The UK Flash Crash Spoofer Case Brings More Questions Than Answers
After reading both the Department of Justice and the CFTC cases against the UK Flash Crash spoofer, Navinder Singh Sarao, we are left with more questions than answers. While some in our industry are already debating whether or not Sarao was a high frequency trader, we don’t think this is the important issue in this case. This case is about manipulation and the lack of regulatory oversight which allowed it to continue for five years.
We trust by now that you are familiar with the details of the case but if not the CFTC summarized it here:
“According to the Complaint, for over five years and continuing as recently as at least April 6, 2015, Defendants have engaged in a massive effort to manipulate the price of the E-mini S&P by utilizing a variety of exceptionally large, aggressive, and persistent spoofing tactics. In particular, according to the Complaint, in or about June 2009, Defendants modified a commonly used off-the-shelf trading platform to automatically simultaneously “layer” four to six exceptionally large sell orders into the visible E-mini S&P central limit order book (the Layering Algorithm), with each sell order one price level from the other. As the E-mini S&P futures price moved, the Layering Algorithm allegedly modified the price of the sell orders to ensure that they remained at least three or four price levels from the best asking price; thus, remaining visible to other traders, but staying safely away from the best asking price. Eventually, the vast majority of the Layering Algorithm orders were canceled without resulting in any transactions. According to the Complaint, between April 2010 and April 2015, Defendants utilized the Layering Algorithm on over 400 trading days.”
The headline of the case is that a UK trader helped cause the Flash Crash of May 6, 2010. But the real story is that this particular trader was running the same manipulative scheme for five years before getting caught. The trader, Sarao, was not part of a sophisticated firm that operated microwave networks or paid for colocation services but rather a single individual who tweaked a software program that he used to repeatedly run the same manipulative layering strategies. We have a number of questions/issues about this case:
Was Sarao the only person running this strategy over the past five years?
Considering the thousands of traders around the globe that have access to much more sophisticated software and hardware, we have to believe that Sarao is not the only person running these sorts of manipulative strategies. Even Sarao admitted to regulators that he knew of another trader doing the same thing. The DOJ case stated:
Referring to another trader, SARAO further asked, “I see he continues to do this all day every day, yet you have a problem when I showed someone it for 5 mins?”
Is the E-Mini S&P 500 contract the only commodity that was being spoofed over the last five years?
While it is the most active instrument, there are plenty of other commodities (oil, for example) that exhibit many of the same characteristics as the E-Mini. We would be shocked if this same type of behavior is not going on in other commodities.
Why did regulators take five years to catch Sarao?
This is the most disturbing question. The CME was aware of Sarao’s manipulative activities as early as 2009 and sent a letter to his FCM (futures commission merchant) about his behavior. Sarao laughed at this letter and according to the DOJ:
“In a responsive email dated May 25, 2010, SARAO wrote to his FCM that he had “just called” the CME “and told em to kiss my ass.”
Rather than investigating Sarao more after the Flash Crash, the CFTC and the SEC chose to blame a mutual fund for the Flash Crash. But all they needed to do was examine Tag 50, which is a unique identifying code assigned by an FCM to a trader that must be used to enter an order on Globex, and they could have tracked all of Sarao’s orders. This would have showed that on the day of the Flash Crash:
“Over the course of the day, SARAO modified more than 20 million lots, whereas the rest of the market combined modified fewer than 19 million lots. SARAO’s activity created persistent downward pressure on the price of E-Minis. Indeed, during the dynamic layering cycle that ran from 11:17 a.m. to 1:40 p.m., SARAO’s offers comprised 20 to 29% of the CME’s entire E-Mini sell-side order book, significantly contributing to the order book imbalance.”
Was Sarao or others operating similar spoofing algorithms during the 2007-2009 financial crisis?
We all vividly remember the heart pounding, violent moves of the financial crisis. Multi-hundred point swings were commonplace and were usually initiated by news headlines. But were these moves exacerbated by spoofers like Sarao? The FBI agent quoted in the DOJ complaint stated: “I know that SARAO preferred to trade during periods of high market volatility.” Well, there was no higher volatility periods than during the financial crisis.
How could have sophisticated market makers been duped by a guy trading out of his house in the UK?
This question baffles us the most. Market makers spend millions on technology and hire the smartest programmers from around the globe to ensure that their strategies are the fastest and most sophisticated but they were duped by a guy trading from his house in the UK? Something here doesn’t add up. Sarao didn’t even try to cover his tracks. According to the CFTC’s case , “he primarily utilized 188/289 lot size spoofing on the sell side ofthe Order Book in conjunction with the Layering Algorithm.” Are we to believe that sophisticated market makers couldn’t spot this activity? Our friends at Nanex have continually pointed out these spoofing patterns over the past few years which makes us believe that other industry participants knew when the spoofing also was activated.
Did the CFTC’s new power granted to them under Dodd Frank Section 747 finally allow them to aggressively pursue this case?
We have to imagine that the CFTC was aware of Sarao but they might not have been able to bring a case since spoofing was hard to prosecute prior to Dodd Frank. In 2014, the CFTC issued their final interpretative guidance on section 747 which clearly defined spoofing and allowed them to aggressively pursue spoofers.
To sum up, we are very concerned by the Sarao case for the facts that it presented and for the questions that it has left unanswered. Actions of spoofers hurt all market participants (retail, institutional, market maker) and shatter investor confidence. How many investors have been driven out of the market over the past six years because spoofers like Sarao scared them away?