What caused US stocks to swoon in the 2010 “flash crash”? American investigators think it was a chap working from his bedroom in Hounslow. Are they serious? Simon Wilson reports.
What’s happened?
Navinder Singh Sarao, a 36-year-old futures trader from Hounslow, was arrested on charges of manipulating the US stockmarket and contributing to the 6 May 2010 flash crash, when US stocks dropped almost 10% in minutes before quickly rebounding. According to the US authorities, Sarao made $879,018 profit on the day of the crash, and $40m in all between 2010 and 2014.
What makes the case extraordinary is that Sarao is not part of a big financial institution; he was a lone day-trader working out of a bedroom in his parents’ house. Sarao denies wrongdoing and is fighting extradition to the US. He remains in custody after failing to raise £5m in bail money.
What exactly is he accused of?
One count of wire fraud (meaning an online crime), ten counts of commodities fraud (in the US, stock index futures are regulated by the Commodities Futures Trading Commission) and ten counts of commodities manipulation. There’s also one count of “spoofing” – placing an order with the intention of cancelling the order before execution, potentially profiting from confusion in the market.
The criminal complaint alleges he “used an automated trading program to manipulate the market for E-Mini S&P 500 futures contracts (E-Minis) on the Chicago Mercantile Exchange”, the largest US futures market. US prosecutors say that this alleged manipulation earned him significant profits and contributed to “a major drop in the US stockmarket on 6 May 2010, that came to be known as the flash crash”.
How did all that cause the crash?
That’s where it gets murky. The complaint is fairly clear about what is alleged in terms of dodgy trading practices. By allegedly placing multiple, simultaneous, large-volume sell orders at different price points – a technique known as “layering” – Sarao would have created the appearance of substantial supply in the market. He also allegedly modified these orders frequently – “dynamic layering” – so that they remained close to the market price, and typically cancelled the orders without executing them.
When prices fell as a result of this activity, Sarao allegedly sold futures contracts only to buy them back at a lower price. Conversely, when the market moved back upward as the market activity ceased, Sarao allegedly bought contracts only to sell them at a higher price. All that sounds plausible enough. What many analysts are sceptical about is (a) how Sarao actually made money from his trading and (b) how all this helped cause the flash crash.
Who is sceptical?
Craig Pirrong, a US finance professor who has often served as an expert witness in legal cases involving commodities and derivatives, has expressed strong doubts about the case. He writes that the complaint is “mystifying on the issue of how Sarao made money (allegedly $40m dollars between 2010 and 2014)”.
And although the complaint goes into great detail regarding the allegedly fraudulent orders that were never executed, it is “maddeningly vague on the trades that were”. Moreover, attributing the flash crash to Sarao’s activity is also “highly problematic”.
Why does he say that?
“The complaint alleges that Sarao employed the layering strategy for about 250 days, meaning that he caused 250 out of the last one flash crashes,” says Pirrong. A defence lawyer would have a field day going through the other 249 instances when his actions didn’t cause a flash crash.
“Yes, perhaps the market was unduly vulnerable to dislocation in response to layering on 6 May 2010, and hence his strategy might have been the straw that broke the camel’s back, but that is a very, very, very hard case to make given the very complex conditions on that day.”
What do other commentators say?
UK commentators have been similarly bemused by the case against Sarao. It is disingenuous to believe that “a man armed with a few million dollars and a roomful of computers could make billions of dollars vanish from the US equity market”, says the FT. The idea is “like blaming a flea on an elephant’s rump for a stampede”. And if dodgy trading by Sarao really sparked the crash, the bigger question is why the US equity market “so closely resembled a powder keg”.
But perhaps there’s a simpler explanation, suggests Alistair Osborne in The Times – namely “that, five years on, America still needs a scapegoat for its embarrassing flash crash, and threatening someone with 380 years in jail also has a nice deterrent effect”. Yet, if Sarao really did what the authorities allege, there are essentially two explanations. “Either he’s a genius or the US markets are dead easy to manipulate. If it’s the latter, we may as well all have a go.”
Plenty of blame to go around
The weak case against Sarao leaves “plenty of blame to go around”, says The Economist. Indeed, the idea that he was even partly to blame “will only add to the alarm the flash crash engendered”.
How could one day-trader have been allowed to generate $200m of selling orders – over a fifth of the daily volume in the E-mini contract – during a period of market upheaval without having been blocked by one party or another? Consequently, the financial watchdogs have plenty of questions to answer. “The most pressing of them will be, if a trader from Hounslow can cause the S&P 500 to crash, who or what else could do the same—or worse?”