Order-based manipulation: evidence from Hong Kong stock market

Author:Chun-Hin Chan
Position:Department of Finance, The Chinese University of Hong Kong, Shatin, Hong Kong

Purpose – The paper aims to investigate order-based manipulation that consists of order-placing strategies. Design/methodology/approach – Using the bid and ask record provided by Hong Kong Exchanges and Clearing Limited, a Level II dataset, the paper develops a methodology to obtain cancelled orders during regular trading hours. The paper examines the cancelled orders and potential... (see full summary)

I Introduction

Stock market manipulation is an important topic to both market practitioners and academics. Since stock exchanges were founded, manipulators artificially change the stock prices so as to make profits. Allen and Gorton (1992) classify stock market manipulation into three types, namely, action-based manipulation, information-based manipulation and trade-based manipulation. After the extensive provision in the Securities Exchange Act of 1934, the first two types of manipulation which involve explicit actions to change the firm's intrinsic value and release of false information or rumors to alter the stock price are prohibited. However, Mei et al. (2004) suggest that the third type, trade-based manipulation, where the manipulator does not rely on insider information nor visible actions except trading, is difficult for regulatory body to detect and eradicate. Jarrow (1992) , Allen and Gorton (1992) , Kumar and Seppi (1992) and Huberman and Stanzl (2004) also study trade-based manipulation. Due to the lack of relevant empirical data, these studies are based on building theoretical models to study the possibility of trade-based manipulation.

While there are still many questions about trade-based manipulation, Kong and Wang (2011) introduced a new type of manipulation called order-based manipulation. In such manipulation, no trades are executed. It obviously differs from trade-based manipulation which involves trading the stock, i.e. buying following by selling for “pump and dump” (or short-selling following by buying for “dump and cover”). Nowadays, more than half of the world's stock exchanges are order-driven, with a limit order book at the center of the trading process. The Stock Exchange of Hong Kong (SEHK) is an example of order-driven markets. Unlike the New York stock exchange or NASDAQ, SEHK has no specialists or dealers. Liquidity is provided solely by the trading public who submit limit orders. Most transaction prices are resulted from a series of trading in which investors submit market orders and accept the price offered in the limit order book. Bourghelle and Cellier (2006) state that a limit order trader provides to other investors the ability to execute against his limit order in order-driven markets. There exists interaction of a large number of anonymous traders choosing whether to trade immediately or to wait by placing market or limit orders, respectively. They can change their orders at any time as long as their orders have not been executed. It creates opportunities for manipulators to generate profits by placing and withdrawing limit orders strategically. This type of manipulation involves only submission of buy or sell limit order followed by cancellation of the order before it is executed. Concerning order-based manipulation, manipulators frequently place and withdraw limit orders even though they do not want to have their limit orders executed. Intuitively, the purpose of this behavior is to affect the view of other investors who also attempt to get information in the limit order book. For example, if there are lots of limit buy orders placed at a price lower than the current price, there seems to be strong demand of the stock and a so-called support is created. Manipulator pretends to be an informed trader and uses block orders to push the stock price higher. Ranaldo (2004) proves that changes in the order book affect the limit and market order trading in opposite ways. Therefore, it is apparently profitable for large traders to exploit these opportunities in order-driven markets.

Kuk et al. (2009) investigate the influence of strategic submission of aggressive limit orders that are subsequently followed by cancellation in pre-opening session on price discovery of IPO firms. By examining cases of IPO firms went public on the Australian securities exchange, both theoretical and empirical analyses suggest that investors can be misled by “submit and cancel” strategy and hence the accuracy of the price discovery process artificially influenced. Kong and Wang (2011) consider a prosecuted order-based manipulation case in China. The study focuses on public administrative penalty decision on a Chinese individual investor, Jianming Zhou, released by the...

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