Spoofing: effective market power building through perception alignment

Abstract

Purpose This paper aims to show that market power exists in financial markets and analyze how spoofing is used by a high-frequency trader to build market power by taking advantage of both behavioral weaknesses of individual investors and microstructural loopholes of trading venues. Design/methodology/approach After showing that market power exists in the financial market, this paper centers around the question of how market power is constructed in the financial market. To sharpen the answer to the question, the paper compares the conditions needed for market power construction in the financial market with those needed in the goods market. The paper selects spoofing, the frequently used order-based tactic in high-frequency trading strategies, to analyze in detail how spoof orders can ignite herding with market power building as the essence. The Flash Crash that occurred in the New York Stock Exchange on May 6, 2010 provides an excellent case of market power construction exhibited in spoofing. Findings The behavioral mechanism of market power construction in the case of spoofing is perception alignment. It becomes effective when two necessary conditions are met: the spoof trader takes advantage of the incomplete order display set up by the exchange; and the behavioral weaknesses exhibited by numerous individual investors. In addition to these key conditions, this paper finds other ones for market power to be created in the financial market. They are easier, quicker, more secret, more flexible and less risky relative to the conditions for market power building in the goods market. Practical implications The detailed analysis points to the behavioral mechanism, i.e. perception alignment, and microstructural mechanism, i.e. incomplete order display, that could be responsive to regulation. Originality/value The originality of the findings is to uncover the mechanism of spoofing in taking advantage of behavioral biases of individual investors. The value is to gain more complete understanding of the essence of herding caused by spoofing.