Quote stuffing refers to a practice whereby traders place an abnormally large number of buy and sell orders and almost immediately cancel them. The term was coined in 2010 by Eric Scott Hunsader, the founder of Nanex, a financial data firm. At the time, High-Frequency Trading was used to manipulate the financial markets, contributing significantly to a severe market crash known as the Flash Crash. In a matter of minutes, the Dow Jones Industrial Average dropped by almost 1,000 points.
How Does it Work?
In order to understand how it works, consider an example. Say you have 10,000 units of Bitcoin in your personal account. You to sell those units at the highest possible price. In order to achieve that, you decide to drive the price up by artificially manipulating the market.
You place 1,000 different purchase orders on a digital asset exchange. When trading systems used by other market players notice this, they figure that Bitcoin demand is on the rise. Consequently, they place orders for their clients, enhancing the effect and driving prices up.
The entire process takes mere seconds, during which you cancel your purchase orders and sell your 10,000 bitcoin units for a neat profit.
Who Can Execute the Strategy?
In most cases, the practice is carried out by High-Frequency Traders who are either large market players or market makers. Only such big players can execute the strategy because for it to be effective, the trader requires a direct link to the crypto exchange in question. However, the practice has also been associated with algorithmic traders such as smart order routers among others.
Why and When Traders Use the Tactic
As illustrated in the example above, the key objective of quote stuffing is to manipulate digital asset prices. When this happens, a trader can have the opportunity to make money by arbitraging. Using this approach, market players exploit temporary price differences resulting from data inefficiencies between exchanges.
By flooding the market with fake orders, market participants create confusion. The speed at which the strategy is employed makes it difficult for competing traders to react to the move. This is because the validity period of the phantom orders made is so short that executing trades against them is next to impossible.
Effects of Quote Stuffing
While high-frequency trading in itself is not illegal, this practice has numerous undesirable effects. Consider some of them:
i. One of its worst effects is that it interferes with the efficiency of digital currency exchange platforms. The algorithmic trading tools used for the practice overwhelm exchange resources due to the flood of phantom orders. As a result, it has been known to freeze trading and cause confusion for automated trading programs.
ii. While on the one hand it creates trading opportunities for the perpetrator, it disrupts normal market operations, impacting other participants negatively. By offering a deceptive sense of demand and supply in the market, it can lead to unexpected losses for an unsuspecting trader.
In a bid to curb quote stuffing, some crypto exchanges have introduced measures limiting the number of transaction orders that can be submitted per second. Regulators such as the Securities and Exchange Commission (SEC) are also increasingly scrutinizing the practice and have imposed hefty fines on the malpractice.