It didn’t take U.S. authorities long to determine the root cause behind the May 2010 ‘Flash Crash’. Five years later they claim to have identified the initiator of the ‘spoofing’ that caused the Dow Jones Industrials Average to tank over 1000 points within a single trading day.
The term ‘Flash Crash’ was coined following the dramatic pullout of liquidity from the markets in a matter of seconds by high-frequency trading (HFT) companies. Dubbed by renowned finance investigating literature author Michael Lewis as ‘Flash Boys’, the trading companies using algorithms specifically devised to buy and sell assets within microseconds, leading to the single biggest points drop in the history of the Dow Jones Industrial Average.
After an individual named Navinder Singh Sarao was apprehended in the U.K., court documents filed by the U.S. government against him reveal the prospective root cause for the ‘Flash Crash’. Authorities have stated on numerous occasions that the beginning of the black swan was entangled in S&P Futures trades. This is precisely what Navinder Singh Sarao was trading from his home.
The E-Mini S&P 500 futures contracts which Mr. Sarao was trading between June 2009 and April 2014 could have had a much higher impact than the alleged perpetrator aimed for.
According to the affidavit of the FBI agent leading the investigation, the contract traded on the Chicago Mercantile Exchange (CME) was a core asset which Sarao used. For the five years since April 2010, using a practice called ‘spoofing’ the trader engaged in manipulation of the prices of the S&P 500 Futures market.
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The spoofing practice allegedly worked in the following way – Mr. Sarao placed multiple large volume sell orders on the CME, which were interpreted by market participants as substantial supply on the market and led to the dramatic decline. At the same time, these orders were never executed as they were cancelled or modified just before execution.
The FBI investigation claims that Sarao accrued substantial funds by applying the strategy. The document also alleges that the trader misrepresented and lied about his use of computer automation to execute the split-second modifications to orders that facilitated manipulation.
The trades were executed through the CME Group’s Globex electronic trading platform, which allows traders worldwide to use servers located in the Chicago area.
The spoofing or layering practice used by the trader has been a manipulative tool for years. Traders placing a multitude of orders in one direction of the market aim to trick other market participants that there is substantial interest in a particular market direction.
According to current legislation, the practice is illegal and creates a false impression that market participants are evaluating a given financial product, which prevents legitimate supply and demand forces from determining the correct market price.