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StreetwiseProfessor<>Ticked Off About Spoofing? Consider This
Filed under: Commodities,Derivatives,Economics,Exchanges,Politics,Regulation — cpirrong @ 6:51 pm

https://streetwiseprofessor.com/ticked-off-about-spoofing-consider-this/

An email from a legal academic in response to yesterday’s post spurred a few additional thoughts re spoofing.

One of my theories of spoofing is that is a way to improve one’s position in the queue at the best bid or offer. Why does one stand in a queue? Why does one want to be closer to the front?

Simple: because there is a rent there to capture. Where does the rent come from? When what you are queuing for is underpriced, likely due to some price control. Think of gas lines, or queues for sausage in the USSR.

In market making, the rent exists because the benefit from executing at the bid or offer exceeds the cost. The cost arises from (a) adverse selection costs, and (b) inventory cost/risk and other costs of participation. What is the source of the price control?: the tick size.

Exchanges set a minimum price increment–the “tick.” When the tick size exceeds the costs of making a market, there is a rent. This makes it beneficial to increase the probability of execution of an at-the-market limit order, i.e., if the tick size exceeds the cost of executing a passive order, it pays to game to move up in the queue. Spoofing is one way of gaming.

This has a variety of implications.

One implication is in the cross section: spoofing should be more prevalent, when the non-adverse selection component of the spread (which is measured by temporary price movements in response to trades) is large. Relatedly, this implies that spoofing should be more likely, the more negatively autocorrelated are transaction prices, i.e., the bigger the bid-ask bounce.

Another implication is in the time series. Adverse selection costs can vary over time. Spoofing should be more prevalent during periods when adverse selection costs are low. These should also be periods of unusually large negative autocorrelations in transaction prices.

Another implication is that if you want to reduce spoofing . . . reduce the tick size. Given what I just discussed, tick size reductions should be focused on instruments with a bigger bid/ask bounce/larger non-adverse selection driven spread component.

That is, why police the markets and throw people in jail? Mitigate the problem by reducing the incentive to commit the offense.

This story also has implications for the political economy of spoofing prosecution (which was the main thrust of the email I received). HFT/algo traders who desire to capture the rent created by a tick>adverse selection cost should complain the loudest about spoofing–and are most likely to drop the dime on spoofers. Casual empiricism supports at least the first of these predictions.

That is, as my correspondent suggested to me, not only are spoofing prosecutions driven by ambitious prosecutors looking for easy and unsympathetic targets, they generate political support from potentially politically influential firms.

One way to test this theory would be to cut tick sizes–and see who squeals the loudest. Three guesses as to whom this might be, and the first two don’t count.<<(And the answer is ?