Hey, Dave here, long time no blog. I’m filling in the next couple days. This criminal indictment of Navinder Singh Sarao, the guy who allegedly provoked the flash crash in 2010, looks like a perfect example of selective prosecution. See also Paul Murphy at FT Alphaville (“pure financial keystone cop-ery “) and Julia La Roche at Business Insider. Sarao is resisting extradition, so this will play out for a while.
By Rajiv Sethi, Professor of Economics, Barnard College, Columbia University. Cross posted from his blog.
A London trader recently charged with price manipulation appears to have been using a strategy designed to trigger high-frequency trading algorithms. Whether he used an algorithm himself is beside the point: he made money because the market is dominated by computer programs responding rapidly to incoming market data, and he understood the basic logic of their structure.
Specifically, Navinder Singh Sarao is accused of having posted large sell orders that created the impression of substantial fundamental supply in the S&P E-mini futures contract:
The authorities said he used a variety of trading techniques designed to push prices sharply in one direction and then profit from other investors following the pattern or exiting the market.
The DoJ said by allegedly placing multiple, simultaneous, large-volume sell orders at different price points — a technique known as “layering”— Mr Sarao created the appearance of substantial supply in the market.
Layering is a type of spoofing, a strategy of entering bids or offers with the intent to cancel them before completion.
Who are these “other investors” that followed the pattern or exited the market? Surely not the fundamental buyers and sellers placing orders based on an analysis of information about the companies of which the index is composed. Such investors would not generally be sensitive to the kind of order book details that Sarao was trying to manipulate (though they may buy or sell using algorithms sensitive to trading volume in order to limit market impact). Furthermore, as Andrei Kirilenko and his co-authors found in a transaction level analysis, fundamental buyers and sellers account for a very small portion of daily volume in this contract.
As far as I can tell, the strategies that Sarao was trying to trigger were high-frequency trading programs that combine passive market making with aggressive order anticipation based on privileged access and rapid responses to incoming market data. Such strategies correspond to just one percent of accounts on this exchange, but are responsible for almost half of all trading volume and appear on one or both sides of almost three-quarters of traded contracts.
The most sophisticated algorithms would have detected Sarao’s spoofing and may even have tried to profit from it, but less nimble ones would have fallen prey. In this manner he was able to syphon off a modest portion of HFT profits, amounting to about four million dollars over four years.
What is strange about this case is the fact that spoofing of this kind is, to quote one market observer, as common as oxygen. It is frequently used and defended against within the high frequency trading community. So why was Sarao singled out for prosecution? I suspect that it was because his was a relatively small account, using a simple and fairly transparent strategy. Larger firms that combine multiple strategies with continually evolving algorithms will not display so clear a signature.
It’s important to distinguish Sarao’s strategy from the ecology within which it was able to thrive. A key feature of this ecology is the widespread use of information extracting strategies, the proliferation of which makes direct investments in the acquisition and analysis of fundamental information less profitable, and makes extreme events such as the flash crash practically inevitable.
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Fascinating post, thank you. If the objective of those who made the criminal indictment of this individual small player is deterrence, that raises the question of deterrence of what and for whom?
If there is truly an emerging legal effort underway to address HFT as a tool of broad market manipulation and to begin to clean up and regulate the financial markets, then we need to see some much bigger fish being brought in.
The criminal indictment of one relatively small individual trader who likely gamed some large HFT firms on that afternoon in early May nearly five years ago and disrupted their assumptions of market control, merely raises additional questions about the reasons for selective prosecution.
I have to second you Chauncey. But adding … we need to stop naked shorts … and naked buys … and force traders to hold for at least one day … whatever asset they legitimately have an interest in. That would kill all these high speed frauds … whether by small fish or big fish.
Clearly Sarao made a serious mistake: namely, not pulling his stunts from the trading desk at TBTF Bancorp. There was no way little ol’ him was going to be able to budget for the bribes (sorry, fines and political contributions) needed to stay out of trouble doing that kind of thing. And he probably wasn’t going to retain Covington & Burling for more than a couple of billable hours either. Get with the program, pal!
What I find fascinating about this story isn’t the selective prosecution of a bit-player in the naked short arena, but that he so easily spoofed HFT algos, triggering the crash. If Mr. Sarao could do this, in his own home, without a direct feed to market data, imagine what a well-funded player with access to the direct feeds could do. Retail investors should be nervous.
It is more plausible to believe that there is an insertion point in Twitter’s network than a magical algorithm.
So any guesses as to who the person was the provided the “tip” that lead to this guy?
And why did they spend 2.5 years investigating this guy when it was obvious he was a very small player?
Who/how did he make such powerfull enemies?