US authorities accused Navinder Singh Sarao of putting out a large number of fake sell orders from his house in west London. But if what's now an economic crime contributed to the 2010 flash crash the guiltiest party was the whole financial market.
At issue is the practice of spoofing other traders with orders that aren't ever intended to become trades, in Sarao's case using E-Mini S&P 500 futures, traded on the CME. It is not illegal to test the market with orders that might not be completed, but intentionally deceptive orders have been prohibited under US law since July 2010.
The courts will eventually decide whether Sarao crossed the still-blurred legal line. The debate on what actually caused the flash crash on May 6, 2010 will continue. But Sarao clearly took advantage of two sorts of inefficiencies in financial markets.
First comes momentum trading. According to the US complaints, Sarao used an algorithm that generated orders to fabricate buying or selling pressure. The goal was to persuade other investors to jump on the fake bandwagon, create real price movements and then profit as the illusion disperses.
This spoofing only adds a twist of deception to a common practice which pays no attention to real value and makes no economic sense. Without trend-following, markets can display the wisdom of crowds. With it, the herd thinking of the mob is inevitable.
Second is the power of leverage. It has not been proven that Sarao, a sole trader without huge financial resources, actually influenced prices in the largest and most liquid equity market in the world, but the possibility cannot be excluded. He seems to have borrowed against a tiny deposit to trade E-Mini futures in much bigger volumes than his own firepower would allow. That's how the derivatives markets sometimes act as the tail wagging the stock market dog.
In a financial world without these inefficiencies, Sarao would not be fighting extradition to the United States. But traders should know better than anyone that such a world is not likely to come along soon.
