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2015-05-06 08:17:05
By Andrew Verity BBC Economics correspondent
Exactly five years after the "flash crash" suddenly wiped nearly a trillion
dollars from the markets, the US authorities are largely pointing at one man -
a 36-year-old trader from Hounslow in west London.
But could one man really be responsible for the single biggest upheaval to
trading in a decade?
Becoming a financial master of the universe, manipulating markets across the
globe, wiping a trillion dollars off US stock markets and making yourself
millions, may seem a tall order.
But according to allegations from no less an authority than the FBI, you don't
have to travel to the City in a pinstripe suit at 6am and slick your hair back
like Michael Douglas.
You can stay at home in your parents' suburban semi in Hounslow, even in your
mid-thirties; wear a worn-out grey jogging top and bottoms; hang out in your
bedroom and tinker on a computer.
You can get up at noon and crash out at 4am.
Get yourself a seat on the Chicago Mercantile Exchange - there's no need to
travel to Chicago: it's all done remotely. Place bets on which way the S&P 500
index of shares in leading US companies is going to go - by trading contracts
based on the future value of the index.
If you want the market to go down, place orders to sell stuff you don't
actually own and never intend to sell. Your object is to influence the market -
without actually trading.
Contracts change hands when the price at which they are offered is the cheapest
on the market. To make sure your trades never go through, you make sure the
price you offer to sell at is just a little bit above the cheapest price on the
market.
Other traders, looking at the market's order book, see far more sell orders
than buy orders. Fearing that the selling pressure will drag down the price,
they sell - or their automated trading software does - and the price falls.
When it does so, you can make money, for example by placing a real order to
buy.
Financial panic
According to the FBI's allegations, Navinder Singh Sarao, known as Nav to his
friends and neighbours, did this on such a scale and to such lucrative effect
that over four years he made $40m ( 27m).
And humiliatingly for the regulatory authorities, the Chicago Futures Trading
Commission in the US and the Financial Conduct Authority in the UK, he was
allegedly able to evade any regulation and bat off regulators' inquiries for
more than five years.
In late April 2010, Navinder Singh Sarao established a new company on the
Caribbean island of Nevis, Nav Sarao Milking Markets Limited - though it had
little to do with the dairy industry. The FBI claims it was part of a tax
avoidance strategy.
Navinder Singh Sarao operated from this semi-detached house in Hounslow, west
London
On May 6 2010, exactly five years ago, argues the FBI, Mr Sarao used a computer
programme or algorithm to create a huge number of sell orders between 11.17am
and 1.40pm.
The FBI claims his sell orders were equivalent to the entire amount of "buy"
orders placed by every other market participant. Minutes later came financial
panic.
Between 1.41pm and 1.44pm the S&P plunged 3% then in just 15 seconds it dropped
another 1.7%. Within minutes the S&P dropped 6%, far quicker than during
previous crashes, before bouncing back up.
'Very bright, very diligent'
The above, however, is only the FBI's view. Beyond what has been said in court
by his lawyers - that his arrest was a "bolt from the blue" - we still know
very little of his side of the story.
Mr Sarao has been bailed on condition he places 5m as security. So far he
hasn't come up with it. He is contesting the US attempt to extradite him.
Fellow traders find the FBI's allegations hard to believe. If his computer
programme or algorithm was switched off at 1.40pm on May 6, how come the big
falls on the market took place after that point?
Could just one man at home really cause such havoc in the markets?
Could one man based in his bedroom in west London really cause the markets to
crash?
Before setting up his own trading company at his parents' house, Mr Sarao
graduated from Brunel University and worked for five years at the Woking
offices of the commodities and futures traders, Futex.
Futex says there were no incidents of any impropriety during his time with the
firm. It also says he never used an algorithm to trade, instead using old-style
"point and click".
According to Futex boss Paulo Rossi, he was "very bright, very diligent,
willing to take on risk - and he did take on risk." But he can't credit the
idea that Mr Sarao could manipulate the whole Chicago futures market and cause
an international financial panic.
"He was unusual in that he wasn't interested in money in order to spend the
money. He was interested in purely focusing on growing his trading account," Mr
Rossi told Bloomberg.
Bouts of illiquidity
Experts on the "flash crash" originally blamed the Kansas-based investment fund
Waddell and Read, for trying to offload $4.1bn of futures contracts - a sell
order so large it swamped the available buyers and allowed prices to go into
free-fall.
Professor Maureen O'Hara at Cornell University, who was on the Flash Crash
Commission that investigated the incident, resists the new alternative theory
that blames it on one man.
"You can get a world where at the moment you have 100 sellers and you don't
have 100 buyers. That price will fall off a cliff not because the underlying
asset is worth less but because there is temporarily illiquidity.
"What you don't want to happen in a market is for prices to fall just because
of that temporary imbalance."
She says that, far from being the work of one man, those temporary bouts of
illiquidity are behind the flash crash of 2010 - and several "mini flash
crashes" since.
With automated trading, prices can fall sharply if there are more sellers than
buyers
You also get a different picture if you talk to people who know Mr Sarao. One
boyhood companion and neighbour, Anil Puri, describes him as "a nice guy, fun
to be with, sociable". But he's also surprised he could be accused of anything
like manipulating markets in Chicago.
Another family friend, Rupinder Kesar told the BBC she was so shocked she
hadn't been able to go to work the following day and was still trying to
understand what has happened.
Automated trading
In fairness, the US authorities don't quite blame Mr Sarao alone for the flash
crash, which briefly wiped a trillion dollars off US markets on 6 May. But they
do allege he contributed to it, by creating a big imbalance in the market
between buy and sell orders.
And they claim that on that one day he made $879,000 ( 582,000). They also
quote an email where Mr Sarao asserts that he made the majority of his money in
just 20 days of trading.
If he behaved as the FBI alleges, then Mr Sarao may have evaded detection for
years with embarrassing ease. The Chicago Mercantile Exchange told him on the
day of the crash that "all orders are expected to be entered into in good faith
for the purpose of executing bona fide transactions".
After the crash he was allowed to continue trading. On 29 May 2014 he was asked
about his sell orders and cancellations by the Financial Conduct Authority but
told the regulator he was "an old school point-and-click prop trader". And he
was still trading just a month ago.
The real importance of the FBI's allegations is less what they may say about
Nav Sarao, and more what this says about how open to possible manipulation, in
this age of automated trading software, the futures market has become.