The story of Navinder Singh Sarao, the 36-year-old British trader accused of contributing to the temporary nosedive of the US stock market on May 6 2010 has the makings of a Bollywood or Hollywood film.

Dubbed the ‘Hound of Hounslow’ (a tongue-in-cheek nod to the West London, Heathrow fly-path suburb, a far cry from the slick world of the ‘ Wolf of Wall Street ’), Sarao, who had lived with his parents and appeared in court in London wearing a tracksuit and t-shirt, is accused of making up to $40 million between 2009 and 2014. Sarao made the money from the E-Mini, a stock market index for futures contracts on the Chicago Mercantile Exchange (the US’s largest futures exchange) based on the S&P 500 Index.

Spoofing the system

According to the FBI’s affidavit, published by the US Department of Justice, as it seeks to extradite him to the US, Sarao used a strategy called ‘dynamic layering’. This involved placing multiple sell orders that he had no intention of carrying out (duping other automated trading systems into thinking large sell orders were going through), and subsequently modifying and cancelling them, to generate large profits for himself, including $879,018 on May 6, when the Dow Jones Industrial Average fell around 10 percent in minutes.

The orders he placed on that day “significantly” contributed to the order book imbalance on the day — previously identified as one of the causes of the crash. Media outlets including The Times estimate that, should he be extradited (his extradition hearing is set for August) he could face a jail sentence of as long as 380 years, based on the charges against him.

Documents subsequently published build up a picture of Sarao as a feisty but nervous individual. Emails published by US authorities note that on one occasion when he was contacted by the CME via his broker, about his use of the dynamic layering technique (better known as ‘spoofing’) he said he had told the CME to “kiss my ass.”

Others point to instances where he described himself as an “old school pint and click prop trader” and another as an insomniac who struggled to sleep before 4am.

He was certainly enterprising, working with a trading software company to create software he called ‘Navtrader’ that suited his specific needs. According to the US complaint document he used elaborate tax avoidance strategies to park much of his profits.

The delay and after

The decision to focus on Sarao seems to have backfired somewhat however, with US authorities facing ridicule from many within the industry, and outside it.

The idea that a trader working out of his home in London suburbia could crash a sophisticated system, using readily available technologies, and a technique he continued to use for four years after the crash, to many seems ludicrous and more an indictment of a vulnerability-ridden system without the necessary safeguards and checks that would have identified such a major threat, than an individual.

Others have pointed to the huge disparity in treatment — the lifelong prison sentence potentially faced by Sarao against that of individuals at various banks who engaged in a host of nefarious activities, from manipulating benchmark rates to money laundering.

It has raised many questions — for one about timing. Writing for BloombergView , Michael Lewis, the author of Flash Boys , the vivid expose of high frequency trading, questioned why authorities had chosen to pursue Sarao so many years after the event.

The joint Securities and Exchange Commission and Commodities and Futures Trading Commission (CFTC) report of October 2010 failed to mention spoofing, instead the lengthy report identified a large automated sell algorithm by a large mutual fund on the E-mini market as the final trigger on a day of high volatility and low liquidity.

Systemic problems

The length of time it seems to have taken authorities to bring the charges forward also highlights the increasing complexity of the market, particularly with the predominance of high frequency trading, and the dangers that go with this lack of comprehension. (Lewis also notes that the CFTC had right from the start had access to the data of a Chicago-based market data company, which should have given them immediate information on the spoofing activity. They chose instead to focus solely on actual trades).

Others have pointed to other potential holes in the case against Sarao. “Did Sarao cause flash crashes the other 400+ days he ran spoofing (algorithms)?” tweeted Eric Scott Hunsader, the founder of data and analytics firm Nanex and a prominent critic of high frequeny trading.

What will the impact of the case be? Australian fund manager John Hempton of Bronte Capital argues it’s not necessarily a positive development, serving largely to protect front-runners, high frequency traders who use technology to profit from identifying the trades of others before they’re completed. He argues that the techniques employed by spoofers such as Sarao made the world “unsafe for front running high frequency traders.” Banning spoofing simply “made the world safe for the conventional high-frequency traders at a real cost to the investing public,” he argues. (It’s interesting to note that Sarao himself, in emails, claimed to have strong objects to high frequency trading).

Pursuing Sarao may well discourage others from this illegal practice, but does little to answer the wider questions thrown up by the crash — or inspire confidence that future crashes can be prevented.

While new safeguards have been put in — circuit breakers that can halt trading of stocks across all markets, and measures to break trades that were clearly made in error — regulators have admitted that the system remains far from fail-safe.

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