On Tuesday, when high frequency trader Michael Coscia received a three-year prison sentence for a financial crime, it got industry practitioner attention. A clear message was sent amid a more nuanced approach the US Attorneys in Chicago are taking to combat acts that destabilize US markets.

Tough HFT prosecution designed to send a message to deter future market destabilizing acts

At a higher level, the DoJ isn’t looking at the Coscia case in the rear view mirror. There is a clear message being sent to end a lucrative practice critics had charged had become rampant: the practice of market manipulation.

“Traders contemplating sophisticated scams will think twice if they know that there are more significant consequences than a civil lawsuit or a regulatory action,” Assistant U.S. Attorney Sunil Harjani told the court in arguing for a six-year prison sentence. “Hedge funds and proprietary trading firms will closely review their trades, and strike down get-rich-quick manipulation trading schemes because the cost is not worth the benefit.”

Coscia, of Rumson, N.J., received a three-year sentence for “spoofing.” In determining the sentence, U.S. District Judge Harry Leinenweber noted the difficult to determine financial damage that had been caused and the 54-year old’s age for not granting prosecutors the tougher sentence. The former head of Red Bank, NJ-based Panther Energy Trading LLC was the first high frequency trader convicted under the Dodd-Frank Act, which his lawyers called unconstitutional in court.

Spoofing is considered a destabilizing tactic that works similar to a more common “bait and switch” strategy. The trader floods one side of a computerized market making system order book with quotes and trade orders that have no intention of being executed. The orders are a “come-on” to trick the computer into believing the market’s supply and demand balance is shifting. The computer, through an “electronic eye,” identifies this imbalance and adjusts market prices accordingly, often times in favor of the “spoofer.” It has been alleged that this was a significant cause that led to the 2010 “flash crash” and has resulted in smaller destabilizing market price fluctuations since then.

In court, prosecutors wrapped up their case by using the example of a kid in the playground raising his hand up in the air, faking to give you a high five but pulling it away at the last second. There is risk the high-five hand will get hit, but the intent is that it doesn’t get hit.

A jury took less than one hour to convict Coscia on six spoofing counts and six fraud counts. After serving three years in prison, Coscia will receive two years of supervised release.

DoJ built case against Coscia that showed intent and was “overwhelming”

Calling the DoJ case against Coscia “overwhelming,” Vincent Schmeltz, a lawyer with Barnes & Thornburg who practices derivatives and market structure law and attended the trial, noted an important message that was sent. Schmeltz noted that DoJ has been building strong cases that prove algorithmic intent: market orders designed in the computer program to deceive but never intended to be executed. Regulators now use algorithms to detect when predatory high frequency trading systems are disrupting markets, he noted.

The concept of algorithmic intent is much easier to prove than the intent a government official may have had in using an email server, for instance. With all crimes — including those committed by major banks — the key going forward is deterrence and that means making criminal activity result in meaningful punishment.

“In order to prevent future market manipulation, the economic incentives need to be taken out of the crime,” Schmeltz told ValueWalk. “By adding the potential for doing prison time, the value equation for committing high frequency trading crimes just changed rather dramatically.”

High Frequency Trading

Commonalities between Coscia and Oystacher case

Both Coscia and a pending Commodity Futures Trading Commission case against Chicago trader Igor Oystacher have similarities. Both accused of spoofing claim that they did not intend to engage in criminal acts and that their actions are a common method of “price discovery” that was done in human trading pits as well as electronic markets.

In a separate case, in Chicago U.S. District Judge Amy St. Eve ruled Tuesday Oystacher can continue to trade while he waits for his February, 2017 trial. Schmeltz dismissed the significance of the move, noting that internal barriers to spoofing have been put in place at 3Red Trading, the firm Oystacher founded.

“Both judges in the criminal and civil cases are on record as saying these spoofing activities are ‘problematic’ and change must occur,” Schmeltz said, pointing to a significant recent increase in market monitoring at the CFTC, CMEGroup and other regulators.

Oystacher, a former chess champion, is accused of continued spoofing after the CFTC had warned him through a civil case they considered his trading methods to be a violation. Oystacher is currently trading the S&P 500 and US Treasury bond futures.

During April court testimony he had previously professed ignorance that his actions were considered illegal and refused to acknowledge common industry definitions such as “flipping” and “trading.”

“You’re an intelligent guy, aren’t you?” a CFTC lawyer asked the man who tested in the 99th percentile in reasoning skills. “I don’t know what that means,” Oystacher replied.