By Bradley Hope And Andrew Ackerman
Investigators overlooked evidence given to them just hours after
the 2010 "flash crash" that could have enabled them to uncover the
strategies of Navinder Sarao, the trader now accused of helping
cause the violent selloff in stocks that day, according to members
of a committee that oversaw the investigation.
As a result, it took five years to find the traces of
manipulation that authorities now say contributed to the wild
swings in the U.S. futures market and the ensuing panic, the
committee members said.
Mr. Sarao, a 36-year-old resident of suburban London, was
arrested last week; he was charged with profiting from illegal
trading strategies from 2009 to 2014 and contributing to the
crash.
Neither Mr. Sarao nor his lawyer has commented on the
allegations.
Since Mr. Sarao's arrest, some critics have attributed the lapse
to incomplete data. Yet some members of the group tasked by the
Securities and Exchange Commission and Commodity Futures Trading
Commission to find the causes of the crash and recommend regulatory
reforms in its aftermath now say the real problem was an overly
narrow focus by investigators.
While investigators had access to the full set of data from that
day, they focused on a subset related to actual trades, the
committee members said. Had investigators delved deeper into the
bigger set that included all the bids and offers entered, they
said, they likely would have noticed that Mr. Sarao single-handedly
put enormous pressure on a key futures contract tied to the S&P
500 stock index by making bids and quickly canceling them in a
bluffing tactic known as "spoofing."
Maureen O'Hara, a former member of the joint committee and a
professor specializing in market structure at Cornell University,
said investigators "should have seen this."
"Nowadays, market manipulation doesn't just involve the trades.
It's about the orders," she added.
Susan Phillips, a former Federal Reserve governor who also
served on the joint committee overseeing the crash investigation,
echoed Ms. O'Hara's view, saying in hindsight investigators
probably should have uncovered market manipulation, but added the
committee wasn't focused on individual traders.
Regulators say the criminal and civil charges against Mr. Sarao
underscore shortcomings in their own technology that allowed his
suspicious trades to escape close scrutiny until late 2012.
It took a whistleblower, who through his lawyer has declined to
be identified, some two years to uncover the manipulative trading
pattern in the futures market. A new team of investigators from the
Justice Department and the CFTC--aided by a consulting firm and a
professor from the University of California at Berkeley paid $600
an hour--took another 2 1/2 years to put together a case against
Mr. Sarao for allegedly manipulating the market and contributing to
the conditions that led to the flash crash.
The product Mr. Sarao is accused of manipulating--a futures
index contract known as the E-mini S&P which mimics stocks in
the S&P 500--was cited by regulators in their report as
suffering a "liquidity event" when a big seller--later reported to
be Waddell & Reed--sold nearly $4.1 billion worth of E-mini
contracts.
Andrei Kirilenko, a former CFTC chief economist who helped write
the report on the crash, disputes the contention that investigators
overlooked or gave short shrift to key evidence of
manipulation.
"All data [were] being used," he said. "We were looking for
statistical evidence of something that explains this enormous
systemic event." Mr. Kirilenko says they did that by pinpointing
the Waddell & Reed trade that triggered the crash.
Mr. Kirilenko who led the CFTC's portion of the investigation,
disputed his group missed Mr. Sarao's alleged misconduct, arguing
that his reported activity was statistically insignificant.
Court documents suggest it wasn't just federal regulators who
had a chance to connect Mr. Sarao to the market swings on May 6,
2010.
On the same day, CME Group Inc., which operates the futures
market on which Mr. Sarao allegedly engaged in manipulative
activity, sent a warning to him that his orders were "expected to
be entered in good faith for the purpose of executing bona fide
transactions," according to court documents.
It wasn't clear from the criminal complaint against Mr. Sarao if
the warning referred to orders sent that day.
Meanwhile, the trader's broker, MF Global, also appeared to have
failed to put a stop to the alleged market manipulation despite
repeated warnings from exchanges, documents show.
Mr. Sarao's arrest added a new chapter to the U.S. government's
narrative of how the Dow Jones Industrial Average plummeted nearly
1000 points in a matter of minutes before recovering much of the
lost ground. Previously, a joint report by the CFTC and the SEC
issued in September 2010 said the crash was set off by a big sale
of contracts from a large trader at an especially vulnerable
moment, but no manipulation was cited.
There was unease in the markets that day over the European debt
crisis, according to the report.
Ms. Phillips of the oversight committee said regulators may not
have had the resources to analyze alleged "spoofing" by individual
traders such as Mr. Sarao.
"We talked about spoofing but the notion was it was very
difficult to parse out," she said. "It was in the background and
people were suspicious that that was going on."
After the flash crash, CME staff stayed in the office until 10
p.m. to pull together a data file to send to the CFTC, according to
the CME.
The exchange sent the CFTC a full data file that included all
trades, orders, modifications, cancellations and rejections for the
E-mini futures contract on the CME's main trading platform.
Usually, the CME would only send a file with all the cleared trades
from the day before to the CFTC.
CFTC officials have long complained that the agency is
chronically cash-strapped and lacks the resources to adequately
monitor the markets it oversees. Funding woes prompted the agency
to furlough employees two years ago and to delay or shelve certain
enforcement matters, The Wall Street Journal reported.
Michael Dunn, a former Democratic member of the CFTC, said
exchanges including the CME also were to blame for not bringing the
allegedly manipulative trading to a stop or to the attention of
regulators.
"The exchanges are culpable to a degree in this if in fact they
were allowing someone to use an algorithm" to manipulate markets,
he said.
Mr. Sarao appears to have been on the CME's radar since at least
2008, when two employees from the exchange visited him at his
trading station in the offices of Futex Global in London, according
to former colleagues.
"They came to watch him trade," said Leif Cid, a former trader
who was mentored by Mr. Sarao, in an interview. "They wanted to
know how he did what he did."
Such visits were common for traders who were responsible for a
large amount of volume on the exchange, according to a person
familiar with the CME.
The CME contacted Mr. Sarao's broker on "several occasions in
2009 and 2010" about "suspicious activity," according to the
criminal complaint filed against Mr. Sarao.
The CME declined to comment on its interaction with Mr.
Sarao.
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