Spoofing and Price Manipulation in Order Driven Markets

We model the trading strategy of an investor who spoofs the limit order book (LOB) to increase the revenue obtained from selling a position in a security. The strategy employs, in addition to sell limit orders (LOs) and sell market orders (MOs), a large number of spoof buy LOs to manipulate the volume imbalance of the LOB. Spoofing is illegal, so the strategy trades off the gains that originate from spoofing against the expected financial losses due to a fine imposed by the financial authorities. As the expected value of the fine increases, the investor relies less on spoofing, and if the expected fine is large enough, it is optimal for the investor not too spoof the LOB because the fine outweighs the benefits from spoofing. The arrival rate of buy MOs increases because other traders believe that the spoofed buy-heavy LOB shows the true supply of liquidity and interpret this imbalance as an upward pressure in prices. When the fine is low, our results show that spoofing considerably increases the revenues from liquidating a position. The PnL of the spoof strategy is higher than that of a no-spoof strategy for two reasons. First, the investor employs fewer MOs to draw the inventory to zero and benefits from roundtrip trades, which stem from spoof buy LOs that are ‘inadvertently' filled and subsequently unwound with sell LOs. Second, the midprice trends upward when the book is buy-heavy, therefore, as time evolves, the spoofer sells the asset at better prices (on average)