does not go away, people have found ways to deal with it. When confronted with deception, people will either:
  • Ignore it, and act as it does not exist. 
  • Try to keep it from happening by introducing rules and legislation. 
  • Accept it as fact of life. 
  • Work around it.
  • Find flaws in the method of deception, and take advantage of these flaws. 
  • Join in, and deceive others in a likewise manner.
The magic of human beings is that for each “deception situation”, each of us will take one of these approaches, and this choice will be based on personal values. We will either take the escapist approach of ignoring the deception, or take the constraining approach of trying to limit future deception, or take the liberal, somewhat darwinistic, approach of accepting the deception as “a natural part of the system”, or when possible work around or take advantage of the deception, or finally become a deceiver ourselves. Note that the constraining approach has two variants:
  • Rules or laws are set up that disallow a form of deception. 
  • Rules or laws are set up that limit behavior with the goal to limit the ability of deception. 

Given these remarks, what should be done about spoofing in financial markets? Exchanges prefer either to ignore spoofing or to ban it by disallowing spoofing as a form of deception. I think that is wrong, that spoofing should be allowed, and that throttling mechanism within the market APIs are the best way to deal with exchange overloading causes by trading behavior. Here is my reasoning.

Market prices are the result of equilibrium that happens between buyers and sellers. It is the outcome of competing ideas, competing beliefs, competing interest, competing focuses, competing technologies, etc. Someone or an algorithm may want to buy, others and other systems want to sell, they are all taking risks, often thinking differently, and the outcome is market activity.

Spoofing is an ultra-short-term strategy that provides a healthy counter balance to strategies that are based on speed, and only on speed. The thing is, among all those traders and trading machines, are those that base their decision making more on the current market prices than on real world activity. These market participants are taking short-term risks, risks that often lead to profits because of their extreme speed. These are profits taken from others that are competing on the short term, and also profits taken from those are taking longer-term view. In this jungle of “eat or be eaten”, it is perfectly right that spoofing makes profits by disrupting short-term strategies.

Spoofing that makes a profit by physically overloading the exchange’s matching engines is wrong. It is wrong because it puts the whole exchanges at risk, both in its operational integrity, as in the ability for the exchange to be master of its rules and regulations. It is not right to allow spoofers to purposely affect the processing behavior of other participant’s orders. For example, by purposely causing the exchange to slow down and order queues to build up. Yet here again we are confronted with the difficulty to distinguish between behaviors that are purposely trying to kill exchange performance, and behaviors that are directly business driven, yet end up impacting exchange performance because of the amount of trading activity they generate. Therefore I agree that exchanges should introduce constraints that protect their networks and execution engines, but care must be taken to how this is done. As mentioned above, two approaches are possible: One can simply “outlaw” spoofing, and hope that it is not done, and if done, hope that it will not harm exchange infrastructure; Or, one can change things, to keep spoofing from impacting on the exchange’s execution. Throttling dangerously high trading activity is the natural way to approach this problem.  It is perfectly reasonable that exchanges limit trading activities that disrupts exchange integrity be implementing throttling within the trading APIs. Therefore, it is is right for the exchanges to configure API  throttling limits to limit spoofing activity that would impact too strongly on the exchange's network or matching engine. It is wrong for exchanges to simply ban spoofing, as that would give an unfair advantage to participants that apply trading strategies that are hurt by spoofing. 

Ps: Thanks to Adrian for remarking that deception may lead to deception.

All original content copyright James Litsios, 2015.

2 comments:

Adrian said...

Interesting read James. Personally I'm all for it, the issue with new techlike this goes further to show that knowledge is power etc. All this does is make the "game" of trading further meta from its current incarnation and that's not necessarily a bad thing. You also exclude an important option from your writeup:

When confronted with deception, people will either:
Ignore it, and act as it does not exist.
Try to keep it from happening by introducing rules and legislation.
Accept it as fact of life. Possibly want to educate people on the subject.

The other option is that when confronted with deception, some people will try to figure out the deception and take advantage of it.

Remember the Norwegian traders who figured out Timberhill's system and took advantage? They were ultimately cleared of any wrongdoing and of course I'm sure Timberhill eventually fixed their algos :) This made the markets more efficient no? All spoofers are doing is attempting to automate this process and find inefficiencies in other peoples algos. Same argument applies, one day people will figure out how to spoof spoofers and the game becomes more meta.

James Litsios said...

Adrian, I like that: deception leads to even more deception! I will need to update the post.