As a Christmas present, somebody gave me a book called “Flash Crash”, by Liam Vaughan. It’s the story of Navinder Singh Sarao, the man accused - and indeed convicted - of being responsible for the equity market flash crash of May 2010. It’s engaging, well-written and reads a lot of the time as a financial thriller, a genre that particularly appeals to me. Whether it is the full story or not, I have no way of knowing, but it runs through Sarao’s career from debutant trading arcade neophyte to arch-manipulator and convicted criminal (turned prosecution witness).
Just before reading this book, I was intrigued by the stories beginning to appear in the press speculating about who were the major winners when the Nymex WTI contract plunged to a negative close in April 2020. It appears that it was a group of allied - but independent - largely ex-IPE locals and their associates, based in suburban Essex, who are rumoured to have cleaned up to the tune of about $600million. Apparently, regulators are searching though trading records to see if there is any sign of collusion or market manipulation.
Well. There is a bit of a theme to these two cases, and unfortunately it is that you can’t always get what you want (to quote Mick Jagger) and that unintended consequences will very often come back to bite you.
In the first example, Sarao was found guilty of spoofing the market. We should note here that spoofing is illegal in the US, but not, as far as I am aware, in the UK. Spoofing in this context means placing orders in such a way as to make the market (in other words, the other market participants) believe that there is more - or less - buying - or selling - than is actually the case. So, having established his position, our trader spoofs the others into reacting in a way which enables him to trade in the opposite direction to take his profit. For those familiar with the open outcry trading of the LME Ring, that’s really rather like the trader who goes into the Ring short, offers aggressively to persuade others to follow, and then takes his (or her) profit by buying back a few seconds later. On the surface, that doesn’t seem worthy of a gaol sentence.
But, of course, the S&P e-mini contact, which was by far the largest part of Sarao’s portfolio, is traded purely electronically, which changes the picture somewhat. Now, the market is basically a visible order-book, and the main players High-Frequency Traders, who use their computing power to examine that order book, to attempt to see behind it and to scalp fractional profits on the back of the nano-seconds of advantage that computing power gives them.
I’m not making an excuse for Sarao - what he did was illegal in the jurisdiction in which his trades were executed, and for that there is of course a penalty. However, what the regulators and exchange operators have done is also culpable. They have effectively forgotten that the purposes of securities and futures markets are to raise capital for industry, to enable risk to be hedged and to facilitate the proactive use of the time value of money. Instead, they have turned them into arcade games - that’s why we call bucket shops trading arcades these days - because the volumes of the algos and HFTs generate so much exchange fee income (and broker commission). In doing this, in pretending that the volume generated by HFTs is genuine liquidity in the market (see earlier columns here outlining this point), they have abdicated what should be their responsibility to those market users with real economic interest in the product they are trading. The guilt in this case is not all one-sided. And, let’s not forget that plenty of experienced traders have been making this point for a very long time.
The other case also throws up an uncomfortable truth. The spread of WTI contracts on Nymex apparently enables traders to buy a contract to trade at the close (similar - but, and I’m not going to go into detail here, not quite the same as traditional LME closing official price trading). It doesn’t take a trading genius to work out that on those occasions when there is a strong likelihood that the market will go down (or up), traders will take the opportunity to put in orders to be guaranteed filled at the closing price and then trade the opposite way coming up to the close - through aggressive orders put in the electronic order book - to lock in profits. This is apparently what happened on the day in question back in April 2020. Readers will recall that oil demand was collapsing under coronavirus concerns, that storage facilities for the WTI contract were filling to the brim (and beyond) and that the WTI contract has particular delivery requirements; in those circumstances, a significant weakening of the price was almost inevitable, creating exactly the conditions the Essex traders were able to exploit. There is - as far as I know - so far no suggestion of illegal practices, which would largely focus on whether or not the traders were working as a concert party - but as we all know, when someone makes a great deal of profit, many others immediately cry foul. In this case, you have to ask yourself why would you create this opportunity in the market, by offering the trade on close contract? It’s not entirely conducive to keeping an orderly market……..but I’m sure it brings in extra volume, just like the case above.
“Flash Crash”, by Liam Vaughan, is published by William Collins.