In the 1920s a group of investors, known as the Radio Pool, traded among themselves in the stock of Radio Corporation of America, the tech company of the day. They succeeded in driving up the price, took their gains and left other investors to cope with falling prices when the pool withdrew its artificial support. In a 1934 report, the United States Senate committee investigating securities trading practices found the operations of the Radio Pool and others like it troubling:
The testimony before the Senate Subcommittee again and again demonstrated that the activity fomented by a pool creates a false and deceptive appearance of genuine demand for the security on the part of the purchasing public and attracts persons relying upon the misleading appearance to make purchases. By this means, the pool is enabled to unload its holdings upon an unsuspecting public.1
On August 7, 2017, a federal appeals court in Chicago affirmed the conviction of a trader for spoofing and commodities fraud based upon a scheme, carried out through a computer algorithm, designed to manipulate market prices and mislead other market participants by creating the illusion of market movement. Sound familiar? The case is United States v. Coscia2.
Michael Coscia employed a trading program through which he placed large and small orders on the opposite sides of the market, in each case the small order at the desired price, and large order designed to shift the market towards the price at which the small order was listed. Here’s how the system worked in connection with Coscia’s trading of copper futures.
Coscia placed a sell order for five contracts at the price of $327.55,3 which was higher than the market price at the time. He then placed orders many times larger on the opposite side of the market at steadily increasing prices, which started at $327.40 and grew incrementally to $327.50. These buy orders created the illusion of market movement, increasing the perceived (but illusory) value of any given futures contract and allowing Coscia to sell his current contracts at $327.55, a price that he created. The buy orders were immediately cancelled.
Having sold five contracts for $327.55, Coscia now needed to buy the contracts at a lower price in order to make a profit. He therefore placed an order to buy five copper futures contracts for $327.50, which was below the price that he had just created. Coscia then placed large-volume orders on the opposite side of the market, priced at $327.70 and then $327.65, which created downward momentum, fostering the appearance of orders at incrementally decreasing prices and allowing Coscia to fill his small orders at the deflated price of $327.50. The large orders were then immediately cancelled. Coscia repeated the process tens of thousands of times, resulting in profits of $1.4 million over a period of weeks.
The investors in the Radio Pool spent months or even years distorting the price of RCA by creating the appearance of demand and market movement. Coscia accomplished the same thing in two-thirds of a second.
At his trial, perhaps the most damning evidence of Coscia’s intent came from the designer of his computer program, who testified that Coscia asked him to create a program that acted “like a decoy,” which could be “used to pump the market.” The large orders would be cancelled after the passage of time or if they were partially filled or if the small orders were completely filled. Pressed for an explanation of his system at a deposition taken by the Commodity Futures Trading Commission, Coscia simply answered, “That’s just how I programmed it. I don’t give it much thought beyond that.“
There was also circumstantial evidence of Coscia’s intent. His order-to-fill ratio (the average size of his total orders divided by the average size of orders he filled) was 1.6%. The ratio for other traders ranged between 91% and 264%.
The jury convicted Coscia of violating the anti-spoofing provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act4, which prohibits a bid or offer with the intent that it be cancelled before execution, and commodities fraud under a statute5 which makes it a crime “to defraud any person in connection with any commodity for a future delivery.” Coscia was sentenced to thirty-six months’ imprisonment followed by two years’ supervised release.
The Coscia case has been described as a landmark, and we think rightly so, because it represents an affirmance of the first conviction under Dodd-Frank’s anti-spoofing provision. But there may be a bigger story here. Coscia was also convicted of garden variety commodities fraud under a statute on the books prior to Dodd-Frank, which suggests that at least one jury and one court are prepared to say spoofing is simply a category of commodities fraud.
Wholly apart from the question of whether what he did met the technical requirements of spoofing, Coscia’s fraudulent intent was proved because he employed a system that used large orders to artificially inflate or deflate prices and shift market equilibrium in a direction and velocity he chose. When the expected market reaction was achieved and profits taken in the “real” portfolio, the larger market distorting orders would be cancelled. Coscia would have been convicted even if Dodd-Frank contained no anti-spoofing provision. It was the very nature of the system he designed which established his fraudulent intent.
The history of market manipulation follows a straight line from the crude attempted corners by Jay Gould in the 19th century to the pools of the 1920s to the programming of algorithms to “pump” the market today. The difference is that the corners and pools were legal in their day. Things have changed, and so have the proofs of fraud.
Convictions for fraud in the financial markets have often been difficult because they require proof of intent. But that proof seems surprisingly obvious in Coscia’s case. The evidence supporting the existence of fraudulent intent, which the Court described as “substantial,” was contained in the very computer program Coscia designed, which he intended to put out decoys to create the illusion of market movement.
For us, one interesting question is what effect the Coscia decision will have on high speed trading in general. What of the other kinds of high frequency trading programs, where ultrafast computers allow traders to get a look at the bids and offers of other market participants and trade ahead of them, contain evidence of fraud? We’ll see.
1 Report for the Committee on Banking and Currency Pursuant to S.Res.84 (72nd Congress, at 32 (June 8, 1934).
2 31 2017 U.S. App. LEXIS 14508 (7th Cir. August 7, 2017).
3 The tick size for copper futures is one-half and one-thousandth of a cent. Numerical measurements of five represent one tick.
4 7 U.S.C. 6c(a).
5 18 U.S.C. 1348(1).