Last week, UK authorities arrested Navinder Singh Sarao, a futures trader that the CFTC claims may have contributed to the May 6, 2010 “Flash Crash”. In a September 2010 report, the SEC and CFTC pointed to a mutual fund complex using algorithmic trading in E-mini contracts during an already stressed market as the cause of the crash. However, nearly five years later, the CFTC stated that an investigation found Sarao created an “extreme E-mini S&P order book imbalance that contributed to market conditions that led to the Flash Crash.”
In a complaint dated April 17, 2015, the CFTC alleges that Sarao engaged in a “massive effort to manipulate the Chicago Mercantile Exchange's (CME's) E-mini S&P 500 futures contract . . . by utilizing a variety of exceptionally large, aggressive, and persistent spoofing tactics.” According to the CFTC, Sarao used a “layering” algorithm that placed orders at several price points outside of the best offer to simulate mounting downward market pressure. The complaint asserts that these orders were placed “with very little risk,” and that the algorithm placed an average of several hundred orders per day that were modified thousands of times, and that 99% of the orders did not result in a trade. The CFTC notes that Sarao’s activity sometimes amounted to 40% of all active sell-side orders.
Further, the complaint alleges that Sarao turned the algorithm on and off multiple times to create artificial volatility, eventually cashing in when the market rebounded. On twelve sample days selected by the CFTC (including the date of the Flash Crash), Sarao traded an average of $7.8 billion notional per day, with profits averaging $530,000. The complaint also states that Sarao used “flash spoofing,” or adding and quickly cancelling orders in various sizes to create further volatility and “amplify the impact of the Layering Algorithm.”
The complaint details emails between Sarao and a company that built the trading platform he utilized in which Sarao requested assistance in enhancing the program to allow several orders with a single click at different prices and automatically cancel orders if the market moved within a certain price point from the orders. Sarao subsequently emailed the company asking for the code used so that he could modify it himself. The CFTC alleges that the algorithm modified Sarao’s orders to keep them at least three or four “ticks” away from the market so that the orders would not execute.
On May 6, 2010, Sarao turned the algorithm on at 12:17pm EST for the second time that day. Over the next two hours, the algorithm placed six orders that totaled 3,600 contracts in the E-mini, representing between $170 million and $200 million in value. For perspective, the average lot size was 7 contracts, according to consultants retained by the Department of Justice in the investigation. Over the course of the two hour period, the six orders were modified more than 19,000 times before they were ultimately cancelled at 2:40pm. According to the complaint, this “contributed to an extreme order book imbalance in the E-mini S&P market.” During the same period, the complaint notes that Sarao used “flash spoofing” to place 135 orders totaling 32,046 contracts; 132 of the orders were cancelled without execution.
The Department of Justice also filed a criminal complaint on April 11 covering the same activity and charging Sarao with “one count of wire fraud, 10 counts of commodities fraud, 10 counts of commodities manipulation, and one count of ‘spoofing.’” According to the DOJ complaint, when the Futures Commission Merchant (FCM) though which Sarao traded contacted him at the behest of the CME regarding the activities, he stated that he “was just showing a friend of mine what occurs on the bid side of the market almost 24 hours a day, by the high frequency geeks.” The CME eventually sent Sarao a letter dated May 6, 2010 (the date of the Flash Crash) regarding activity conducted in March 2009, admonishing him that “all orders entered on [the trading platform] during the pre-opening are expected to be entered in good faith for the purpose of executing bona fide transactions.”
When contacted about similar activity in July 2010 by the FCM on behalf of the Eurex exchange, Sarao claimed that his orders were always at risk and entered manually. Finally, the UK’s Financial Conduct Authority contacted Sarao in May 2014, prompted by the CFTC, and Sarao again claimed that his trades were manually entered and that he simply had “always been good with reflexes and doing things quick.”
Regulators missed the activity because they focused too narrowly on actual trades instead of reviewing entered orders as well, according to a recent Wall Street Journal report citing members of the joint SEC-CFTC task force that investigated the crash. The article noted that a yet-to-be-identified whistleblower came forward two years after the crash to report the activity. The CFTC and DOJ then conducted a more than two-year investigation, aided by paid consultants, eventually culminating in the recently-filed complaints.