By Michael Lewis, originally posted in Bloomberg
The first question that arises from the Commodity Futures Trading Commission’s case against Navinder Singh Sarao is: Why did it take them five years to bring it?
A guy living with his parents next to London's Heathrow Airport enters a lot of big, phony orders to sell U.S. stock market futures; the market promptly collapses on May 6, 2010; it takes five years for the army of U.S. financial regulators to work out that there might be some connection between the two events. It makes no sense.
A bunch of news reports have suggested that the CFTC didn’t have the information available to it to make the case. After the flash crash, the commission focused exclusively on trades that had occurred that day, rather than orders designed not to trade -- at least until some mysterious whistle-blower came forward to explain how the futures market actually worked. But this can’t be true.
Immediately after the flash crash, Eric Hunsader, founder of the Chicago-based market data company Nanex, which has access to all stock and futures market orders, detected lots of socially dubious trading activity that May day: high-frequency trading firms sending 5,000 quotes per second in a single stock without ever intending to trade that stock, for instance. On June 18, 2010, Nanex published a report of its findings.
The following Wednesday, June 23, the website Zero Hedge posted the Nanex report. Two days later the CFTC’s chief economist, Andrei Kirilenko, e-mailed Hunsader. “He invited me out to D.C. and I talked with everyone there (and I mean everyone -- including a commissioner),” Hunsader says. “The CFTC then flew out a programmer to our offices where we showed him how to work with our data. Took all of a day. We sent him back with our flash crash data, and that was pretty much the last we heard about that project.”
In October 2010, Hunsader was still poring over data from the flash crash. “Between October 7 and October 14, I noticed Sarao’s spoofing,” he says. Hunsader assumed it to be the work of an algorithm of some large high-frequency trading firm -- as this sort of deception had become common practice for big HFT firms. He told the CFTC about it in a phone call -- but that they hadn’t discovered it already for themselves surprised him.
“It’s important to know the CFTC had our data, and the ability to use it in August 2010,” Hunsader says. “We were focused on stocks (the CFTC does futures), so they should have seen it right away.”
Which raises another obvious question: If you are going to sit on this information for five years, why not sit on it forever? The people at the CFTC who decided to come forth, five years after the fact, with this new and improved explanation for the flash crash, must have known they would be creating a controversy with themselves at the center of it. It’s actually sort of brave of them.
They’ve been ridiculed in the news media and will no doubt soon be hauled before various congressional committees. They’ll have annoyed their colleagues at the Securities and Exchange Commission, who now look like even greater fools than they did before, for not bothering to mention in their report on the crash the various nefarious activities of algorithmic traders, and instead offering up as the primary cause of the crash a stupid mistake made by a money manager in Kansas. The authors of the SEC report either consciously ignored or did not bother to acquire from the CFTC a lot of accessible, and damning, information about what was happening in the U.S. stock markets the day of the flash crash. The world will now want to know why they did this. (And why we should not instantly listen to Paul Volcker and fold these two regulators into one.)
But it’s unfair to dwell too long on the regulators. Financial regulators, like editorial writers, are at best the markets’ last line of defense; they are less inclined to join any battle than they are to wander in afterward and shoot the wounded.
Traders who seek to manipulate the U.S. stock market are meant to encounter resistance from the market itself. During the flash crash, Navinder Sarao apparently used Jon Corzine’s now defunct MF Global to place orders and clear trades. Why didn’t MF Global see what he was up to, or at least call him to ask him about it? There’s now a big business on Wall Street of firms renting out their HFT infrastructure to prop shops. Does that business depend on the brokers paying no attention to what their customers are doing? Do the big Wall Street firms that rent out their technology bear any responsibility for what their customers do with the weapons they've been given? For that matter, why don’t U.S. securities exchanges assume any responsibility for what happens on them?
Sarao’s manipulative orders were placed on the Chicago Mercantile Exchange. Why didn’t the CME notice what was going on? Or did they notice, and simply not care, as the behavior was standard practice for their high-frequency trading clients?
Then there is the biggest question of all: How can a guy working from his parents’ house in suburban England whose only actionable orders were to BUY stock market futures cause such a sensational collapse in U.S. stocks? On the day of the flash crash, Sarao never actually sold stocks. He was trying to trick the market into falling so that he could buy in more cheaply. But whom did he fool with his trick? Whose algorithms were so easily gamed that they responded to phony sell orders by creating a crash? Stupidity isn’t a crime. Still, it would be interesting to know who, at this particular poker table, on this particular day, was the fool.
It would also be interesting to know how it occurred to Sarao that his trick might work. There’s a fabulous yet-to-be-told story here, about a smart kid in the U.K. who somehow figures out that the machines that execute the stock market trades of others might be gamed -- and so he games them. One day while he is busy trying to trick the U.S. stock market into falling, the market collapses, more sensationally than it has ever collapsed. And instead of digging some hole in Hounslow in which he might hide for a decade or so, or fleeing to Anguilla, where he has squirreled away his profits, he stays in his parents’ home and keeps right on spoofing the U.S. stock market -- and then is shocked when people turn up to accuse him of wrongdoing. He’s not some kind of exception to the standard operating procedure in finance. He’s a parody of it.