The first red flag might have been the name of the firm: Nav Sarao Milking Markets Ltd. That was the name Navinder Singh Sarao originally gave to his trading venture, incorporated in the Caribbean tax haven Nevis, to deal in futures contracts on the Chicago Mercantile Exchange (CME).
Within a month, the U.S. Department of Justice alleges, Sarao initiated trades from his parents' London home that helped instigate the Flash Crash, a market disruption on May 6, 2010, that sent prices into a calamitous free fall and set Wall Street trembling.
But as more details emerge about Sarao’s alleged scheme, investors and market watchers are wondering why it took so long -- a few weeks shy of five years -- for regulators to finger the trader who allegedly touched off a crash that saw $1 trillion in value evaporate in mere minutes.
“It’s really egregious,” said Eric Hunsader, founder of the market research firm Nanex. “Within days they should have seen this.”
In a 31-page criminal complaint, the Justice Department alleges that Sarao -- now under virtual house arrest in London, where he has challenged U.S. calls for extradition -- used commercially available software to engage in an illegal form of market manipulation known as spoofing or layering. The practice involves sending torrents of sell orders flooding into a security with the intent of suddenly canceling them and exploiting the subsequent price dips.
Authorities say Sarao faces 22 charges, including wire fraud and commodities manipulation, that could add up to a maximum of 380 years in prison.
How Could He Escape Notice?
On the day of the Flash Crash, the complaint says, Sarao entered around $200 million worth of orders for Standard & Poor's 500 futures contracts called E-Minis, totaling as much as 29 percent of sell orders at the time, sending the E-Mini price reeling.
But Sarao didn’t mind. He made $879,018 that day trading E-Minis, the complaint says. By 2014, his profits had allegedly reached around $40 million.
But with such blatant displays of allegedly illegal activity -- Sarao at one point entered offers that exceeded a notional value of $11 billion -- how could he escape notice?
“It tells you something very important about what the market believed was manipulative behavior,” said Trace Schmeltz, a securities lawyer at Chicago law firm Barnes & Thornburg.
The CME, the line of regulatory defense against spoofing traders, hadn’t completely ignored Sarao’s alleged misdeeds. According to the Justice Department, the CME sent Sarao an email on the day of the Flash Crash that orders were expected to be entered “in good faith for the purpose of executing bona fide transactions.”
Sarao would later tell his merchant at the exchange that he’d called the CME and “told them to kiss my a--.” He was allowed to continue trading on the exchange.
The CME, like federal regulators, can access a Consolidated Audit Trail, which allows regulators to scrutinize each individual trade that occurs on a market. “The CME is who should have found this first,” Hunsader said. “They should have spotted this 10 minutes after it was happening.”
More Trades, More Money
The CME Group declined to comment, citing the ongoing investigation. But analysts worry that the CME’s revenue model interferes with its motivation to police trading. The more trades that zip through the exchange, the more money it makes. That means it could be disincentivized from tackling manipulative traders who still bring valuable liquidity to the market.
“The primary gatekeeper miserably failed to do basic audit for compliance and enforcement,” said Haim Bodek, a former algorithmic trader who is now a vocal critic of trading platforms that he says unfairly benefit high-speed trading firms.
“There’s a big question as to whether exchanges were looking the other way on trading like this because they liked the liquidity,” Schmeltz said. “The CME is a public company and they need to make a profit.”
In October of last year, the CME clarified its spoofing regulations, a change it said would better protect against market manipulation.
Even for the government agencies in charge of regulating markets, these sorts of cases present difficulties, said Kevin McPartland, principal of market structure and technology at the market intelligence firm Greenwich Associates. Sarao is only the second individual to face federal charges for spoofing, which was outlawed by the 2010 Dodd-Frank Act.
“While the regulators technically have access to whatever data they need, they don’t necessarily have the staffing to crunch that data,” McPartland said. In this case, feds were helped along by a whistleblower who reportedly supplied them with his own analysis.
Trading watchdogs might also be behind in the high-frequency arms race. “The market moves faster than the regulators do,” McPartland said. “By the time there is a concrete response, the market has moved on.”
'A Systemic Event'
But official inquiries into the Flash Crash are almost five years old. In October 2010, the Securities and Exchange Commission and the Commodity Futures Trading Commission, regulators chiefly responsible for ferreting out market abuses, released a joint report on the event.
Markets were already touchy from the deepening European debt crisis, the report said, when futures prices were jolted by turbulence from high-frequency traders, who use near light-speed technologies to place buy and sell orders thousands of times faster than a human could.
Regulators hypothesized that these algorithms tangled in a way that created a sudden vacuum of demand for the futures contracts, an event that “cascaded into a systemic event for the entire U.S financial market system,” they wrote.
Though the study claimed high-frequency traders played a role in the Flash Crash, they all but ruled out manipulative behavior. That conclusion mystified Hunsader, who had assisted the CFTC post-mortem and supplied the agency with Nanex data analyses that suggested high jinks in the E-Minis market.
Andrei Kirilenko, then the CFTC's chief economist, said in a public panel that he was taking Nanex’s data “very, very seriously” and warned that it might be a “federal felony” if he divulged too much about the findings.
“What we've seen in the data,” Kirilenko said at the time -- noting that he had “data from the entire universe” of market transactions -- “was the identities of traders, transaction by transaction, with lots of flags in it -- the entire audit trail.”
Given the tools at the disposal of the CFTC and SEC, questions remain as to how Sarao was allegedly able to continue to make tens of millions of dollars on the same strategies that helped precipitate the Flash Crash.
“How do you have a commission come out with a study and then five years later it’s a guy trading out of his parents' house in London?” Schmeltz asked.
Hunsader worries about the implications for the broader market. “If a guy trading on his own could cause that kind of damage, couldn’t a country or terrorist cell do so much worse?”
“Shouldn’t alarm bells be going off at the regulators?”