How a Mystery Trader With an Algorithm May Have Caused the Flash Crash

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Alleged Flash Crash Trader Fights U.S. Extradition

From a modest stucco house in suburban west London, where jetliners roar overhead on their approach to Heathrow Airport, a small-time trader was about to play a hand in one of the most harrowing moments in Wall Street history.

Navinder Singh Sarao was as anonymous as they come -- little more than a day trader by the standards of the Street.

But on that spring day five years ago, U.S. authorities now say, Sarao helped send the Dow Jones Industrial Average on the wild, 1,000-point ride that the world came to know as the flash crash. By regulators’ account, he was responsible for a stunning one out of five sell orders during the frenzy. On Tuesday, he was arrested by Scotland Yard and charged in the U.S. with 22 criminal counts, including fraud and market manipulation.

The following day, the 36-year-old Briton appeared in London court to contest the extradition bid, a move that could delay the U.S. case for years. Clad in a long-sleeved yellow t-shirt and white sweatpants, he told Judge Quentin Purdy that he wouldn’t consent to the U.S. request.

The news of his arrest left many grasping for answers. Sarao has no record of having worked at a major financial firm in the U.S. or the U.K. At the time of the flash crash, Sarao was renting space from a proprietary-trading firm and clearing his transactions through MF Global Holdings Ltd., the now-defunct firm headed by Jon Corzine, said a person with knowledge of the matter. One of Sarao’s neighbors in Hounslow, 11 miles from central London, said what neighbors so often say: He was quiet, kept to himself, never caused trouble.

$40 Million

That picture, according to U.S. authorities, belies a years-long history of lightning-quick computer trading that netted Sarao $40 million in illicit profits.

Sarao didn’t cause the flash crash single-handedly, authorities say. Nonetheless, Tuesday’s developments fly in the face of the prevailing narratives of what happened. Regulators initially concluded that a mutual fund company -- said to be Waddell & Reed Financial Inc. of Overland Park, Kansas -- played a leading role. Many in the industry countered that a confluence of several forces, including high-frequency trading, was probably behind the crash.

By all accounts, the flash crash was more than a mere technical glitch. It raised fundamental questions about how vulnerable today’s complex financial markets are to the high-speed, computer-driven trading that has come to dominate the marketplace.

Whistle-blower Tip

Little is known about Sarao and his trades, beyond what was said in London court and contained in a complaint filed by the U.S. Department of Justice. A related civil suit filed by the U.S. Commodity Futures Trading Commission provides a few additional glimpses into his supposed activities. The case stemmed from a whistle-blower who brought “powerful, original analysis” to the CFTC’s attention, said Shayne Stevenson, a Seattle lawyer representing the whistle-blower.

According to U.S. authorities, Sarao spent the past six years thumbing his nose at regulators while using software designed to manipulate markets. In addition to fraud and manipulation, he was charged with spoofing -- an illegal practice that involves placing orders with the intent to cancel before they’re executed.

In May 2010, Sarao’s actions created imbalances in the derivatives market that then spilled over to stock markets, exacerbating the flash crash, according to the CFTC.

Introverted Trader

“We do believe and intend to show that his conduct was at least significantly responsible for the order imbalance that in turn was one of the conditions that led to the flash crash,” Aitan Goelman, the CFTC’s director of enforcement, told reporters Tuesday.

When he was trading, Sarao kept to himself, often tuning out noise and distractions with headphones, according to a person who knew him. Sarao’s computer screen almost always flashed futures data tied to the Standard & Poor’s 500 Index and his interactions were typically limited to workers installing new trading algorithms, said the person, who spoke on the condition of anonymity.

When he started his allegedly manipulative trading in 2009, Sarao used off-the-shelf software that he later asked to be modified so he could rapidly place and cancel orders automatically. At one point, he asked the software developer for the code, explaining that he wanted to play around with creating new versions, according to regulators.

Canceling Orders

In the year leading up to the flash crash, Sarao popped up on regulators’ radar. Exchanges in the U.S. and Europe saw he was routinely placing and then quickly canceling large volumes of orders, according to an FBI affidavit unsealed Tuesday by a federal court in Illinois.

The CME Group Inc., which operates an exchange for one of the most common derivatives tied to the S&P 500, contacted Sarao about his trades after concluding that some of his activities appeared to have had a significant impact on 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 FBI affidavit.

Spoofing Markets

On May 6, 2010, the day of the flash crash, CME sent Sarao another message. All orders to CME’s electronic exchange were to be “entered in good faith for the purpose of executing bona fide transactions,” CME said, according to the FBI affidavit.

That same day, Sarao and his firm, Nav Sarao Futures Limited Plc, used “layering” and “spoofing” algorithms to trade thousands of futures S&P 500 E-mini contracts. 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.

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, according to the CFTC.

The crash spooked investors, became front-page news around the world and left regulators wondering how it happened.

About three weeks later, Sarao told his broker that he had just called the CME and told them to “kiss my ass,” the affidavit said.

No one put an end to Sarao’s trading for another five years. Among the nearly two dozen charges, one is tied to trades from March 2014.

Wire fraud is punishable in the U.S. by maximum prison term of 20 years, commodities fraud by a sentence of as long as 25 years, and commodities manipulation and spoofing by terms of as long as 10 years or a $1 million fine.