UK Trader Charged in Flash Crash

On Tuesday, a single trader was arrested at his home in the United Kingdom, accused of market manipulation over the course of the last five years, and of playing a role in the Flash Crash of May 2010. As a result of the arrest, the Commodity Futures Trading Commission (CFTC) unsealed a civil enforcement action in the Northern District of Illinois, and the Department of Justice (DOJ) unsealed a criminal complaint with the same allegations.

Navinder Singh Sarao (through his company Nav Sarao Futures Ltd PLC) is accused of using automated trading programs to manipulate the market for futures contracts on the S&P 500. Specifically at issue is the S&P 500 E-Mini contract traded on the CME, a futures contract where the notional value of each contract is worth 50 times the level of the S&P 500 (called the "mini" because the traditional contract size was 500 times the level of the S&P index). An active trader in E-Mini S&P futures, Sarao is accused of using a technique called "layering" in order to manipulate the market. Layering is a more complex form of "spoofing" which is essentially the practice of entering buy or sell orders into the market and then cancelling them before they can be executed, thereby distorting perceived supply and demand in a security. Spoofing itself wasn't outlawed until the passage of Dodd-Frank in 2010, and even now, enforcement agencies find it difficult to prove the intent element - that is that the trader always intended to cancel the order from the second it was placed.

Sarao's layering strategy occurred on the sell-side. The E-Mini contract trades in increments of 0.25 cents per index point or about $12.50 in contract value (called a tick). The ten best ticks (buy or sell side) to the current price are displayed for traders to get a sense of market volume. Sarao is alleged to have placed large, false sale orders usually in the range of the 4th to 7th best tick available, meaning that there were a minimum of three price points that would have to be executed first before the market got to his orders. This made it unlikely that any of his trades would be executed, and Sarao further is said to have used his automated trading systems to cancel (or modify) these offers before they were executed, and to establish new false offers in the 4th - 7th spots as the price of the contract moved towards (or away from) his execution point. All of this activity was designed to give the appearance of substantial selling pressure in the market, causing the price of the futures contract to drop. Sarao could then profit from his activity in two ways: by shorting the futures contract prior to running his layering program, he could profit by repurchasing contracts he had borrowed and sold at the new depressed price. Alternatively, he could buy the futures contract at the lower price, booking in a profit as the market rebounded once his manipulations had stopped. The table below shows an example of layering, with the future value of the S&P contract hovering at around $2,107.75.

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In this case, we start in scenario A, where slots 4 through 7 are occupied by inflated false trades. Large quantities of contracts are being offered for sale (or so it appears to anyone looking at the market) at prices three ticks away from the current market. Traders may decide that they want to get out in front of that selling pressure and sell now, before those trades are executed, so they place more sale offers at tick 1, 2 or 3 (scenario B). An imbalance of buyers versus sellers drives the price down, establishing a new lower price, with ticks around it. Sarao's algorithms then reestablish his large sales orders in the new slots 4 through 7, cancelling the old ones (scenario C). This process will continue until Sarao decides to buy at the new depressed futures price, after which point, he can turn off his programs and capitalize on the market rebounding.

Both agencies allege that on many of his active trading days, Sarao was 20-30% of the sales volume available in the entire market. He also had far fewer sale orders actually executed than most traders, and his trade lot size was substantially higher than most traders. But what exactly was his role in the Flash Crash?

Sarao was active on May 6, 2010, using his algorithms from 11:17 to 1:40 Central Time in order to place 3,600 contracts worth of downward pressure on the market. By 1:40, his outstanding sales orders roughly equaled the entire outstanding amount of buy orders remaining. However, the real damage came after he turned his programs off. From 1:41 to 1:44 the futures price dropped 3%,and another 1.7% by 1:45. At that point, the panic had bled into the actual markets, causing the S&P and other equity indices to drop 6-7% that day and other single-name stocks to drop even more. Sarao may be guilty of tipping already nervous markets over the edge, by causing these order imbalances (as the DOJ alleges). The CFTC previously pointed to a large 75,000-contract sale executed over 20 minutes commencing at 1:32 (later determined to have been an equity hedge trade executed by Waddell & Reed) as the precipitating factor in the Flash Crash. A more recent report published by the CFTC approximately one year ago supported this view, stating, "...we show that HFTs did not cause the Flash Crash, but accelerated a price movement due to a large order imbalance caused by an automated execution program to sell E-mini S&P 500 futures contracts. We also show that HFTs contributed to the Flash Crash by engaging in their typical immediacy-absorption practice of aggressively removing the last few contracts at the best bid or ask levels and then establishing new best bids and asks at adjacent price levels." It's unclear what portion of the blame falls on Sarao himself.

Sarao intends to fight his extradition to the United States, and while the DOJ claims he has made over $40 million from manipulative trades from 2010-2014, so far the UK court has turned up only 100,000 pounds in various betting accounts, and 5 million pounds in a personal trading account (which includes a 4.7 million pound loan). The ongoing legal battle will almost certainly reveal more information about the day-to-day functioning of markets, and perhaps will lead to changes in how regulators protect the integrity of those markets. The fact that one trader, operating out of his home, was able to have such a large impact on numerous days over a long period of time has led many investors to challenge the perceived fairness of markets in general.