How Lon­don man may have helped trig­ger ‘flash crash’

The China Post - - INTERNATIONAL - BY BERNARD CON­DON

He op­er­ated from a mod­est sub­ur­ban Lon­don home he shared with his par­ents, far from the city’s glam­orous fi­nan­cial cen­ter. He used off- the- shelf soft­ware any­one can buy.

Yet, if U.S. au­thor­i­ties are cor­rect, Navin­der Singh Sarao, 36, man­aged to send a jolt of fear through the world’s mar­kets by help­ing to set off the 2010 “flash crash,” in which the Dow Jones av­er­age plunged 600 points in less than seven min­utes.

Just how big a role he played has been hotly de­bated since the fed­eral com­plaint was un­sealed ear­lier this week, but the idea that a lit­tle-known in­vestor had even a small part is deeply trou­bling, say traders and mar­ket ex­perts.

“If this guy can do it,” asks fi­nance pro­fes­sor James An­gel of Ge­orge­town Uni­ver­sity, “who else is do­ing it?”

In an age of rapidly ad­vanc­ing com­puter power, the fear is that it’s not just big banks and hedge funds that can cre­ate chaos on ex­changes and wipe out the sav­ings of mil­lions of or­di­nary in­vestors. Some­one work­ing from home might be able to do it, too.

“The risks are com­ing from the small guys who are un­der the radar,” says Irene Aldridge, man­ag­ing part­ner of re­search firm ABLE Al­pha Trad­ing and an ex­pert in the kind of high-speed com­put­er­ized trad­ing that Sarao did. “The reg­u­la­tors don’t have the real­time tools to mon­i­tor them.”

Sarao al­legedly em­ployed a ruse called spoof­ing, a bluff­ing tech­nique in which traders try to ma­nip­u­late the price of stocks or other as­sets by mak­ing fake trades to cre­ate the im­pres­sion they want to sell when they re­ally want to buy, or vice versa.

Eric Scott Hun­sader, founder of Nanex, a provider of fi­nan­cial data that has doc­u­mented what it claims are cases of bla­tant spoof­ing, says the prac­tice is wide­spread — in stocks and bonds, oil and gold, cot­ton and cof­fee. He says bluff­ing is turn­ing mar­kets into a law­less Wild West, de­spite ef­forts by trad­ing firms to fight back with soft­ware that can sniff out the false trades.

If the al­le­ga­tions against him are true, Sarao may rank among the best of this new breed of bluffers.

His feat was im­pres­sive be­cause of the tar­get of his al­leged bluff­ing — in­vestors in E-Mini S&P 500 fu­tures, which are fi­nan­cial con­tracts that al­low you to bet on the rise and fall of the Stan­dard and Poor’s 500 stock in­dex. Pass­ing off a fake trade like that as real, much less mov­ing prices, isn’t easy, be­cause E-Mini is one of the most widely traded, trans­par­ent and scru­ti­nized mar­kets in the world.

“Ev­ery­one is watch­ing it,” says Manoj Narang, for­mer CEO of Trade­worx, a high-fre­quency trad­ing firm.

Mak­ing Un­re­al­ized Or­ders

A key to spoof­ing is plac­ing large or­ders to sell or buy with­out ever ex­e­cut­ing them. Since other traders can see your or­ders, a large one to sell might con­vince them prices are likely to head down. One to buy might make them think prices are likely to rise. So they will of­ten mimic your or­der, which moves prices up or down, as if you had sold or bought your­self.

Next, you cancel your or­der, and do the op­po­site — buy­ing at the new, ar­ti­fi­cially lower price or sell­ing at the new higher one.

The ad­vent of high-fre­quency trad­ing firms has added a level of so­phis­ti­ca­tion and speed to this bluff­ing tech­nique.

Us­ing com­put­ers to sift through news ar­ti­cles, so­cial me­dia feeds and other data in split sec­onds, th­ese firms are able to snatch tiny, fleet­ing prof­its that mere mor­tals can’t spot. The firms can also bluff fast, send­ing a se­ries of sell or­ders, for in­stance, then can­cel­ing them as the price moves down and re­plac­ing them with new or­ders — all within thou­sandths of a sec­ond.

Dy­namic Lay­er­ing

The com­plaint against Sarao says it was just this sort of light­ning-fast spoof­ing, called dy­namic lay­er­ing, that al­lowed him to make nearly US$ 880,000 ( NT$ 27.03 mil­lion) on May 6, 2010, the day of the flash crash.

His com­puter sent a se­ries of or­ders to sell E-Mini fu­tures. Then, as their prices moved, his com­puter changed or re­placed those or­ders in rapid suc­ces­sion — a stunning 19,000 times in less than 2 1/2 hours be­fore it can­celed all of them, ac­cord­ing to the com­plaint. Sarao’s of­fers to sell were so nu­mer­ous that at one point they rep­re­sented at least one-fifth of all or­ders to sell E-Mini fu­tures from around the world.

“This is the equiv­a­lent of an ele­phant com­ing to a tea party,” says Nanex’s Hun­sader. “It’s hard not to spot.”

Stocks lost US$ 1 tril­lion in value dur­ing the flash crash. The mar­ket bounced back by the close of trad­ing, but the breadth and speed of the drop rat­tled in­vestors and reg­u­la­tors alike.

Bri­tish-born Sarao, a for­mer bank em­ployee and Brunel Uni­ver­sity stu­dent, is charged with fraud, com­modi­ties ma­nip­u­la­tion and other of­fenses. He was ar­rested in Lon­don on Tues­day and in­di­cated in court that he will fight ex­tra­di­tion to the U.S. In court, his lawyer said the ar­rest came as a “bolt from the blue” to Sarao. The at­tor­ney did not re­spond to re­quests for com­ment for this ar­ti­cle.

Be­tween 2010 and 2014, Sarao earned US$40 mil­lion on E-Mini trad­ing alone, ac­cord­ing to au- thor­i­ties, though the com­plaint doesn’t say how much of that was through al­legedly il­le­gal trades.

Narang, the for­mer high-speed trad­ing ex­ec­u­tive, casts doubt on that fig­ure, not­ing that the com­plaint doesn’t list Sarao’s losses, just his win­nings.

He also says Sarao’s al­legedly bo­gus sell or­ders were of­ten too far from the pre­vail­ing prices for traders to take se­ri­ously. In fact, Narang won­ders if Sarao played much of a role at all in the flash crash.

Larry Tabb, CEO of fi­nan­cial mar­kets con­sul­tancy TABB Group, has his doubts, too: “I don’t think that what he was do­ing on a nor­mal day would have any im­pact on the mar­kets.” A reg­u­la­tory re­view af­ter the flash crash found that the mar­ket was vul­ner­a­ble to a plunge that day be­cause a com­put­er­ized sell­ing pro­gram at a mu­tual fund had run amok.

What­ever Sarao’s role, reg­u­la­tors are clearly wor­ried.

Spoof­ing was pro­hib­ited by the Dodd-Frank law in 2010, the Wall Street over­haul en­acted af­ter the fi­nan­cial cri­sis. But what is spoof­ing and what is le­git­i­mate trad­ing is some­times hard to pin down. Traders cancel or­ders all the time be­cause of new in­for­ma­tion. It’s the in­tent to fool oth­ers, and not the can­cel­ing it­self, that is il­le­gal.

Still, reg­u­la­tors are start­ing to crack down. In Jan­uary, a Canadian trader was ar­rested on spoof­ing charges. That fol­lowed charges against a New Jer­sey trader who al­legedly made US$ 1.5 mil­lion en­ter­ing false trades in the gold, soy­bean oil and cop­per mar­kets.

The crim­i­nal charges are not com­ing fast enough, though, for Nanex’s Hun­sader, who thinks spoof­ing is ram­pant and far too easy to pull off. Af­ter all, if Sarao re­ally did help crash the mar­ket, he asks, why not “a ter­ror­ist cell or some­one with deeper pock­ets?”

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