US authorities are set to pursue their case against Navinder Sarao, a UK trader they accuse of market manipulation, after he lost his final attempt to appeal his extradition. The legal process will be keenly watched for indications of how US regulators are approaching high-frequency and algorithmic trading.
The US Commodity Futures Trading Commission (CFTC), which made the allegations in April 2015, argues that Sarao used automated trading systems to place and cancel hundreds of thousands of orders that he had no intention of executing (known as ‘spoofing’) to affect the price of the E-mini S&P.
The CFTC says Sarao used an automated layering algorithm that could ensure that market participants would see large sell orders in the order book at prices above where the best asking price was.
Adjusting the flow of these sell orders – their size, number and price – and cancelling them before they can be executed would have the effect of either depressing the market or allowing it to rebound, the CFTC says.
The CFTC cites a series of dates where it argues that Sarao’s activities manipulated the market, including May 6 2010, the date of the so-called flash crash, when the S&P500 fell 5% and then recovered in just a few minutes.
The CFTC argues that Sarao’s actions contributed to the flash crash, but more broadly says that he had engaged in spoofing on the vast majority of the 800 days that he was active in the E-mini S&P market over the period, generating profits of about $40 million.
Academics dispute connection
Some academics dispute the suggestion that Sarao’s actions might have been a contributing factor to the crash. A paper by Eric Aldrich of the University of California, Joseph Grundfest of Stanford University Law School and Gregory Laughlin of Yale University, entitled ‘The flash crash: A new deconstruction’, argues that deep order book imbalances have little material effect on subsequent prices. A draft of the paper was published in January 2016, with the final version in September.
The final paper, published after analysis of messaging traffic “at the millisecond level of granularity” for the E-mini order book, finds that anomalies in market data feeds are more likely to have contributed to the crash by resulting in a withdrawal of liquidity by algorithmic traders. Such a condition was vulnerable to being exacerbated by large sell orders.
The paper also notes that the CFTC and the Securities & Exchange Commission initially concluded in a staff report on the events of May 6 2010 published later that year that the crash was likely to have been caused by market instability combined with a large unnamed automated sell order executed in a destabilizing manner.
The academics stress that their findings challenge specifically the suggestion that Sarao’s actions as described were a material contributing cause of the flash crash. They do not address the question of the legality of his trading, but they argue that if Sarao were to be found guilty of having manipulated the market, any sentence should not be amplified simply because the flash crash happened at the same time.
Nonetheless, the question of distinguishing causation and correlation is a critical one for policymakers, the academics argue, particularly if it led the authorities to conclude that Sarao’s actions did contribute to the flash crash. In that event, they argue, policymakers might find it rational to prosecute certain trading activity on the grounds that doing so would lower the probability of crashes, rather than tackling the thornier question of how the dynamics of automated trading in general might affect market conditions.
“The danger is that regulators will perceive this form of enforcement activity as an effective substitute for more fundamental restructuring of modern markets,” the academics write.
Plea bargain pressure
As for Sarao, he is likely to be under pressure to discuss a plea bargain, says Alistair Graham, a partner at law firm Mayer Brown, who represented Ian Norris, former CEO of engineering company Morgan Crucible. Norris was extradited to the US in 2010 and was then sentenced to 18 months in prison for conspiracy to obstruct justice. Graham accompanied Norris to the US when he was extradited.
“If Navinder Sarao is extradited to the US his first hurdle will be to try to secure bail, which, as a UK national who has fought extradition, is far from straightforward. […] When perhaps at a low ebb, he will likely come under enormous pressure to agree a plea bargain in relation to the charges,” he says.
“Typically the authorities use the threat of the maximum tariff, which is typically very much longer in the US than in UK, to encourage such discussions. All of this makes the task of fighting the charges a seriously uphill one, and often people will consider whatever deal enables them to return to the UK as soon as possible.”