The arrest of a little-known futures trader this week drew back the curtain on one of the pernicious-sounding practices that have been linked to the distortion of global financial markets.
In the criminal complaint filed against a British trader on Tuesday, prosecutors said that a trading strategy known as spoofing was used to manipulate prices and helped lead to the 2010 “flash crash,” in which the biggest markets in the United States were thrown into disarray in minutes.
The 1,000-point plunge in the Dow Jones industrial average on May 6, 2010, challenged investor confidence and raised questions about how carefully regulators were watching out for rogue trading.
Long before this week’s case, however, spoofing was one of the most contentious — and according to some analysts, most common — ways for some high-frequency trading firms to manipulate stock prices. Traders using the technique look to make money by buying and selling securities in seconds, sometimes milliseconds.
Navinder Singh Sarao appeared in a British courtroom on Wednesday.
Priscilla Coleman / MB Media
A trader involved in spoofing puts in orders with the intention of moving the price of a financial asset — in the flash crash case, it was a futures contract betting on the direction of the Standard & Poor’s 500-stock index. When the price moves, that trader quickly cancels the orders and takes advantage of the price change.
There are few in the industry who are willing to defend spoofing and other deceptive strategies with names like layering and quote stuffing. But there is also much debate about how common spoofing and similar strategies have become. And it has been difficult to find firm evidence as to whether such strategies are directly harming ordinary long-term investors.
Spoofing is an evolution of older strategies used by traders in the physical pits, who tried to cajole competitors into offering slightly better or worse prices, sometimes through crafty hand signals.
“Technically it is market manipulation, but some people would call that clever,” said Matt Samelson, the chief executive of the consulting firm Woodbine Associates.
The large high-frequency trading firms have generally argued that spoofing is a strategy used by mostly fringe or nefarious actors. And although it is illegal, spoofing does not usually play a significant role in influencing stock prices, the firms say.
In the case of Navinder Singh Sarao, the British trader arrested this week, regulators contend that the spoofing strategy significantly contributed to the chaos of the flash crash. According to prosecutors in the United States, he appears to have acted alone from his home outside London.
Before the arrest, the industry was closely following a recent case involving one of the largest high-frequency trading firms, Allston Trading, of Chicago. The firm was accused by another high-speed operation of using spoofing techniques on a regular basis without facing any punishment from the Chicago Mercantile Exchange, the home of significant high-frequency trading activity.
The firm making the accusations, HTG Capital Partners, also of Chicago, said in a lawsuit filed last month that it had observed “a clear, discernible and consistent pattern of manipulative and disruptive trading” in 2013 and 2014.
Because the C.M.E., where the behavior in question was said to have taken place, allows participants to remain anonymous, HTG named the defendants in the case as anonymous John Does. (HTG had previously made a similar case against Allston to the regulatory arm of the Chicago exchange.)
A spokesman for Allston, Dave Lundy, on Wednesday denied all of HTG’s claims and said, “Spoofing should be stopped.” He added that the firm supported efforts by regulators “to ensure that all market participants comply with the law and act with the highest standards.”
The Allston case seems to support the prevailing wisdom that almost all high-speed trading strategies are used, in large part, by high-frequency trading firms against similar firms rather than ordinary investors.
Still, the case of the British trader suggests that such strategies can lead to big problems in the global markets.
On Wednesday, Mr. Sarao appeared in court in London, where he indicated that he would oppose extradition to the United States. American prosecutors have charged him with wire fraud, commodities fraud, commodities manipulation and spoofing. In court, Mr. Sarao wore a yellow sweatshirt and white track pants and sat behind a glass wall looking dazed.
Bail was set at 5 million pounds, or $7.5 million, and Mr. Sarao was able to raise the money with the help of his family. One condition of Mr. Sarao’s release was a prohibition on Internet use.
The complaint against Mr. Sarao said that he had used spoofing over hundreds of days from 2009 until this year, and did so despite being questioned by the C.M.E., which regulators rely on to police its own markets.
Mr. Sarao himself complained to the C.M.E. about how common abusive trading practices were on the exchange. When the exchange questioned him, Mr. Sarao denied any wrongdoing but asked whether its interest suggested that “the mass manipulation of the high-frequency nerds is going to end.”
Spoofing has long been against the exchange’s rules, but a new spotlight was shined on the strategy after the financial crisis, when the Dodd-Frank financial overhaul of 2010 explicitly outlawed it, opening the door to some of the criminal charges against Mr. Sarao.
The Securities and Exchange Commission and the Commodity Futures Trading Commission have both appeared to show more of an interest in cracking down on spoofing and similar practices, especially since the author Michael Lewis last year gained widespread publicity for “Flash Boys,” a book that was critical of high-speed trading.
Last fall, in the first case of its kind, a New Jersey trader was indicted on charges that he manipulated financial contracts tied to several commodities, including copper and soybean oil.
The C.M.E. last year posted a new rule aimed at taking on “disruptive” and “abusive” trading practices like spoofing.
But just a few months later, the C.F.T.C. criticized the exchange for failing to adequately monitor and punish bad behavior in a timely fashion and recommended that the exchange improve its tools for detecting spoofing.
A spokeswoman for the exchange, Anita Liskey, said on Wednesday that “spoofing has always been prohibited in C.M.E. Group markets. We have a clear record of prosecuting spoofing as well as other disruptive trading activities.”
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