Taxing Fictive Orders: How an Information Forcing Tax Can Reduce Manipulation and Distortion in Financial Product Markets

Abstract

In a society where behavior is significantly influenced through private ordering, the example of others is meaningful. Actions, whatever they manifest on the part of the actor, serve to inform and direct observers. Furthermore, the intent of actors is difficult to assess. These observations are only more true in the context of financial instrument trading, which is largely determined through complex, anonymous algorithms and serves to guide actors far beyond the market participants responding to orders to buy or sell. The potential for misdirection through entering and then cancelling orders has been recognized by the Dodd Frank Act, which imposes penalties on traders that place an order with intent to cancel it (or "spoofers"). Fictive order flow can endanger markets and manipulate prices due to the modesty of traders observing distorted order volumes. Modesty in today's electronically driven financial markets is both a virtue and a vice. Modesty is both a means for impounding dispersed information and the source of distortion and manipulation.Policing order cancellations properly recognizes the potential for traders to over-react to changes in manifest supply and demand for a financial product and the public good nature of price information. The post-Dodd-Frank regime, however, is grossly inadequate. Punishing only intentional order cancellations is both under- and over-inclusive. Un-intended order cancellations are not simply likely, but represent the great majority of orders in status quo market dynamics. And un-intended order cancellations pollute the price signal no less than premeditated cancellations. On the over-inclusive side, consistent rates of bid- and offer-cancellations are predictable and thus should not significantly distort prices. Thus steady rates of order cancellation should not be penalized, even if intentional. Furthermore, the pre-requisite of intent results in regressive enforcement, high enforcement costs, and gross under-enforcement. Finally, the regulatory regime (and the literature) neglect the costs of artificial silence and focus only on excessive noise. Nothing is being done to deter excessive dearths of orders.This article explains how these flaws of the initial thrust to recognize the social costs of fictive orders should be addressed through a tax that ratchets super-linearly with a trader's net number of bid or offer cancellations. An intent-agnostic tax on excessive cancellations would avoid the over- and under-inclusion of the present regime as well as its expense and regressive consequences. Proceeds from the tax can be used to subsidize orders when market participants temporarily withdraw from trading.