CME Group Inc. concluded within four days of the 2010 flash crash that algorithmic trading on futures exchanges didn’t exacerbate losses in the market.
When Washington regulators did a five-month autopsy in 2010 of the plunge that briefly erased almost $1 trillion from U.S. stock prices, they didn’t even consider whether it was caused by individuals manipulating the market with fake orders.
Their analysis was upended Tuesday with the arrest of Navinder Singh Sarao -- a U.K.-based trader accused by U.S. authorities of abusive algorithmic trading dating back to 2009. Even that action was spurred not by regulators’ own analysis but by that of a whistle-blower who studied the crash, according to Shayne Stevenson, a Seattle lawyer representing the person who reported the conduct.
The episode shows fundamental cracks in the way some of the world’s most important markets are regulated, from the exchanges that get to police themselves to government agencies that complain they don’t have adequate resources to do their jobs.
Regulators were aware of Sarao’s trading behavior as early as 2009, when officials at CME -- which runs the exchange where Sarao allegedly placed his problematic trades -- spotted him placing and then canceling large numbers of orders, and warned him against placing deceitful trades, according to an FBI affidavit. Sarao continued to manipulate markets through March 2014, the FBI said.
“How this continued for six years when the CME appeared to know about, it kind of boggles my mind,” Dave Lauer, president of Kor Group, a lobbying and research firm, said by phone. “This is about as simple and easy as you can get, and it took them this long to do anything about it.”
Market regulation relies on a chain of oversight, starting with brokerages and clearing firms that are obliged to keep customers from misusing their access to markets. Even though Sarao wasn’t registered as a broker in the U.S., the four firms he used to place his trades, including the now-defunct MF Global Holdings Ltd., had a duty to tell regulators about any suspicious actions he would have taken.
According to the FBI, exchanges in the U.S., including CME, and Europe noticed that Sarao was possibly manipulating markets and told his broker about it. In response, Sarao told his broker that he called the CME and told them to “kiss my ass,” according to the affidavit.
The 2010 flash crash laid bare the lack of regulatory grasp on markets that have become increasingly driven by high-speed computerized trading and fragmented over dozens of exchanges. Even after five years, concerns persist. On Oct. 15 of last year, U.S. Treasuries went for a wild ride, enduring the biggest yield swings in a quarter century. The turbulence left investors wondering whether electronic trading was now impacting what’s considered one of the most stable markets.
Regulators’ response to the 2010 flash crash -- a five-month dissection by the Commodity Futures Trading Commission and the Securities and Exchange Commission -- was meant to demonstrate a strong understanding of what went wrong.
Allegations that a lone day trader helped spark the tumble, if borne out, suggest regulators missed the mark.
It turns out regulators may have missed Sarao’s activity because they weren’t looking at complete data, according to former CFTC Chief Economist Andrei Kirilenko, who co-authored the report. He said in an interview that the CFTC and SEC based their study of the sorts of futures Sarao traded primarily on completed transactions, which wouldn’t spotlight the thousands of allegedly deceitful orders that Sarao submitted and immediately canceled.
Spoofing wasn’t even part of the CFTC’s analysis of the crash, said James Moser, a finance professor at American University who was the agency’s acting chief economist in May
2010. The flash-crash review marked the first time that the agency worked through the CME’s massive order book. CFTC officials often needed to call the exchange for help interpreting the data, he said in an interview.
“We didn’t look for any sort of spoofing activity,” said Moser, who added that he doubts that Sarao’s activity was the main cause of the crash. “At that point in 2010, that wasn’t high on the radar, at least in our minds.”
On the day of the flash crash, Sarao used “layering” and “spoofing” algorithms to enter orders for thousands of futures on the Standard & Poor’s 500 Index. The orders amounted to about $200 million worth of bets that the market would fall, a trade that represented between 20 percent and 29 percent of all sell orders at the time. The orders were then replaced or modified 19,000 times before being canceled in the afternoon. None were filled, according to the affidavit.
The imbalance on the exchange due to Sarao’s orders “contributed to market conditions” that saw the derivatives contract plunge and later also the stock market, the CFTC said this week.
CFTC Chairman Timothy G. Massad said Wednesday that the lag between the 2010 analysis and this week’s arrest owes to the complexity of markets.
“There were many factors that came together to cause the flash crash,” Massad said in a briefing to reporters in Chicago. “Sometimes it takes a long time to put together these cases.”
The CFTC, whose leaders say it is chronically underfunded by Congress, still doesn’t monitor all trading activity in the futures markets that it oversees. The Justice Department relied on an outside consulting group, not the CFTC, to audit Sarao’s years of trading.
The agency needs “more discrete, nuanced information about these particular trades that could inform us on our regulatory obligations,” Vince McGonagle, the CFTC’s director of market oversight, told the Senate Agriculture Committee in May 2014.
That data would come from exchanges like CME, which are responsible for policing everyone who trades on their markets. Over several years, Sarao appears to have rebuffed CME’s warnings.
Order data in the futures market primarily resides at the exchanges where futures are traded. Terrence Duffy, executive chairman of CME, told the Senate Agriculture Committee last year that requiring all trading firms to register with the CFTC -- which would require them to report more of their trading activity -- wasn’t necessary.
“We maintain a complete and comprehensive audit trail of every message, every order and every trade,” Duffy said.
Kirilenko said there was no shame in relying on criminal authorities to dig out all of the factors that contributed to the flash crash.
“If it takes the powers and resources of the DOJ and the FBI to help us find out more about what happened on that day and help make the markets more resilient, then maybe that’s what’s needed,” he said.
SEC Commissioner Michael Piwowar, speaking Wednesday at an event in Montreal, said there needs to be a full investigation into whether the SEC or CFTC botched the flash crash analysis.
“I fully expect Congress to be involved in this,” he said.
Senator Richard Shelby, the Alabama Republican who heads the banking committee, said in a statement Wednesday that he intends to look into questions raised by Sarao’s arrest.
Mark Wetjen, a CFTC commissioner speaking at the same event, echoed Piwowar’s concerns about regulators’ understanding of the events.
“Everyone needs to have a deeper, better understanding of interconnections of derivatives markets on one hand and whatever related market is at issue,” Wetjen said. “It doesn’t seem like that was really addressed or looked at in that report.”
Sarao, who was arrested in the U.K. on Tuesday and faces an extradition request, was also accused of cheating throughout the period of June 2009 to April 2014.
Four days after the plunge on May 6, 2010, CME said algorithmic trading -- the sort of automated technique Sarao purportedly used -- didn’t exacerbate losses in the market.
“There is no visible support of the notion that algorithmic trading models deployed in the context of stock index futures traded on CME Group exchanges caused the market fluctuations in question,” the exchange said in the report on May 10, 2010. “Further, we find no evidence in CME stock index futures of any undue concentration of activity amongst algorithmic or any other types of traders.”
The CME “did a thorough analysis of all activity in our markets during the flash crash, and concluded – along with regulators – that the flash crash was not caused by the futures market,” Anita Liskey, a CME spokeswoman, said in an e-mailed statement. “If new information has come to light, we look forward to reviewing it with the commission.”
The CME even suggested at the time that the real problem that day stemmed from the regular stock market -- the pool of trading distributed across the New York Stock Exchange, Nasdaq Stock Market and dozens of other venues -- rather than the derivatives transactions CME hosts. The U.S. government said Sarao traded CME’s futures contracts tied to the S&P 500, the key benchmark for U.S. share prices.
“While inconclusive at this point, we believe that the stock market incident of May 6th might be traced to divergent trade practices and price protection mechanisms amongst the various stock trading venues on which domestic equities are traded,” CME said in the report five years ago.
In November, the CFTC told CME it needed to improve how it polices trading on its exchanges. The CME generally met surveillance obligations, but took too long to finish probes and imposed penalties that were too soft, the CFTC said. The agency also said that two CME markets, Nymex and Comex, needed to keep developing ways of detecting spoofing.
CME had interacted with Sarao, even on the day of the flash crash, according to the U.S. government’s complaint. The exchange contacted him about his trades after concluding he appeared to be significantly swaying opening prices.
Sarao explained some of his conduct to the CME in a March 2010 e-mail as “just showing a friend of mine what occurs on the bid side of the market almost 24 hours a day, by the high-frequency geeks.” He then questioned whether CME’s actions regarding his activity meant “the mass manipulation of high frequency nerds is going to end,” according to the U.S. Department of Justice’s complaint released Tuesday.
Former Senator Ted Kaufman, who sits on an SEC advisory group that will recommend policy changes to the regulator, said market police need better information.
“Here we are years later finding they spoofed in a major way for a long period of time,” he said. “We just have to get the data we need to have the regulator independently determine what is going on in our markets.”