Streetwise Professor

April 22, 2015

Did Spoofing Cause the Flash Crash? Not So Fast!

Filed under: Derivatives,Economics,HFT,Regulation — The Professor @ 12:41 pm

The United States has filed criminal charges against on Navinder Sarao, of London, for manipulation via “spoofing” (in the form of “layering”) and “flashing.” The most attention-grabbing aspect of the complaint is that Sarao engaged in this activity on 6 May, 2010-the day of the Flash Crash. Journalists have run wild with this allegation, concluding that he caused the Crash.

Sarao’s layering strategy involved placement of sell orders at various levels more than two ticks away from the best offer. At his request, “Trading Software Company #1” (I am dying to know who that would be) created an algorithm implemented in a spreadsheet that would cancel these orders if the inside market got close to these resting offers, and replace them with new orders multiple levels away from the new inside market. The algorithm would also cancel orders if the depth in the book at better prices fell below a certain level. Similarly, if the market moved away from his resting orders, those orders would be cancelled and reenetered at the designated distances from the new inside market level.

The complaint is mystifying on the issue of how Sarao made money (allegedly $40 million dollars between 2010 and 2014). To make money, you need to buy low, sell high (you read it here first!), which requires actual transactions. And although the complaint details how many contracts Sarao traded and how many trades (e.g., 10682 buys totaling 74380 lots and 8959 sells totaling 74380 lots on 5 May, 2010-big numbers), it doesn’t say how the trades were executed and what Sarao’s execution strategy was.

The complaint goes into great detail regarding the allegedly fraudulent orders that were never executed, it is maddeningly vague on the trades that were. It says only:

[W]hile the dynamic layering technique exerted downward pressure on the market SARAO typically executed a series of trades to exploit his own manipulative activity by repeatedly selling futures  only to buy them back at a slightly lower price. Conversely, when the market mved back upward as a result of SARAO’s ceasing the dynamic layering technique, SARAO typically did the opposite, that is he repeatedly bought contracts only to sell them at a slightly higher price.

But how were these buys and sells executed? Market orders? Limit orders? Since crossing the spread is expensive, I seriously doubt he used market orders: even if the strategy drove down both bids and offers, using aggressive orders would have forced Sarao to pay the spread, making it impossible to profit. What was the sequence? The complaint suggests that he sold (bought) after driving the price down (up). This seems weird: it would make more sense to do the reverse.

In previous cases, Moncada and Coscia (well-summarized here), the scheme allegedly worked by placing limit orders on both sides of the market in unbalanced quantities, and see-sawing back and forth. For instance, the schemers would allegedly place a small buy order at the prevailing bid, and then put big away from the market orders on the offer side. Once the schemer’s bid was hit, the contra side orders would be cancelled, and he would then switch sides: entering a sell order at the inside market and large away-from-market buys. This strategy is best seen as a way of earning the spread. Presumably its intent is to increase the likelihood of execution of the at-the-market order by using the big contra orders to induce others with orders at the inside market to cancel or reprice. This allowed the alleged manipulators to earn the spread more often than they would have without using this “artifice.”

But we don’t have that detail in Sarao. The complaint does describe the “flashing” strategy in similar terms as in Moncada and Coscia, (i.e., entering limit orders on both sides of the market) but it does not describe the execution strategy in the layering scheme, which the complaint calls “the most prominent manipulative technique he used.”

If, as I conjecture, he was using something like Moncada and Coscia were alleged to have employed, it is difficult to see how his activities would have caused prices to move systematically one direction or the other as the government alleges. Aggressive orders tend to move the market, and if my conjecture is correct, Sarao was using passive orders. Further, he was buying and selling in almost (and sometimes exactly) equal quantities. Trading involving lots of cancellations plus trades in equal quantities at the bid and offer shares similarities with classic market making strategies. This should not move price systematically one way or the other.

But both with regards to the Flash Crash, and 4 May, 2010, the complaint insinuates that Sarao moved the price down:

As the graph displays, SARAO successfully modified nearly all of his orders to stay between levels 4 and 7 of the sell side of the order book. What is more, Exhibit A shows the overall decline in the market price of the E-Minis during this period.

But on 4 May, Sarao bought and sold the exact same number of contracts (65,015). How did that cause price to decline?

Attributing the Flash Crash to his activity is also highly problematic. It smacks of post hoc, ergo propter hoc reasoning. Or look at it this way. The complaint alleges that Sarao employed the layering strategy about 250 days, meaning that he caused 250 out of the last one flash crashes. I can see the defense strategy. When the government expert is on the stand, the defense will go through every day. “You claim Sarao used layering on this day, correct?” “Yes.” “There was no Flash Crash on that day, was there?” “No.” Repeating this 250 times will make the causal connection between his trading and Flash Clash seem very problematic, at best. Yes, perhaps the market was unduly vulnerable to dislocation in response to layering on 6 May, 2010, and hence his strategy might have been the straw that broke the camels back, but that is a very, very, very hard case to make given the very complex conditions on that day.

There is also the issue of who this conduct harmed. Presumably HFTs were the target. But how did it harm them? If my conjecture about the strategy is correct, it increased the odds that Sarao earned the spread, and reduced the odds that HFTs earned the spread. Alternatively, it might have induced some people (HFTs, or others) to submit market orders that they wouldn’t have submitted otherwise. Further, HFT strategies are dynamic, and HFTs learn. One puzzle is why away from the market orders would be considered informative, particularly if they are used frequently in a fraudulent way (i.e., they do not communicate any information). HFTs mine huge amounts of data to detect patterns. The complaint alleges Sarao engaged in a pronounced pattern of trading that certainly HFTs would have picked up, especially since allegations of layering have been around ever since the markets went electronic. This makes it likely that there was a natural self-correcting mechanism that would tend to undermine the profitability of any manipulative strategy.

There are also some interesting legal issues. The government charges Sarao under the pre-Dodd-Frank Section 7 (anti-manipulation) of the Commodity Exchange Act. Proving this manipulation claim requires proof of price artificiality, causation, and intent. The customized software might make the intent easy to prove in this case. But price artificiality and causation will be real challenges, particularly if Sarao’s strategy was similar to Moncada’s and Coscia’s. Proving causation in the Flash Crash will be particularly challenging, given the complex circumstances of that day, and the fact that the government has already laid the blame elsewhere, namely on the Wardell-Reed trades. Causation and artificiality arguments will also be difficult to make given that the government is charging him only for a handful of days that he used the strategy. One suspects some cherry-picking. Then, of course, there is the issue of whether the statute is Constitutionally vague. Coscia recently lost on that issue, but Radley won on it in Houston. It’s an open question.

I am less familiar with Section 18 fraud claims, or the burden of proof regarding them. Even under my conjecture, it is plausible that HFTs were defrauded from earning the spread, or that some traders paid the spread on trades they wouldn’t have made. But if causation is an element here, there will be challenges. It will require showing how HFTs (or other limit order traders) responded to the spoofing. That won’t be easy, especially since HFTs are unlikely to want to reveal their algorithms.

The spoofing charge is based on the post-Frankendodd CEA, with its lower burden of proof (recklessness not intent, and no necessity of proving an artificial price). That will be easier for the government to make stick. That gives the government considerable leverage. But it is largely unexplored territory: this is almost a case of first impression, or at least it is proceeding in parallel with other cases based on this claim, and so there are no precedents.

There are other issues here, including most notably the role of CME and the CFTC. I will cover those in a future post. Suffice it to say that this will be a complex and challenging case going forward, and the government is going to have to do a lot more explaining before it is possible to understand exactly what Sarao did and the impact he had.


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  1. Great article.

    One possible execution strategy: place a passive bid two ticks away from current best, then layer the offer side with very large offers, creating the illusion of massive supply but no actual transactions. The intent being that this illusion of supply is sufficient downward pressure to move the market through the passive bid due to the combined action of other market participants. With the downward pressure still applied, place an equal-sized passive offer one tick above where the bid was, then release the pressure by canceling the layered offers. The intent being that the sudden disappearance of the illusory supply is sufficient to move the market through the resting offer and back to its original equilibrium position.

    For this to work it seems that you’d need an incredible size for the artificial downward pressure and because you’re relying on others to actually move the market, that large size would need to be visible. The complaint is at pains to point out both the unusual size of the layered offers and that the defendant purposefully placed them in the visible part of the book.

    Still – with such large offers used for the downward pressure, the strategy is incredibly risky: the trader is one untimely macroeconomic news event away from being run over with disastrous consequences. Even with these offers placed with the “move if close” algorithm, an algorithm running in a spreadsheet on the trader’s workstation is hardly going to be able to move these orders out of the way quickly enough.

    I’m particularly confused why such tactics wouldn’t be immediately identified by the exchange given the sizes required. I see CME adjudications frequently that imply that they pay close attention to this kind of thing.

    Comment by Rob Walker — April 23, 2015 @ 4:21 am

  2. Pirrong writes: ” ‘Trading Software Company #1’ (I am dying to know who that would be) created an algorithm….”

    The CFTC has released several of Sarao’s emails. Sarao used Trading Technologies (TT) to enter orders. And he tweaked TT’s order-entry system to his own specs with additional programming by Edge Financial, a company I’ve never heard of. (TT is very well-known, and highly disliked for their litigiousness.)

    Sarao writes in one email that his biggest winner occurred while he was sleeping: “[M]y biggest day was actually made for the most part whilst I was sleeping !”

    Hilarious stuff. It’s obvious why Sarao was the sole proprietor of his trading firm: No prop shop on earth would permit a trader to go home with an unhedged position.

    Comment by Elstir — April 23, 2015 @ 1:07 pm

  3. Firstly, thank you for the article. I appreciate any honest attempt at investigating the topic.

    My biases: Sarao’s practices appear ubiquitous with industry. Short selling should be illegal but isn’t.

    Now onto some of your questions that I didn’t fully agree with the answers:

    “Market orders/limit orders?”: While Sarao exhibited risky behavior I don’t know a real trader who uses Market orders. HFT in particular is concerned with penny differences. They can’t afford market orders. So the assumption is limit or trailing orders.

    “Sarao bought and sold the exact same number of contracts (65,015). How did that cause price to decline?”

    The issue here is the essence of short selling. If a simplified example stock has a market cap of $10 at 1 dollar per share (10 shares total). And I suddenly short sell 5 shares that I don’t own. There’s no restriction on the people I “borrowed” them from from selling their shares as well. So theoretically now you have 15 shares trading on the market but the company has not increased its profits or assets by 50%. So the value of those shares is instantiously deflated. Their fair market valuation of $10 is spread over 15 trading shares and their per share price is $67 cents a share. I “buy to close” 5 shares at 67 cents. Those 5 artificial shares don’t “Disappear” from the market until I close them. So the market can’t logically react until after I do. Theoretically I’ve now harvested .33 cents off 5 imaginary shares. The the Example stock, now shifts back to $1/share to maintain its $10 fair value at $10 market cap right? False, that $33 cents came from someone. Most likely a pension fund operating on slow, inefficient rules or even a smart trader using protective trailing stops have now been triggered to sell when otherwise would not have.

    “One puzzle is why away from the market orders would be considered informative, particularly if they are used frequently in a fraudulent way”

    This article is correct in that the little guys often lack buy/sell power needed to manipulate the market. A more common strategy employed by big and small traders, is to try to detect sizeable market manipulation attempts, presumably being carried out by “the big boys” and to ride the coat tails. If Blankfield is selling blocks of 10,000 shares, you don’t set a buy order, you sell whatever shares you can short, before your clearing house runs out of shares to borrow. For this reason, the book value presents value and hazards.

    “HFTs learn”

    Honestly the appearance that these HFTs don’t fail every day, is a credit to their designers. But unless we’re looking at one as an example, I think you’re giving them a little too much credit if you think they’re anything more than really simple rules, that were easy enough for a trader to communicate to a non-trader (programmer).

    Comment by Craig — September 4, 2015 @ 1:01 pm

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