Addressing spoofing -A Form of Market Manipulation- January 2016 Market Surveillance and Compliance Department Japan Exchange Regulation

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1 Initiatives to ensure fairness and transparency in the JPX market Addressing spoofing -A Form of Market Manipulation- January 2016 Market Surveillance and Compliance Department Japan Exchange Regulation

2 Content Recent trends in spoofing Placing orders past and present Past record of SESC s recommendation for monetary penalty for spoofing Example of spoofing Spoofing revisited Explanation of spoofing Addressing spoofing Points to look at for market surveillance Spoofing case involving multiple brokers Addressing spoofing by HFT Tips and complaints from investors in market surveillance Frequently Asked Questions (cf.) Overview of market surveillance for market manipulation (cf.) Workflow of market surveillance for market manipulation Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 2

3 Recent trends in spoofing Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 3

4 Placing orders past and present Past Orders are placed mainly by phone or over the counter Present Many orders are placed on the Internet Orders take some time to be placed on the stock exchange. Order books cannot be seen by investors. Difficult to cancel or change orders frequently. Orders are placed immediately. Real-time order book information is available on the Internet. Easy to cancel or change orders frequently. (Eg) Order book Sell Price Buy MKT Developments in IT have led to a growing number of investors trading on 2,000 OVER real-time order book information Spoofing appeared as one form of market manipulation using real-time order book information The ease of placing, canceling and changing orders on the Internet on their own might have lowered the psychological barrier for wrongdoing, spoofing UNDER 1,500 Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 4

5 Past record of SESC s recommendation for monetary penalty for spoofing What is "spoofing"? "Spoofing" is the practice of making bids or offers with no intention of execution, for the purpose of drawing bids or offers from other investors, in order to create a more advantageous stock price. Past record of SESC s recommendation for monetary penalty for spoofing Market Manipulation Cases which contains spoofing Cases that contain spoofing are constantly identified. *Compiled by JPX-R based on SESC press releases We will introduce a spoofing case that resulted in a monetary penalty. (Details have been modified.) Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 5

6 Example of spoofing Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 6

7 Spoofing revisited "Spoofing" is the practice of making bids or offers with no intention of execution, for the purpose of drawing bids or offers from other investors, in order to create a more advantageous stock price. Such practice violates Article 159(2)(1) of the Financial Instruments and Exchange Act (FIEA). (cf.) PDF file of English translation of FIEA From the next slide, spoofing is explained using an example. The example might also be called "layering". Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 7

8 Explanation of spoofing (1) (1) A sell order which is intended to be executed is placed. 30 units of shares at 500. (2) A buy order of 55 units of shares is placed at 490 and the order is executed while the execution rises the stock price to 490. (3) The rest of the buy order is used for spoofing. Order book before spoofing Placing a spoofing order Spoofer Qt Sell Price Qt Buy Spoofer Spoofer Qt Sell Price Qt Buy Spoofer MKT MKT 2,000 OVER 2,000 OVER (3) The rest of the order stays (+30) and is used for spoofing (1) Placing a sell order intended to be executed # 55 55(+55) (2) Price goes up with execution UNDER 1,500 UNDER 1,500 Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 8

9 Explanation of spoofing (2) (4) After a third party s order raises the stock price to 493, an additional spoofing order is placed. (5) Likewise, after a third party s order raises the stock price to 496, two additional spoofing orders are placed. First addition of spoofing order Se c o n d additio n o f spo o f in g o rde rs Spoofer Qt Sell Price Qt Buy Spoofer Spoofer Qt Sell Price Qt Buy Spoofer MKT MKT 2000 OVER 2,000 OVER (4) An additional (5) Two additional spoofing order is spoofing orders are placed. placed (+35) Price 493 goes up (+10) 487 Price goes up (+10) UNDER 1500 UNDER 1,500 Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 9

10 Explanation of spoofing (3) (6) This attracts a buy order by a third party and the spoofer s sell order is executed at the intended higher price. (7) After the execution, the spoofer cancels most of his orders. Execution of the intended sell oder Cancellation of spoofing orders Spoofer Qt Sell Price Qt Buy Spoofer Spoofer Qt Sell Price Qt Buy Spoofer MKT MKT 2,000 OVER 30 2,000 OVER (6) Order attracted (7) Cancellation of from third party spoofing orders # (-10) 497 Price goes up (-10) (-30) (6) The sell order (-45) is executed as intended UNDER 1,500 UNDER 1,500 Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 10

11 Addressing spoofing (Points to look at for market surveillance) Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 11

12 Points to look at for market surveillance Market surveillance for a single product Sudden price fluctuation Sudden volume increase Little price movement with high volume In addition to above points Market surveillance for repeated cancelation and change of orders Placement and cancelation of large orders Repeated cancelation and change of orders etc. * However, it is not a spoofing case if there is no intent of attracting orders from other parties. Market surveillance focused on an investor An investor places both sell orders and buy orders. A spoofer uses multiple brokers. etc We can find spoofers who use multiple brokers. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 12

13 Example of spoofing case involving multiple brokers This example is based on an actual case resulting in a monetary penalty. (Details have been modified.) Spoofer Qt Sell Price Qt Buy Spoofer MKT 1,000 OVER Order attracted from third party Broker B # Broker A Price Placing a sell order throuth Broker B 95 goes up UNDER 1,000 Placing spoofing orders through Broker A A spoofer executes his sell order at 100 with a buy order placed by a third party order attracted by spoofing buy orders. It is very difficult for each broker to identify this spoofing because each broker knows only one side of the spoofer s orders. Spoofing cases where multiple brokers are employed are mainly investigated by SESC and JPX-R, which have the whole picture of the trades involved. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 13

14 Addressing spoofing by HFT (1) Is repeated cancellation and change of orders by HFT spoofing? Repeated cancellation and change of orders in itself is not spoofing. Placing an order that with no intention to execute but was intended to draw a third party s orders is spoofing. Trading according to legitimate market making strategy employed by HFT is not spoofing in this sense. Image of Market Making Strategy HFT Qt Sell Price Qt Buy HFT MKT 1,000 OVER UNDER 1,200 What is HFT (High Frequency Trading)? HFT is not clearly defined but is generally regarded as a type of investment strategy whereby profits are attempted to be made by rapidly buying and selling stocks according to predetermined algorithms. Market Maker Strategy is the strategy that attempts to accumulate margin between displaying sell orders and buy orders by placing both buy orders and sell orders and executing them with others orders. The strategy adjusts its orders along with market movement and thus frequently repeats cancelation and change of orders. When one sees only one side of order book, he might regard the orders as spoofing. However, if he sees the order book as a whole, orders are not imbalanced. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 14

15 Addressing spoofing by HFT (2) Can JPX-R properly monitor trading by HFT which repeats cancellation and change of orders very fast and frequently? Japan Exchange Regulation internally developed a dedicated market surveillance system. The system creates alerts even for cancellations and changes of orders that took place at the millisecond level. JPX-R can confirm all of order placement, cancellation and change afterwards, and rebuild the order book. Of course, the system is updated with changes in the trading environment. JPX-R can catch spoofing even though which is done very quickly and frequently. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 15

16 Tips and complaints from investors in market surveillance JPX-R utilizes tips and complaints of suspected unfair trading activities. You can report tips and complains through JPX website. Tips and complaints of suspected unfair trading activities are checked by market analysts one by one. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 16

17 Frequently Asked Questions Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 17

18 FAQ Who conducts market surveillance for Tokyo Stock Exchange and Osaka Exchange? Market Surveillance and Compliance Department of Japan Exchange Regulation. How many people are in the department? The department is comprised of about 80 people, with more than 60 involved in investigating and examining unfair trading. How does the department detect unfair trading? The department checks price movements, trading volume and orders, etc. of all listed products on Tokyo Stock Exchange and Osaka Exchange. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 18

19 FAQ How are the checks conducted? It is impossible for the department to manually monitor all orders and transactions of all listed products. Japan Exchange Regulation internally developed a dedicated market surveillance system. The system generates alerts for further examination. How many alerts are generated by the market surveillance system? Recently, about 300 alerts per day. The number varies depending on the market condition. Analysts check each one. * About 30 analysts for market manipulation. Can the market surveillance system identify unfair trading due to high frequency trading? Trades are identified based on criteria, regardless of speed or frequency. If a trade falls under the criteria, the system will generate an alert. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 19

20 FAQ If an alert is generated, does it mean that there is unfair trading? No. Alerts only identify trades requiring further analysis. How many unfair trading cases does JPX-R find? JPX-R does not have the authority to determine whether a trade is illegal. However, when JPX-R assesses that a case is highly suspicious, it reports the case to the Securities Exchange Surveillance Commission. Number of investigations Fiscal year Manipulation Insider trading Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 20

21 FAQ (cf.) Flow of market surveillance market manipulation- (1) Selection of Stocks Selection by market surveillance system Receive information from trading participants or other related departments. (2) Investigation (3) Selection of Stocks for Examination (4) Examination (5) Disposition Analysis of stock price and trading volume trends Investigate trend in trading share of each trading participant Hearings with trading participants (refer to customers for which trades were conducted) Submission of trading status reports and analysis of contents (If investigation findings point to the need for further analysis, the case moves to the examination stage.) Refer to trading participants for background of order placement and execution and detailed customer information, and analyze them Report to Securities and Exchange Surveillance Commission* Issue warning to the listed company/securities company as needed * JPX-R supports SESC s activities even after its reporting. Copyright 2015 Japan Exchange Group, Inc. and/or its affiliates. All rights reserved. 21

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