International Forecaster Weekly

Flash Crash Mystery Solved

f the allegations contained in the claim are true ... then perhaps Sarao's market spoofing can be blamed for the crash in the same way that a single straw can be blamed for breaking a camel's back.

James Corbett | May 2, 2015

Remember the 2010 Flash Crash? That breathtaking 36 minute window on May 6, 2010 where the US stock market crashed by as much as $862 billion, only to recover just as quickly? Given the rapidity of today's 24/7 news cycle (and the frequency of economy-threatening disasters these days) you'd be forgiven if you'd already forgotten about it.

    But don't worry, those tireless investigators at the US Department of Justice and the SEC haven't forgotten about it! In fact, they've cracked the case and made an arrest! Eat your heart out, Mounties, it's the DOJ who always gets their man... long as their man is a day trader living in his parent's house in Hounslow with no conceivable connection to the wider world of criminal banksters and their market manipulating accomplices. That's right, if you've been following the market news at all this week you'll no doubt have seen headlines about the arrest of Navinder Singh Sarao, an arrest that is raising eyebrows across the board and causing even the most mainstream-y of commentators to wonder if Sarao's prosecution isn't just a show trial designed to make it look like the DOJ is taking decisive action.

    The case against Sarao hinges on the concept of market "spoofing," where a trader places a buy or sell order that he doesn't intend to fulfill in order to trick other buyers and sellers into bidding at that price point. The trader then cancels his original order and buys (or sells) at the new price. The actual complaint against Sarao and the accompanying affidavit sound convincing to those who don't know the mechanics of this activity. According to FBI agent Gregory Laberta's affidavit:

        "SARAO's use of the dynamic layering technique was particularly intense in the hours leading up to the Flash Crash. SARAO used the technique continuously from 11:17 a.m. until 1:40 p.m.[...]The orders were replaced or modified more than 19,000 times before SARAO canceled them, without having executed any of them, at approximately 1:40:12.553 p.m. At that point, the aggregate volume of SARAO's orders was nearly equivalent to the aggregate volume of the entire buy-side of the order book."

    The argument undermines itself, however, when you parse through the weasel words to discover that not even the FBI can ultimately lay the blame completely at Sarao's doorstep:

        "According to Consulting Group analysts and the expert, that day, SARAO was active in the E-Mini market on the CME, and contributed to the order-book imbalance that the CFTC and the Securities Exchange Commission have concluded, in a published report, was a cause, among other factors, of the Flash Crash."

    "Among other factors?" Shouldn't those other factors be defined before the DOJ begins making victory laps and closing the file on the flash crash? Even the FBI press release on the arrest acknowledges that Sarao is only wanted for his alleged role in "contributing" to the crash.

    So what gives? Did Sarao cause the crash or not? If the allegations contained in the claim are true and if the story of the flash crash that the CFTC told in their report on the event last year is more or less what actually happened, then perhaps Sarao's market spoofing can be blamed for the crash in the same way that a single straw can be blamed for breaking a camel's back. But to blame the final straw out of all of the pile of hay weighing down the camel seems to be missing the point, just as blaming Sarao for spoofing the market is missing the real story here; namely that if the charges are to be believed a single day trader living in his parents' house in suburban London can wipe out nearly a trillion dollars from one of the most liquid markets in the world by placing some fake orders.

    The unspoken and uncomfortable truth is that Sarao is only playing on a problem enabled by the high speed trading algorithms that now account for as much as 60 percent of the trading volume in the US futures markets. These computer-generated trades can function orders of magnitude faster than any human, reacting to changes in market direction and implementing buy and sell orders on the basis of that knowledge thousands of times per second. As the flash crash displayed, once the algorithms get tricked into selling into a falling market, the entire market can be plunged into chaos in a matter of minutes.

    Blaming Sarao for the fact that the HFTs created a selling panic is nonsensical. As self-styled "Grumpy Economist" John Cochrane writes on his blog: "Why is Mr. Sarao being prosecuted and not all the people who wrote badly programmed algorithms that were so easily spoofed? If this caused the flash crash (how, not explained in the article) are they not equally at fault?"

    "The article" Cochrane is referring to is the original Wall Street Journal report on Sarao's arrest, and as he points out it isn't exactly explained how this spoofing led to such a dramatic crash in such a short period of time. In fact, embarrassingly enough for the prosecution in this case, Sarao didn't engage in spoofing like that which allegedly 'contributed' to the Flash Crash once or twice, but on 250 days over the course of years. Why didn't any of those other 249 incidents cause such a dramatic crash?

    As Craig Pirrong of the University of Houston puts it at his "Streetwise Professor" blog:

        "The complaint alleges that Sarao employed the layering strategy about 250 days, meaning that he caused 250 out of the last one flash crashes. I can see the defense strategy. When the government expert is on the stand, the defense will go through every day. 'You claim Sarao used layering on this day, correct?' 'Yes.' 'There was no Flash Crash on that day, was there?' 'No.' Repeating this 250 times will make the causal connection between his trading and Flash Clash seem very problematic, at best."

    In fact, the question of whether Sarao is nothing more than a scapegoat to blame the Flash Crash on has been floated on the op-ed pages of the New York Times and even by famed "rogue trader" Nick Leeson himself. "We are talking about a young trader that was operating out of his mum and dad's house and he's being charged with effectively forcing around the biggest stock market in the world and going up some of the biggest investment banks. That just doesn't ring true. I hate to jump to conclusions but he seems like a scapegoat. Is there something much more sinister that we don't know?" Leeson told LBC last week.

    Perhaps the biggest embarrassment for the Justice Department is that now even Andrei Kirilenko, the MIT Sloan School of Management professor who helped author the government's own report on the flash crash, has openly questioned the merits of the case against Sarao. "The [DOJ] complaint describes that there was a particular trader who was engaged in a certain type of manipulative behavior," Kirilenko told The Post in an interview. "It’s not really clear to me how that caused the Flash Crash."

    What is clear is that spoofing is by no means a rare and unusual activity. In fact, it takes place every single day in every single market across every single asset class. This is not an idle claim. In the wake of the Sarao scapegoat arrest, ZeroHedge and Nanex teamed up to demonstrate the exact same activity that Sarao was being arrested for taking place on the same day in the same market that Sarao traded in. Similar data can (and has) been compiled to demonstrate spoofing in crude oil futures, U.S. Treasuries and Comex Gold Futures.

    So why is the DOJ acting now? and why did they choose Sarao out of the doubtless thousands of such traders (an uncomfortable percentage of whom would have ties to large trading firms)? The first and simplest answer may just be greed. In the wake of the embarrassing (even by government standards) "failure" of regulators at the SEC to catch on to the Madoff scam until it was well too late, it was revealed that a whistleblower had in fact warned them about Madoff's ponzi scheme many years previously. Presumably to avoid this embarrassment again, incentives were thrown into the 2010 Dodd-Frank Act for whistleblowers to pass on such information to the U.S. Commodity Futures Trading Commission (CFTC). The provision allows the tipster to collect as much as 30% of any money recovered from a successful prosecution of the case. In the case of Sarao, an anonymous insider supposedly provided a "powerful, original analysis" of the trades that led to Sarao's arrest, meaning there may be a multi-million dollar payout in store for the tipster.

    But perhaps more to the point, this prosecution will serve the dual role of putting a particularly embarrassing episode of government regulatory "failure" to bed in the mind of most Americans and providing a quick shot-in-the-arm to newly sworn in Attorney General Loretta Lynch. While previous Attorney General Eric Holder's reign will best be known for his failure to launch any important Wall Street prosecutions and for declaring some banks "too big to jail," Lynch may have a quick open-and-shut case to boost her credentials as someone who will be 'tough' on market manipulation.

    It's all a scam, of course. The DOJ (and SEC and CFTC and...) is only interested in quick, pat show trials that throw scapegoats in jail and keep the real banksters safely out of trouble. Any number of episodes from the not-too-distant past (perhaps most remarkably Richard Grove's own experience with the SEC) will be proof enough of that.
    But if there is a ray of hope in all of this, it may be that the DOJ has painted themselves into a corner where they will be forced to actually crack down on the obvious spoofing that continues to dominate the futures markets. Just this past week the Chicago Mercantile Exchange busted two gold traders on the back of the Zero Hedge/Nanex report on gold manipulation. And although these two traders, too, are only a tiny part of a very large problem, busts like these will perhaps convince some of the larger trading firms to calm down their least for now.

    And the average mom and pop trader still wonders why the market always seems to be stacked against them...