Anyone who has seen Martin Scorsese’s 2013 masterpiece The Wolf of Wall Street is at least a little bit familiar with how market manipulation tactics work and how the charismatic con-men that run them can convince anyone to do their bidding. After all, the movie is based on Jordan Belfort’s life, who was convicted of white-collar crimes in the late ’80s after running several pump-and-dump schemes that cost his investors around 200 million dollars.
While Belfort left his days as a Wall Street con artist behind him following his arrest, the game of manipulating market prices, of course, continues. Trading has evolved in different ways since the early ’90s, especially thanks to widespread internet access and the development of algorithmic trading methods. Con artists and scammers evolved as well, coming up with new trading strategies that would give them an upper hand on the market.
Spoofing is one such trading strategy that takes advantage of algorithmic trading to artificially inflate prices and move the market in a given direction, at least until the spoofer makes its profits.
To help you understand it better, we prepared a detailed guide about what spoofing is and how it works through different assets such as stocks or cryptocurrencies.
What Is Spoofing?
Let’s say you’re an investor who owns stocks in a technology company.
One day you submit thousands of online orders to sell your shares. Your orders are seen by other market participants and they are spooked into selling their shares as well since they think the prices will fall. Prices do fall indeed, but you cancel your sell orders and instead take advantage of the low prices to buy even more stocks. Voila! You have managed to spoof the trade and make a profit.
Basically, spoofing is a trading activity in which you manipulate other market participants and the financial market. Spoofers place orders without the intention of following through with their trades in order to manipulate markets by creating false supply/demand lines. Once a spoofer makes their move, one side of the order book (buy/sell) starts filling up, creating more and more pressure in the market. Spoofers can control the timing of the rise or fall of prices because they are the initiators and the closers.
Spoofers don’t necessarily make huge profits with every trade, but they can quickly make multiple trades to increase their profits – sometimes to millions of dollars. Spoofing was a little-known market strategy in the early 2000s but, with the advance of online speed trading, it has become a prominent strategy.
What Is Algorithmic Trading?
Spoofing works primarily thanks to algorithmic trading and high-frequency traders. With algorithmic trading, there are no real people who are making decisions – the algorithms track the markets so that they can place and execute an order milliseconds before they are fulfilled.
Algorithmic trading in financial markets is also known as high-frequency trading because participants deal with high-volume transactions in a matter of milliseconds. That means high-frequency traders, computers that run trading algorithms, react to new market orders so quickly that algorithms can execute orders before the originals can be fulfilled. This gives high-frequency traders a distinct advantage: they are able to adapt to market changes more quickly in order to make the most profit.
Algorithmic trading isn’t illegal, and in fact, it’s a very common trading strategy employed by most stock exchange companies. Human traders can’t compete with algorithmic trading, and it’s mostly used by professionals.
That, of course, blurs the lines between legal and illegal market manipulation. Professional traders do take advantage of mispricing all the time because that is how they make money. On the other hand, these decisions traditionally involve gauging a company’s worth or making predictions based on economic ups and downs. Algorithmic trading does the same but in a cruder way that is open to more manipulations.
For example, the American company CME Group Inc., a conglomerate that comprises several market exchange companies that include the New York Mercantile Exchange, Chicago Mercantile Exchange, and Chicago Board of Trade, makes huge profits from high-frequency trading (HFT). It’s hard for regulators to decide what constitutes spoofing as opposed to regular high-frequency trades because it’s common for professional traders to hedge their bets and make high-volume transactions. That also means policing high-frequency traders puts self-governing bodies like CME in conflict because they make a lot of profit from those trades.
Is Spoofing Illegal?
In the US, spoofing has been illegal since 2010, under the Dodd-Frank Act. According to Dodd-Frank, spoofing is bidding with the intent to cancel before execution. The act constituted the legal premise of the case against US trader Michael Coscia, who was charged with spoofing future markets using algorithmic trading software.
Spoofing is also illegal in Australia. Spoofing, or layering, is placing orders that give the impression of high supply/demand on either the buy or the sell side while placing a genuine order on the opposite side. If the other orders are canceled after the genuine order is filled, this is layering.
In the US, The U.S. Commodity Futures Trading Commission (CFTC) is responsible for monitoring and fining the relevant parties suspected of spoofing or allowing layering to be executed on their platforms. In 2013, David Meister, the former head of CFTC, said the agency would distinguish between traders who use algorithmic trading software and specially designed spoofing software. As spoofing is a clear market manipulation strategy, the agency established a Spoofing Task Force in order to prevent the growth of spoofing in electronic trading platforms.
If not illegal, spoofing is still not allowed in many countries where financial market regulators carefully watch the market prices and price movements in order to understand if the market is healthy. While spoofing may not be explicitly illegal, traders can still be fined for violating the trading regulations and market manipulation.
That said, even if a spoofer is from a country where spoofing is not illegal, trading on global trading platforms means they can be held responsible for their actions by an American judge, as was the case for many spoofers who traded on American futures markets and derivatives markets and through US-based exchange companies.
What Is Flash Crash?
In May 2010, the U.S. stock market crashed, dropping by almost 9% for about half an hour before making a swift recovery. The crash lasted about 7 minutes, leading market watchers to call it a “flash crash” as some stocks rapidly fell in a matter of seconds.
In September 2010, the US Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) released a report detailing the reasons for the crash. The report underscored that the U.S stock market was largely fragmented, as well as very fragile. The triggering event was singled out as a large mutual-funds firm selling a high number of E-mini S&P 500 futures contracts, leading high-frequency traders to aggressively sell the asset to each other.
Former CFTC Chief Economist Andrei Kirilenko and a team of academic researchers released an academic paper on the Flash Crash, detailing how high-frequency traders, such as the CME Group, amplify price volatility, causing fragility in the markets without absorbing risks or bringing liquidity. CME lawyers took action to suspend the CTFC academic task force in retaliation.
In July 2010, the Obama administration signed the most comprehensive financial regulation bill put together since the aftermath of the Great Depression. The Dodd-Frank Wall Street Reform and Consumer Protection Act gave the CFTC the permission to regulate derivatives contracts markets.
The story of the Flash Crash came to an unexpected close in 2015, with the CFTC and the U.S. Department of Justice pointing fingers at an unlikely suspect: Navinder Singh Sarao, dubbed the Hound of Hounslow, a day-trader who bought and sold futures contracts from his bedroom in his mother’s house in West London.
While critics find it unlikely that a single trader can be blamed for triggering a market crash on that level, the CFTC announced that Sarao played a large part in triggering the market crash, due to his market manipulation through spoofing.
Spoofing In Cryptocurrency Markets
The Flash Crash put a shine on spoofing as a dangerous form of market manipulation and helped raise the alarm against malicious high-frequency traders who can take advantage of advanced technology to manipulate the market against the interests of other market participants.
But while the CFTC spoofing task force is busy with trying to monitor and regulate the more traditional futures markets and the big sharks, there is a growing and bustling marketplace that doesn’t – or at least didn’t receive the same attention, until very recently.
Who Is Spoofy?
It all started in 2017, when a blogger known as Bitfinexed made a detailed post about Bitcoin price manipulation on the Bitfinex trading platform, titled “Meet ‘Spoofy’. How a Single entity dominates the price of Bitcoin”. The blogger suggested that an actor with close ties to the platform had been using spoofing tactics to manipulate the price of Bitcoin.
According to Bitfinexed, “Spoofy” has been placing large buy orders to drive up the price of Bitcoin, which they would cancel when the market prices on the trading platform rose. The spoof buy orders raised the prices, allowing “Spoofy” to sell his assets with great profit. Spoofy has also been accused of “wash trading” i.e giving the false impression that a market is generating value to attract other traders in order to create a bubble that is well-suited to spoofing.
Bitfinexed suggested “Spoofy” to be closely connected to the Bitfinex trading platform, as Spoofy held large quantities of assets on the platform, enough to make him one of the largest whales in the system. That means other traders couldn’t counter Spoofy’s orders as they would need to hold an enormous amount of bitcoins on the exchange to do so.
Bitfinexed’s blog post contained detailed explanations, as well as graphs and photos from the Bitfinex platform which the author claimed showed how spoof orders with Tether had been responsible for manipulating the price of Bitcoin on the trading platform. Bitfinexed continued to rally the social media through Twitter and Reddit before going silent for a while, which in hindsight, might have been due to the federal investigation into Tether and Bitfinex he called for in his posts actually happening, though at the time that was kept under wraps.
In 2018, John Griffin, an academic researcher famous for spotting fraud released a paper detailing how Tether-related price manipulation accounted for Bitcoin’s price changes over the past years, lending even more credibility to Bitfinexed’s comments.
What Is the Alleged Relationship Between Bitfinex, Tether, and Bitcoin?
When Bitfinex made his post in 2017, Bitcoin had yet to start its march towards the top of the price charts. Bitfinexed suggested at the time that Tether was used as a way of driving Bitcoin prices on the trading platform.
Tether is known as a “stablecoin” in the cryptocurrency world. In other words, every Tether token that is issued is supposed to be backed by 1 U.S. dollar. Tether used to claim all Tether tokens were backed 1-to-1 by traditional currency the company kept in their reserves so that the value of 1 Tether would always be equal to 1 USD.
The company also claimed transparency through professional audits that show all Tethers in circulation are backed by their reserves. But in January 2018, Tether announced that the relationship with its auditor company had been dissolved, fueling the concerns that the company had been lying about its assets. Fanning the flames were the news that U.S. regulation authority CTFC subpoenaed Tether and Bitfinex regarding a fraud investigation.
The relationship between Tether and Bitfinex had been previously denied by Bitfinex’s Phil Potter but had become public after the International Consortium of Investigative Journalists released the Paradise Papers, which revealed Philip Potter was a Tether founder and director.
Tether and Bitfinex’s story got even more complicated as the price of Bitcoin increased sharply across several trading platforms. In April 2019, the New York Attorney General’s Office disclosed a fraud investigation against Tether and Bitfinex with a court order to stop their operations in the state of New York. The fraud probe concentrated on Bitfinex’s undisclosed loss of $850 million dollars from company reserves due to financial losses and withdrawal orders. The court suggested Bitfinex tapped into Tether’s cash reserves, using it as a slush fund to cover their losses quietly. The court fined Tether and Bitfinex 18.5 million dollars.
How Did Spoofing Affect Bitcoin Prices?
Both Bitfinexed and the finance professor John Griffin had drawn similar conclusions about Tether and Bitfinex, alleging wash trading and spoofing claims though they used different methods for their analyses.
According to Professor Griffin, there were distinct Bitcoin price patterns related to Bitfinex and Tether. He suggested Bitfinex’s Tether was used to buy cryptocurrencies on the trading platform when the prices were dropping at other crypto exchanges.
The authors relied on public data, available thanks to blockchain technology, in order to come up with patterns. The analysis showed Tether was used to buy Bitcoin at other exchanges especially when prices were dropping. Interestingly, the pattern only showed up during the time period when Tether was issued by the Bitfinex parent company. When the NY court order stopped Tether from issuing new tokens, the pattern dissolved.
The analysis fits well into the picture Bitfinexed painted on his blog. According to Bitfinexed, a whale had been manipulating buy and sell orders by placing spoof orders to drive the price of the cryptocurrency up and down.
Why Is Tether so Important?
Tether has grown enormously in the cryptocurrency ecosystem, becoming the highest valued stablecoin. While Tether is the fifth-largest cryptocurrency in the market by market cap alone, it has the highest trading volume according to CoinmarketCap, almost 1.5 times larger than Bitcoin’s. Tether transactions are incredibly important to the cryptocurrency ecosystem at this point.
You can think of Tether as a bank. You give Tether USD and it gives you USDT, that is, Tether tokens that are supposedly backed by dollars. The only problem is that, unlike a bank, Tether is not regulated by anyone as it’s an offshore company, and there is no way of knowing what they are doing with your money. People buy Tether to make trades on crypto exchanges where they bet on cryptocurrency prices to make a profit. Even though it’s unregulated, Tether is trusted by a large percentage of the crypto community as a safe asset.
Tether is also used by finance startups that offer yields to the customers who lend the platform cryptocurrencies, such as the Celcius Network. In fact, the Celsius network founder was in the headlines for disclosing that Tether loaned them a stablecoin loan in exchange for cryptocurrency deposits. Celsius and other high-lending platforms are able to promise incredibly high yields to customers because tethers can be lent out at higher interest rates to other intermediary parties. That means high-rollers can collateralize Bitcoin and other cryptocurrencies to borrow Tether, and use the Tether to buy more BTC and other cryptos, creating a loop.
A recent analysis by digital assets firm Kaiko shows that almost 70% of all Bitcoin trades take place in Tether-BTC pairings (BTC-USDT). That means Tether has become an underpinning force in the cryptocurrency markets.
What Does the CFTC Order Reveal About Tether and Bitfinex?
More recently, Tether was fined 41 million dollars for settling the claims that it had backed tether coins with fiat currencies. CFTC Commissioner Dawn Stump confirmed that the investigation revealed Tether hadn’t been backed by company reserves as previously claimed.
The CFTC order reported that Tether and Bitfinex have custody of third-party funds without any documentation. The order also mentioned how Bitfinex used Tether funds to respond to liquidity crises on the platform.
The most damaging part of the CFTC order is the revelation that Bitfinex force-liquidated customer positions, “acting as counterparty to certain transactions”. This could indicate that Bitfinexed’s claims that Bitfinex played a role in the spoof trades on the platform is be true.
Tether also still hasn’t provided a complete audit of its reserves, according to the CFTC order. As of 2021, there are 69 million Tether coins in the market, and 48 million of them were issued in 2021. Tether amended the description on their website to say that the company holds reserves in many forms including commercial papers i.e short-term loans to several companies. Forensic financial research firm Hindenburg Research announced a 1 million dollar bounty on information disclosing Tether’s financial reserves.
All of that said, spoofing allegations have yet to come to a satisfying conclusion. It’s not clear whether Tether and spoof orders helped Bitcoin price rise, or whether they were effective in the long run. While CTFC definitely has its eyes on the Bitfinex trading platform and Tether, only time will reveal what really went down behind the scenes. For now, we only know that the U.S. Justice Department is separately investigating bank fraud allegations against Tether.
A Few Words Before You Go…
Spoofing is a market manipulation strategy that is used to drive asset prices up and down in order to take advantage of other market participants’ moves to make a profit. Spoofing is related to algorithmic trading and layering, the trading strategies that evolving internet technology makes possible.
A spoofer places large buy or sell orders on one side of the order book to spook other high-frequency traders into buying or selling their assets and takes advantage of the price movement to buy cheap or sell high before canceling the original orders. Assets like futures and derivatives contracts, as well as for cryptocurrencies, are vulnerable to spoofing due to the nature of speedy algorithmic trading used in these markets.
Regulators have begun to take spoofing very seriously after the Flash Crash, and CFTC has been taking steps to identify and fine spoofers in various markets, including crypto.