NEW YORK (Real Money) -- The arrest and extradition request of a 36-year old London trader in connection with the 2010 Flash Crash -- when the Dow Jones Industrial Average lost around 600 points in five minutes and then rebounded -- raises more questions than it answers, for the moment.
Navinder Singh Sarao, who was trading the markets from his family's home in a London suburb under the flight path to Heathrow airport, is presumed innocent until proven guilty. He appeared in a London court on Wednesday and said he was opposed to being extradited to the U.S., where he was charged with 22 criminal counts including fraud and market manipulation.
What took them so long to find him?
This is one of the most important questions in this case. The Flash Crash happened on May 6, 2010, briefly wiping out almost $1 trillion from the market's value. Ever since then, the authorities have struggled to come up with a convincing explanation about what happened.
According to the Department of Justice, Sarao allegedly used an automated trading program to manipulate the market for E-Mini S&P 500 futures contracts (E-Minis) on the Chicago Mercantile Exchange. By allegedly placing multiple, simultaneous and large-volume sell orders at different price points -- a technique known as dynamic layering -- the London-based trader "created the appearance of substantial supply in the market." He is alleged to have modified these orders frequently so that they remained close to the market price, but usually canceled them before execution.
He is alleged to have profited from the fact that he sold futures contracts and, after prices fell as a result of his actions, bought them back at cheaper prices and conversely bought contracts when the market was low, only to sell them back when the market increased after his actions ceased.
In short, he allegedly created the illusion that there was more selling of the contracts than there actually was, driving the price lower.
But surely, since then regulators went through the action that took place on and around the day of the Flash Crash with a very fine comb? And if so, why did Sarao's alleged actions not jump at them as strange at the time?
Why was he allowed to continue his trading scheme for so long?
According to the U.S. Commodity Futures Trading Commission (CFTC) complaint, Sarao is alleged to have been carrying out his activities "for over five years and continuing as recently as at least April 6, 2015." The Department of Justice said that, in an email to his broker dated May 25, 2010, Sarao wrote that he had "just called" the CME "and told 'em to kiss my ass."
If he was engaged "in a massive effort to manipulate the price of the E-mini S&P by utilizing a variety of exceptionally large, aggressive, and persistent spoofing tactics," as the CFTC complaint alleges, how was it possible for him to continue to do it for such a long time without anyone catching wind of what was going on?
Where's the money he is alleged to have made from the trades?
According to the CFTC complaint, "from April 2010 to present, Defendants have profited over $40 million, in total, from E-mini S&P trading." Sarao was carrying out his trading via his company, Nav Sarao Futures Limited. The latest financial figures on the company, available from the U.K. Companies House, show that the company had liabilities of more than 23 million pounds ($34.6 million) at the end of 2013.
Interestingly, as the chart of the Companies House data that is available subscription-free shows, liabilities surged from a relatively meager 387,308 pounds ($587,057) in 2011 to a whopping 27.3 million pounds ($40.7 million) in 2012.
The company's cash levels also jumped in 2010 and 2011. In 2010, it had 18.8 million pounds in cash, up from 436,799 pounds in 2009. In 2011, it had 20.3 million pounds in cash, but in 2012 this had fallen to 4.3 million pounds.
Source: U.K. Companies House
According to the various media accounts, Sarao lives with his wife and two daughters in a house not far from that of his parents in London, where he was arrested Tuesday. Neighbors interviewed by various newspapers say they were never aware of his supposed wealth, with one of them telling the FT that Sarao drove a "broken-down green car" that "belongs to his parents." So, where is all the money?
Why didn't he cause more than one flash crash?
The CFTC alleges that Sarao's activities contributed to the Flash Crash. According to the CFTC complaint, his use of the dynamic layering technique -- a customized computer trading program to place large sell orders for E-Mini S&P 500 futures -- was "particularly intense in the hours leading up to the Flash Crash. Sarao used the technique continuously from 11:17 a.m. until 1:40 p.m." His offers "comprised 20 to 29% of the CME's entire E-Mini sell-side order book, significantly contributing to the order book imbalance," the CFTC said.
Some media outlets have argued that Sarao's layering algorithm cannot have had a substantial contribution to the Flash Crash because that happened between 1:41 p.m. and 1:45 p.m. CT, when the algo was already off.
However, in addition to automatic layering, the CFTC alleges that Sarao also utilized manual large lot orders, known as Lot Spoofing, which intensified the layering algorithm's effects during the Flash Crash. The complaint says: "Between 12:33pm CT -- 1:45pm CT, Defendants placed a total of 135 orders with 188 or 289 lots on the sell-side of the Order Book, totaling 32,046 contracts. Of these 135 188/289-lot orders, 132 orders were canceled without resulting in execution."
The CFTC complaint alleges that Sarao used the dynamic layering technique "on numerous occasions in 2011" and as early as last year. "On numerous occasions in early 2014, Sarao placed multiple, simultaneous sell orders (typically consisting of 300 lots each) that he repeatedly modified so that they would remain several ticks above the best offer -- virtually ensuring that these orders would not be filled," it says. But despite this, no other Flash Crash occurred.
So how come his role was so crucial only back in the 2010 one?
If one trader can indeed cause so much damage, what does this say about the markets?
Perhaps this is the most important question that this case is bringing to the fore. High-frequency trading has often been demonized for allowing freak events like the Flash Crash to occur and this case just reinforces the view that the markets are unsafe for ordinary traders.
Investors with tens of years of experience in the stock markets complain that the algos are making the markets less robust and more vulnerable to wild swings. It is also one of the main reasons why retail investors have been slow to return to the markets after the 2008/2009 financial crisis.
While the individual amounts invested by retail investors are insignificant, they do serve another, very important function in the stock market: by moving in and out of stocks based on what they believe will happen to the economy, they provide key signals about where we are in the economic cycle and what the outlook may be. By contrast, computers, no matter how fast they trade, generally react to market events rather than anticipating them.
Therefore the last, but by no means the least important, question raised by this case should be: Has central bank intervention coupled with computerized trading destroyed the markets' important function as a gauge for the health of the economy?
If so, isn't it time for regulators and policymakers to either correct that error, or admit openly that we must just learn to live with it?
Editor's Note: This article was originally published at 12:03 p.m. EDT on Real Money on April 22.