On a cold morning in April 2015, six FBI agents and police officers pulled up to a semi-detached house in London to arrest a man they thought was one of the world’s most prolific and dangerous market manipulators.
Their target, Navinder Singh Sarao, had amassed $70 million in illegal profits by explicitly manipulating the US stock markets.
What exactly happened?
At 1:41 p.m. Central Standard Time, the S&P 500 index plummeted more than 5% in four minutes. The Dow Jones index followed suit, falling even faster than it had in its entire 114-year history.
Source: SEC
More than a trillion dollars were wiped out in no time…
Individual stocks plummeted as well, turning stock charts into sheer cliff faces. Financial markets around the world went into a panic. Chicago Mercantile Exchange’s stop-logic function halted trading for five seconds. And when trading resumed, markets miraculously skyrocketed!
However, in those 10 minutes, something fishy happened.
The iShares Russell 1000 Value Index, a popular ETF, dropped from $50 to 0.0001 cents. Apple and Sotheby’s shares traded at $100,000 each, temporarily pushing their valuations into the trillions of dollars!
Everything seemed to turn upside down for a split second.
And at the heart of this mystery was the talented but little-known trader Navinder Singh Sarao!
But who was he?
Navinder Sarao, then 32, is a London-based trader who started his trading career as a prop trader in 2002 at the trading firm called Futex, where he amassed a trading fortune of over $2 million in no time!
Soon enough, Sarao realised his potential, left his job at Futex, and started trading as a lone trader from his parents’ home.
After tasting some initial success, around 2007, trading became quite challenging for him.
During the same time, high-frequency trading was on the rise: a method that uses cutting-edge technological solutions to get information faster than anyone else and then takes advantage of market inefficiencies that only exist over a split second. |
And most trading firms, around 2007, started using this sophisticated technology to make money in milliseconds, even before a human could blink his eye!
Of course, it was way faster than Sarao!
It then became almost impossible for him to analyse the market precisely. As soon as he settled on a bid, the prices began to move against him. It appeared that somewhere, powerful traders could monitor his every single move using this new technology.
Sarao felt like the system was rigged against him.
Then, how did he make $70 million from his bedroom?
With his profits dented, Sarao took a fateful decision to fight back, paying a programmer to build a high-frequency trading algorithm he called the NavTrader.
“He argued that the HFT trading firms might be best at reading existing data – but what if my machine could influence the data itself and show something which is not there!” |
Wondering what it is?
Well, Sarao devised a system based on a technique known as “spoofing,” which placed thousands of buy or sell orders by creating an artificial demand or supply for others to follow suit and then quickly cancelling them before the orders got executed.
Let’s understand this better with the help of a hypothetical example:
Suppose you wish to purchase oil futures on a financial exchange but do not want to pay the current market price.
Well, in that case, you can lower the market price by temporarily putting in a large sell order for oil futures, also known as a spoof order.
This will lead other market participants to believe that supply has increased, making them sell their contracts, which ultimately will lower the market price.
And once you’re able to buy oil futures at a discounted price, you then cancel the large sell order, and there you have it, you have successfully engaged in spoofing.
The Nav’s HFT programme did exactly this at essentially super-high speed and proved wildly effective.
It was programmed to place large orders on different assets, driving prices up or down and automatically withdrawing them before the price hits. The programme used to buy contracts at discounted prices and ride the next upswing or sell short at a higher price only to cover them back at a lower price.
Soon, he was making money, a lot of it, more than $70 million!
What was he convicted of?
Just before the flash crash, Sarao placed thousands of sell orders on E-mini S&P 500 index futures contracts, which he planned to cancel later. These orders were worth $200 million; without leverage, the notional amount stood at $3.5 billion!
Since these orders were modified and cancelled more than 19,000 times, it was evident that there was no real supply and that they were placed only to trick people.
That combined with a collapse in buying interest. At one point, Sarao’s fake sell orders alone “were almost equal to the entire buy-side of the order book” to create a price collapse. He took advantage of the falling prices by selling high and buying low. It was a pretty straightforward spoofing case.
Sarao was unaware of the charges until the FBI showed up at his door in 2015. He was charged with electronic fraud and spoofing, both illegal in the United States. In 2016, he lost a legal battle against his extradition case after spending 5 months in UK prison. The US government initially charged him with 22 counts, with a maximum sentence of 380 years in prison.
However, prosecutors decided not to sentence him further jail time because of his “extraordinary cooperation” in assisting the US government in building other spoofing cases. On the other hand, Sarao agreed to pay $12.8 million and was placed under one-year house arrest.
Three key lessons to learn from the flash crash
The first is the increasing involvement of high-frequency trading firms. Their ability to trade at an incredibly high speed, discounting the market information or events in no time, has significantly reduced bid-ask spreads, making markets more efficient and liquid.
Second, the crash highlighted how stock and futures markets are now interconnected. The crash happened in the equities markets, but it resulted from large sell orders placed on e-mini contracts on the futures market.
Finally, the crash also reminded traders about the risks of taking over-leveraged trades in the market. A sharp dip in the markets is capable of delivering even more amplified losses.
FINAL WORDS
The arrest of the British trader has turned the spotlight on spoofing as a technique that may disrupt the financial markets. And to avoid such manipulation, SEC has implemented market-wide “circuit breakers” that will halt trading in stocks/ETFs whenever there is a 10% directional move in less than 5 minutes.
It is also important to note that events like flash crashes are extremely rare, and markets operate normally the vast majority of the time. However, there will always be a systematic risk of losing money merely by participating in the markets. But, not investing at all is also a risk.
Finally, the May 2010 flash crash brought to the fore the undeniable role of HFTs. The way Navinder faced trading challenges owing to HFTs in 2007; it’s now much harder for human intraday traders to compete with cutting-edge HFT algorithms that deploy programs to:
Analyse millions of data points in seconds,
Finding winning patterns
Recognizing market sentiment and
Executing trades at lightning speed, which any human could ever do.
Please note that all the information contained in this newsletter is intended for illustration and educational purposes only. It does not constitute any financial advice/recommendation to buy/sell any investment products or services.
