Who Else is to Blame for the Flash Crash?

It's hard to say if the trader who may have caused the flash crash will be convicted -- but who else should be held accountable?

by Adam Warner

Published on Apr 23, 2015 at 10:01 AM

It's five years later, but at last we know exactly what caused the flash crash (wink, wink). This, from Bloomberg:

"According to the U.S. Justice Department, London trader Navinder Singh Sarao earned $40 million from 2010 to 2014. His product of choice: CME Group Inc.'s E-mini futures on the Standard & Poor's 500 Index, the key measure of U.S. stock prices. He traded so much, the U.S. government says, that he contributed to the flash crash of May 6, 2010, that briefly drove shares into a nosedive that erased nearly $1 trillion in value.

"Sarao, according to the complaint filed in a Chicago court Tuesday, used strategies known as spoofing and layering -- putting in fake orders to drive prices in a favorable direction -- to manipulate trading on CME's Globex market, one of the most important in the world. He would pin his manipulative quotes just above or below current prices to trick other market participants into thinking futures were poised to move. Sarao allegedly posted those orders with no intention of executing them.

'With the aid of an automated trading program, Sarao was able to all but eliminate his risk of unintentionally executing these orders by modifying and ultimately canceling them before execution,' the Justice Department said in its complaint. 'Meanwhile, he exploited his manipulation to reap large trading profits by executing other, real orders.'"

Color me unconvinced. I'm no lawyer, but I would assume "spoofing and layering" is not legal, provided the "spoofer and layer-er" fully intended to never execute the orders. But how do you actually prove that the guy sent in these orders with the full intent to never execute them? Even if you can prove that, how is he different from countless other algos? It's my understanding that they routinely probe markets to feel out liquidity and whatnot. Was this guy trying to exploit the probers and basically put them all on "tilt" at once?

That's more or less what happened (they say) in the actual flash crash. The machines all started lifting bids and selling, and it snowballed. Maybe this guy started it all with his spoofing and then selling. But, unless you prove he somehow set out to try to cause the whole thing so he could exploit it for massive profit, or found some illegal loophole to tip over the whole system, I'm not sure what they're going to ultimately nab him on. Who knows, maybe the Securities and Exchange Commission (SEC) tried to extract some money and he's balked, and they finally had to charge him with something. And, there are other questions:

Yes and yes -- or so it would seem. Now, we don't know actually if there was a margin violation. Hey, the guy was minting coin, maybe he had enough in there to stay within margin rules. Theoretically, no system should allow you to enter a gigantic "spoof" order if the capital required exceeds your account size. The trading system shouldn't know the guy's algo will prevent order execution. So, I'll give the broker a pass, again assuming we don't find out they gave him some sort of unusual accommodations.

The CME Group and the regulatory bodies, though? They allowed this sort of behavior. They still allow similar behavior. Again, it feels like they're punishing a guy for exploiting a structure they permitted. If we can prove malice on the trader's part, that's different, but we need to see that.

I don't mean to imply I'm giving the guy a pass. At best he recklessly endangered the financial markets. But, it strikes me as finding a scapegoat for something that was clearly an accident waiting to happen.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.


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