What did the alleged flash crash trader Navinder (Nav) Singh Sarao intend when he placed thousands of orders on volatile trading days to buy or sell S&P 500 futures contracts, or E-minis, on the Chicago Mercantile Exchange? Did the 36-year-old London resident intend to create an artificial price? Did he intend to cancel his trades before they were executed? Did he intend to defraud? Those are the questions prosecutors must answer if they wish to convict Sarao on criminal charges.
“The case will be completely about his intent, and I think many people are interested to see if the government can prove what was in the mind of Mr. Sarao,” says Clifford Histed, partner at K&L Gates in Chicago and former supervisory federal prosecutor and supervisory enforcement lawyer at the Commodity Futures Trading Commission (CFTC).
Sarao became an instant media sensation April 21 when he was arrested in London by Scotland Yard. He then appeared in court in London and, if the U.S. Department of Justice is to have its way, is to be extradited to the U.S. on criminal violations of the Commodity Exchange Act. The charges include commodity fraud, market manipulation, attempted market manipulation, wire fraud and spoofing (placing orders on an exchange with the intention of cancelling them before they are executed). Spoofing was defined and made a statutory violation in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. He is charged in both criminal and civil complaints with placing multiple large orders on the Chicago Mercantile Exchange to give a false impression of market depth in S&P 500 E-minis. The Feds argue he used off-the-shelf futures trading software to layer, or place multiple orders for, hundreds of contracts at prices three or four ticks away from the market price at the time. Those orders tricked other traders into believing there was genuine demand, prompting them to execute trades that moved the price artificially higher or lower, according to authorities. The layering program modified orders constantly, keeping offers three or four ticks away from the market price to prevent trade execution. Further charges allege that Sarao modified the trading software to automatically cancel orders if prices moved so fast it risked a trade execution.
Sarao also placed large individual spoofing orders and instantly cancelled them. Both the layering and spoofing orders were cancelled 99 percent of the time on the ten days cited in the complaints. “If it were a one-day event, he could say it was a computer error. But it was hundreds of days. So I think [the Feds] have a very good case against him,” says Joseph Saluzzi, co-founder and co-head of equity trading at Themis Trading in Chatham, New Jersey.
While allegedly manipulating the market for E-minis, Sarao also placed and executed other buy and sell trades around the price moves that his activity generated. Those trades, executed on 800 days over the past five years, earned a total net profit of $40 million, federal authorities charge. On the ten trading days cited in the complaints, he averaged $530,000 a day in net profits.
Sarao may have squirreled away some or all of his $40 million in profits in various offshore jurisdictions, from the Caribbean to Switzerland to the Middle East, according to court documents.
Significantly, the one thing the government does not have to prove is a connection to the flash crash of May 6, 2010, according to Histed. This is the case in spite of the fact that Aitan Goelman, CFTC director of enforcement, has claimed the agency intends to show — he didn’t say prove — that Sarao “contributed significantly” to an imbalance in orders that set up the markets for the flash crash.
Notwithstanding the difficulty of proving intent, a number of market watchers expect the government to prevail. “The point is that he was so excessive in his order modification behavior that, even though he was not really a high frequency trader, he was responsible for as much of half the order modifications,” says Haim Bodek, managing principal of Stamford, Connecticut, trading firm Decimus Capital Markets and professed high frequency trading whistle-blower.
Yet, in spite of all the red flags that have been raised, the trading data alone are not going to be sufficient evidence to convict, according to Manoj Narang, founder and former CEO of Tradeworx, a financial technology company in Red Bank, New Jersey. He points out that the layered orders from Sarao were visible on the central order book for fairly long periods of time. “Regardless of whether he intended to cancel or not, if I wanted to place an order against those offers in the layering strategy, there is absolutely nothing he could do to stop me in time,” says Narang. The accused trader certainly agrees, having claimed in a May 2014 e-mail to U.K. independent regulatory body Financial Conduct Authority, “My orders are 100 percent at risk, 100 percent of the time.” Narang sees the U.K. trader as more vulnerable on charges alleging single spoofing orders.
There are legitimate reasons for placing large orders away from the market, says Narang. For example, a trader might want to be the liquidity provider of last resort for large block trades. Prosecutors will need to look at the source code programmed into the trader’s software and get a good handle on how the algorithm operated to prove the trader’s intent. “I assume they have looked at his source code and found that clearly there was no intent to trade under any circumstance,” says Narang.
The Sarao case is only the second time the government has brought criminal spoofing charges in the futures market. The first was in 2013 against Michael Coscia and his company, Panther Energy Trading, of Red Bank, New Jersey. Coscia settled the civil case for a total of $4.5 million in fines to U.S. and U.K. regulators and has yet to go to trial in the criminal case. The outcome of the Sarao case could be consequential, especially if it goes to trial. A defeat would lead to a shake-up in enforcement and surveillance protocols at the CFTC, according to Histed. Conversely, he says, “Success would likely result in more charges of the same variety.”