U.S. prosecutors and regulators have filed criminal and civil charges against British resident Navinder Singh Sarao, alleging that he illegally manipulated markets and helped spark the sudden plunge in stock prices known as the “flash crash” of May 6, 2010.
On that day, the Dow Jones industrial average lost and regained 600 points in a matter of minutes. Nearly five years later, authorities arrested Sarao at his London home.
Sarao has reaped more than $40 million in profits, said a release by the Commodity Futures Trading Commission, by placing a series of “exceptionally large” sell orders that he then would cancel, a maneuver known as “spoofing” designed to undermine prices. Then he would trade in a manner that would generate profits from the market volatility, the commission said.
Sarao used this technique not only during the flash crash but also on more than 400 trading days starting before the flash-crash episode and as recently as April 6 of this year. Altogether he placed hundreds of thousands of orders with no intention of executing them, the CFTC said.
The charges suggest that the CFTC and the Securities and Exchange Commission initially pointed the finger at the wrong firm. In a September 2010 report, the two agencies blamed a single “fundamental seller” — widely identified as the Kansas-based investment firm Waddell & Reed — as the main culprit behind the crash. A spokeswoman for Waddell & Reed did not return a call requesting comment Tuesday.
The technique Sarao allegedly used was startlingly simple. According to the CFTC, Sarao “modified a commonly used off-the-shelf trading platform.” He programmed it to layer four to six “exceptionally large” sell orders for a futures contract pegged to the Standard & Poor’s 500-stock index. Those prices were higher than prevailing prices at that time. As the price of the “E-mini” S&P 500 drew near to the sell orders, the trading platform’s “layering algorithm” would automatically cancel existing orders and set new ones.
The Justice Department said Sarao had used the “multiple, bogus orders” without any intent to execute them. The purpose, the Justice Department said, was “to trick other market participants . . . by creating a false appearance of increased supply in the product and thereby depressing its market price.” The CFTC said that on some days Sarao’s orders, 99 percent of them canceled, accounted for 40 percent of sell-side orders.
“The bad news is that someone can commit that act and it shows the potential fragility of the global financial system,” said Mark Zandi, chief economist at Moody’s Analytics. “It’s disconcerting that an individual can have such an impact on global markets.”
“The good news is they got him,” he added. “I hope they make clear that there are big penalties and use this as a learning experience so that this can’t happen in the future.”
The CFTC filed a civil suit against Sarao and his firm, Nav Sarao Futures. The Justice Department charged him under seal on Feb. 11 with manipulation, attempted manipulation, spoofing and wire fraud.
“Protecting the integrity and stability of the U.S. futures markets is critical to ensuring a properly functioning financial system,” Aitan Goelman, CFTC director of enforcement, said in a release Tuesday. “Today’s actions make clear that the CFTC, working with its partners on the criminal side, will find and prosecute manipulators of U.S. futures markets wherever they may be.”
But some experts said that the government hasn’t come to grips with the underlying problem and that Sarao’s story has a different message.
“My sense is that he’s not alone and whatever he did is occurring regularly in one form or another, all precipitated by the elimination of the short-sell rule and a plethora of other rule changes . . . that have resulted in these unintended consequences and events like the flash crash,” said Ted Weisberg at Seaport Securities. The short-sell rule had barred investors from placing bets on drops in prices when prices had started to fall.
“And I humbly suggest that it will happen again and again in the future,” Weisberg added.
Data from Nanex suggests that Sarao halted his alleged spurious orders nearly three minutes before prices began falling sharply on the day of the flash crash, according to Eric Scott Hunsader, the founder of the financial data firm. Hunsader said the trader did nothing unusual on the day the market crashed.
As the panic built, the increasing volume of sales appears to have overloaded financial institutions’ electronic trading equipment, interrupting communications between the Chicago exchange where the futures are bought and sold and the New York markets where the stocks are traded.
When potential algorithmic buyers who might have stepped in to staunch the bleeding saw the breakdown, they shut down, fearing the worst, and the collapse continued. The entire collapse happened in just a couple of minutes, faster than any human trader could react.
Hunsader said that he did not think Sarao’s orders could have been responsible for more than 10 percent of the total collapse in prices — still a substantial amount. But Hunsader said he believes Sarao’s behavior is typical on the exchanges, and he faulted regulators with failing to reform what he thinks is a flawed system.
“It’s such a common thing,” Hunsader said. “It’s wrong to just single this person out.”
CFTC spokesman Steven Adamske said that the CFTC did not say that Sarao was the sole cause of the flash crash but rather that he “helped create the imbalance and the circumstances by which the flash crash happened.” As to whether regulators would be able to prevent future incidents, Adamske said: “Manipulation in markets has happened and will probably continue to happen. We try to catch what we can, but I’m not too sure we can corral it.”
The Justice Department said in its criminal complaint that Sarao sent an e-mail to a commodity broker asking for help to adjust software that would have “cancel if close function, so that an order is canceled if the market gets close.” The department charged that Sarao had made other e-mail inquiries about automated software that would make sure his “spoofing” orders would not be filled.
Traders in the E-mini market are able to see order books with the 10 best prices on each side of the market. Sarao allegedly placed his orders in the middle of the sell side before canceling and lowering them, “ensuring that the downward price pressure remained constant.”
The Chicago Mercantile Exchange noticed unusual activity by Sarao and warned him that orders “are expected to be entered in good faith for the purpose of executing bona fide transactions,” according to the criminal complaint. In an e-mail dated May 25, 2010, Sarao allegedly wrote to his commodity broker and said that he had “just called” the exchange “and told em to kiss my ass.”
Max Ehrenfreund contributed to this report.