What’s the big deal? As the name indicates, the “flash crash” in the US stock market on 6 May 2010 didn’t last long. The loss of $1 trillion of stock market value was temporary. Calm – and normal share prices – returned within half an hour. The vast majority of investors – millions of people with long-term savings or pension money invested in US companies – didn’t lose a dollar. Most weren’t even stressed by the stock market’s rollercoaster ride. They were busy getting on with their lives.
Unfortunately, the flash crash cannot be dismissed so lightly. The reason it still matters and the reason why the alleged role of Navinder Singh Sarao – dubbed the Hound of Hounslow in a nod to the 2013 film The Wolf of Wall Street – is so intriguing – is that it may have been a near miss.
If, as US authorities allege, this single trader operating out of a semi in Hounslow helped cause a sudden 6% plunge in the world’s biggest stock market, is it a system built on sand? And what damage could be done by market operators with bigger financial resources?
The words “near miss” were used by Andrew Haldane, the Bank of England’s chief economist, in a famous speech in 2011, when regulators were (as now) struggling to understand what happened. “It [the flash crash] taught us something important, if uncomfortable, about our state of knowledge of modern financial markets,” said Haldane. “Not just that it was imperfect, but that these imperfections may magnify, sending systemic shockwaves... Flash crashes, like car crashes, may be more severe the greater the velocity.”
The title of Haldane’s speech was “race to zero,” a reference to the astonishing speed of trading made possible in today’s financial markets by immense computing power created. He talked of an arms race among high-frequency trading (HFT) firms to execute trades faster and faster. “As of today, the lower limit for trade execution appears to be around 10 micro-seconds,” he said (and this was four years ago). “This means it would in principle be possible to execute around 40,000 back-to-back trades in the blink of an eye. If supermarkets ran HFT programmes, the average household could complete its shopping for a lifetime in under a second. Imagine.”
What’s the advantage of speed? Well, many trading strategies benefit from it. Exploiting tiny and temporary differences in price between, say, a quote for a stock in New York and Chicago can be profitable. But your computer programme has to be quicker than the next guy’s by that crucial micro-second.
High-frequency trading may sound like a minority, and rather frowned-upon, sport, but it’s not. HFT is now reckoned to account for three-quarters of trading on US stock markets, and regulators have done nothing to halt its rise. More trading in more places, runs their thinking, creates more activity, which leads to keener pricing that benefits everybody.
So where does Sarao fit in? According to the allegations, he was illegally “spoofing” these constantly churning markets – trying to trick other investors’ computers into making false moves from which he could profit. He was trading contracts called e-minis, whose price rises and falls with movements in the S&P500 index, on the largest US futures market, the Chicago Mercantile Exchange.
The US department of Justice alleges that he used a system called “layering” – for example sending out a series of “sell” orders he intended to cancel but which created the illusion of downward pressure on the market. As other computers reacted to that artificial pressure, he would profit by buying at a lower price and then selling when prices returned. All faster than a blink of an eye.
On the day of the flash crash, the DoJ alleges Sarao used layering “extensively and with particular intensity”, and made a net profit of $879,018 on that day alone. Overall, the DoJ claims Sarao fraudulently made $40m in five years.
We’ll have to wait and see how the prosecutors make their case, if it goes to trial. But many have pointed out that the idea of Sarao helping cause the flash crash seems far-fetched. First, Sarao was running his algorithm on several occasions from June 2009 and the market did not plunge. Second, he’d turned off his computer two minutes before the big fall started. Third, if he merely “contributed” to the crash, were others more to blame? If so, why single out Sarao?
There’s another oddity, too. The Chicago Mercantile Board questioned Sarao about his suspicious trading before the flash crash. Indeed, on the very day, it wrote to him to say that all orders “are expected to be entered in good faith for the purpose of executing bona fide transactions”. He was hardly unknown to authorities, so why did they let him continue trading after May 2010, and wait almost five years to demand his extradition?
One school of thought has it that Sarao, whatever the legality of his techniques, should be hailed as a hero. Hedge fund manager John Hempton of Bronte Capital regards conventional HFT firms as the real villains because their goal is to “rip off” regular investors by “front running” their orders – using computers to spot trading patterns and getting in ahead. “I would prefer the front running computers to go away,” says Hempton. “And the way to make that happen is to allow spoofing. Spoofing makes the world unsafe for front-running high-frequency traders.” He calls the DoJ’s case “plain silly”.
This portrait of computers trying to out-fox other computers is a world away from the traditional image of stock markets – as places where informed buyers would meet informed sellers, and where companies could go to raise capital to fund investment.
That still happens, of course. But the biggest question raised by the flash crash is whether the speed merchants have made the system unsafe for everyone. That was the issue explored by Haldane in 2011. He concluded that new rules of the road may be required and that “grit in the wheels, like grit on the roads, could help prevent another crash”.
