Flash Crash trader case raises doubts on regulation and resilience of securities industry

For the last five years, in a suburban home near London’s Heathrow airport, a 36-year old British futures trader, Navinder Sarao, made a fortune amassing nearly $40 million through what US authorities allege are illegal tactics to manipulate the stock market.

Sarao, who was charged last month with wire fraud, price manipulation, attempted manipulation and spoofing, is facing 22 counts and up to 380 years in prison for his alleged crimes, following investigations by the US Commodities and Futures Trading Commission (CFTC), the Securities Exchange Commission (SEC) and the US Department of Justice.

The explicit charges in the case are perhaps not as shocking as the implications of his arrest – US authorities are saying that Sarao played a significant role in the Flash Crash of May 2010, when the stock market went on a nearly 1,000-point ride before regaining its losses.

Scotland Yard took Sarao into custody in April this year, and US authorities are attempting to extradite him to Chicago, the physical location where the trades technically took place.

Sarao’s five million-pound bail was denied, and he is awaiting a trial with the British High Court next week to fight the impending extradition.

Dubbed the Hound of Hounslow, his assets have been frozen worldwide. In comments last week, he said he had not “done anything wrong, apart from being good at my job.”

The Flash Crash – market volatility due to one trader’s actions?

The CFTC and SEC issued a report on the Flash Crash in September 2010, in an effort to explain why the Dow Jones Industrial Average took a nosedive of 600 points in minutes.

The report mentions a chain reaction started by a Kansas-based mutual fund which placed a single order on the futures market. Later on, the suspects of the domino effect were found to be other firms that had used faulty algorithms to trade on the market.

It was clear regulators were trying to solve the mystery of why the market had gone out of control on May 6, 2010, but couldn’t  put a finger on it.

The wild swing  worried the industry, which had regained its losses almost immediately, but market watchers feared a reprise. Five years later, the CFTC and the Department of Justice had a culprit, thanks to an anonymous whistleblower.

While the trades came ahead of the market crash, they “contributed to an extreme E-mini S&P order book imbalance that contributed to market conditions that led to the Flash Crash,” the DoJ said in a press release.

In essence, the Justice Department claims that the trades Sarao made before the crash were significant enough to cause a shakeup in the market by artificially changing the supply and demand of these particular futures contracts.

The Chicago Mercantile Exchange (CME) had warned Sarao about his high frequency trades that seemed to be cancelled as soon as they were ordered before, but they were just warnings.

Some experts say the connection seems improbable.

Lawrence Baxter, a lawyer and professor at Duke University at the Global Financial Markets Center, said the allegation seems “bizarre and unconvincing.”

“It’s an unusual situation,” Baxter told ACFCS. “The SEC and CFTC investigation and the official report said there was a ‘bad algorithm’ and now clearly that isn’t the cause and they aren’t explaining why there’s a different cause.”

Baxter said high speed trading is a very widespread tactic that is present in 60 percent of the market.

He said that while there are many traders who do the same thing, it would be difficult for one sole trader to be responsible for the Crash.

“It seems like he is a scapegoat,” Baxter said. “If he is guilty of spoofing, it’s hard to believe the systems weren’t able to mitigate it,” he said.

Spoofing is a type of high speed activity which layers multiple trades that the trader does not intend to have executed in order to create an artificial supply and demand and manipulate the market price.

After other investors glom on to the manipulated security, the first investor then closes the long position by selling the security at the inflated, higher price. The industry reaction to Sarao’s case is to the effect of “yeah, right.” said Baxter, echoing postings from blogs like Zero Hedge to Michael Lewis, who is famous for his exposé on the Wall Street high-frequency traders (HFTs), “Flash Boys.”

Baxter said that while industry reactions are not always an accurate gauge of the egregiousness of the suspected action , the allegations from authorities will have to be supported  by some strong evidence in Sarao’s trial to uphold the implicit claims.

Some experts are asking, why now?

The criminal complaint on Sarao and his company, Nav Sarao Futures Limited, PLC, describes activity from 2009 to as recently as April 2015. Sarao continued to do high frequency trades much after the crash, and was not apprehended until last month.

“The people at the CFTC who decided to come forth, five years after the fact, with this new and improved explanation for the flash crash, must have known they would be creating a controversy with themselves at the center of it,” Michael Lewis wrote in Bloomberg last month.

“It’s actually sort of brave of them,” he told Bloomberg.

In a statement, the CFTC Director of Enforcement, Aitan Goelman, said that prosecuting Sarao sends a message to the broader trading sector and makes   “clear that the CFTC, working with its partners on the criminal side, will find and prosecute manipulators of US futures markets wherever they may be.”

High speed trading pervasive, creates ethical and regulatory grey area

While some may disagree on Sarao’s role in the Flash Crash, the case focuses primarily on his practices of manipulation and spoofing through high frequency trading.

“Spoofing is definitely a criminal offense of the Commodities Exchange Act,” Baxter said. “Even if he was doing it to enhance his position is still criminal. “

The Dodd-Frank Act, a powerful set of measures to bolster financial stability, accountability and transparency signed into law in 2010, explicitly outlawed spoofing, opening the door to criminal charges against traders like Sarao.

Withdrawing offers is not illegal unless the trader does it intentionally and profits from the activity, creating a very grey area of regulation, explains financial markets professor Sugata Ray of the University of Florida.

Ray said that algorithmic trading constitutes the majority of the volume in the markets.

“Not all algorithmic trading is bad,” Ray said. “Algorithms, for example, are also used by market makers, who use them to rapidly adjust their quotes to movements in the markets. This in turn results in markets with lower transaction costs in the form of smaller bid-ask spread.”

So what is the difference between the “good” algorithmic trading that largely dominates the market and the nefarious kind  of algorithmic, potentially high-frequency trading (HFT) that authorities say Sarao executed from his Hounslow home?

“The line between illegality and ‘smart trading’ is blurry,” Ray said.  “Many things that seem ‘smart trading’-ish also seem like they could be ‘wrong’ but turn out not to be illegal, unless the SEC decides to categorize it into one of a number of potential ‘illegal’ boxes.”

Ray is the author of the upcoming book, Principles of Quantitative Equity Investing, and believes that in Sarao’s case, the regulators are looking at him because something bad actually did occur.

“There is a fair amount of discretion the regulators have regarding when and whether to pursue action and, like most US legal actions, that decision is often based on realized outcomes, rather than intentions. So many actions that traders were taking during the period of the flash crash that were in the grey zone will now be in the spotlight as investigators comb through the order and trade data.”

Repercussions of the Hound of Hounslow’s case

On the surface, Sarao’s case may confirm the worries of industry experts who have warned that HFT and algorithmic programs that allow traders to “flash” sell and buy stocks can be tremendously disruptive to the financial system.

However, experts in the securities industry warn that the new revelations brought forth by the judicial and regulatory authorities of the US against Sarao should be taken with a grain of salt.

Michael Lewis’ “Flash Boys” 2014 novel on the murky world of high frequency traders became a wild success, exposing the inner plumbing of the stock market that allows the elite and tech-savvy to control the financial system.

Lewis’ book was incendiary, spurring several lawsuits and general discomfort in the industry about an allegedly rigged system.

But even Lewis himself wrote an opinion piece in Bloomberg when the charges were unveiled, asking hard questions about the case that raise doubts about the CFTC’s deductions that Sarao, one lone trader, could have caused such a fuss in the markets on that May day five years ago.

“How can a guy working from his parents’ house in suburban England, whose only actionable orders were to BUY stock market futures, cause such a sensational collapse in US stocks? On the day of the Flash Crash, Sarao never actually sold stocks,” Lewis wrote.

In 2014, he told the UK Financial Conduct Authority he was successful at trading because “he had always been good with reflexes and doing things quick.”

As Sarao’s case unfolds, evidence of his operation may reflect potentially illegal practices that may be widespread, and sparingly enforced. These spoofing tactics have become more commonplace, and antiquated regulatory regimes lack not only the resources to attack the current problem, but to even recognize how the evolving technologies and methods may become ripe tools for financial warfare.  According to J.R. Helmig, founder of Leveraged Outcomes, LLC, who since 2003 has counseled extensively on HFT methods being used as attack vectors, the role of critical infrastructure protection is often overlooked.

“It’s not just a matter of having the policies and screening software in place.  One also has to examine the role of the underlying technological infrastructure and the ability to protect the control systems from cyber security threats.  What if the authorities cannot control the circuit breakers because hackers have penetrated the control mechanisms?”

If the allegations of US authorities are correct, that one individual could have the potential to cause a disturbance in the global financial system – one of the most unthinkable financial crime risks there is.


Press Release CFTC:


Statement Chicago Mercantile Exchange:


Navinder Sarao Criminal Complaint: