NEW YORK (Real Money) -- Tuesday's big story, away from the hustle and bustle of earnings season, was the arrest of Navinder Singh Sarao by British authorities (in cooperation with the U.S. Department of Justice).
Sarao is being accused by the U.S. Commodity Futures Trading Commission (CFTC) of "unlawfully manipulating, attempting to manipulate and spoofing" the E-Mini S&P 500 futures (Es) contract. The CFTC's complaint goes on to allege that Sarao was "engaged in a variety of other manual spoofing techniques whereby defendant(s) would place and quickly cancel large orders with no intention of the orders resulting in transactions."
Despite claims that Sarao has engaged in illegal trading practices, such as spoofing, on numerous occasions since the 2010 flash crash, the DOJ's focus appears to be squarely on the defendant's key role in the (day-timeframe) events that triggered the May 6, 2010 flash crash.
Anyone actively involved in the markets from a day-timeframe trading perspective has likely witnessed orders, often very large orders, flash on the bid or offer (or just slightly outside the national best bid or offer) only to be canceled within a split second.
This incessant entering and canceling of orders is known as spoofing. In a nutshell, the participant entering the orders has no intention of allowing said orders to be executed. He is simply trying to create the illusion of extreme supply or demand. As the fake supply pushes prices lower, the participant can bid into the weakness, completely cancel all his fake orders, and sell his recently acquired inventory into the price rebound. It may be a bit more complicated than that, but not much.
Let's be very clear about this: Short-term futures traders aren't the only ones affected by spoofing. But since day-timeframe equity scalping has faded in a huge way since the 2008 financial collapse, the majority of participants have both adjusted and evolved, while accepting that regulatory agencies are incapable of curbing the practice.
Aside from traders accepting spoofing and other practices commonly (and often incorrectly) associated with high-frequency trading as an unavoidable cost of doing business, many in the news media continue to think such practices have little effect on mom and pop investors.
Call me crazy, but such things as market stability, integrity and trust are probably pretty important to everybody.
Turning our attention to equity traders, let me give you an example of how spoofing affects stock traders. One trader I've known for many years regularly deals in blocks of 5,000 to 10,000 shares.
He's complained with increased frequency over the past five years that while he may see 10,000 or 20,000 shares offered, the majority of shares vanish the second he hits the key, and only a fraction of his order gets filled. Having traded since the late 1990s, I can state firsthand that this sort of behavior did not exist to the degree it does today prior to the explosion of high-frequency trading (HFT) computers around 2008.
Can we ban HFT, or otherwise greatly reduce its role in the marketplace? No, of course not. That ship has sailed. Is it possible to dramatically reduce the illegal practice of spoofing? You bet it is! And it would be astonishingly simple.
Back in the 1990s, traders paid a cancel tax. And while no one likes to pay any sort of tax, the amount wasn't prohibitively expensive. My proposal is this: The SEC and CFTC should join forces to implement a cancel tax of 25 cents on any order entered within 1% of the national best bid or offer that fails to remain active for 30 seconds. If an order remains active beyond that 30-second threshold and is canceled, no fee would be imposed.
Such a nominal amount would have no lasting impact on the discretionary trader canceling a handful of trades during the trading day.
But it would crush traders who regularly spoof the market with thousands of essentially fake orders. If structural integrity is a concern, and participants want to eliminate destructive and manipulative practices like spoofing (which is what the CFTC is really trying to get Sarao on), implementing a tax or fee targeted at the very core of day-timeframe market manipulation tactics would be the quickest and simplest solution.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.