(Bloomberg) — The sleuth who pieced together Navinder Singh Saraos pattern of spoofing isnt an FBI agent or regulator. Hes an academic whose research has taken the view that high-frequency trading is good for markets.
When the Commodity Futures Trading Commission needed an expert to sort through Saraos activity, it turned to Terrence Hendershott, a University of California, Berkeley, professor. Hendershott pored over almost 400 days of trading data, documenting Saraos practice of using fake orders to move prices in a way that benefited him.
Hendershotts role was revealed in an affidavit, made public Wednesday, that provides support for prosecutors claims against Sarao. The London-based traders spoofing is alleged to have fed the May 2010 flash crash, when close to $1 trillion in U.S. stock value vanished in 20 minutes before prices recovered.
Henderschott is one of the top three or four people regulators could have chosen for the job, said Maureen OHara, a Cornell University professor who is chairman of Investment Technology Group Inc. If Terry looked at it and felt that it contributed to the flash crash, it certainly makes me more comfortable with the substance of that conclusion.
Regulators first learned of the alleged spoofing from a whistle-blower, according to Shayne Stevenson, a Seattle lawyer representing the person.
A PhD graduate of Stanford University, Hendershott started his career at the University of Rochester, moved to Berkeley in 2001, and spent two years as a visiting economist at the New York Stock Exchange, according to his faculty web page. His research has found that high-frequency traders, who rely on computers to trade huge volumes of stocks and other assets, make the process of establishing prices more efficient.
Using data from Nasdaq OMX Group Inc., Hendershott and two co-authors wrote last year that speed traders smooth out pricing errors and provide liquidity on some of the most volatile trading days.
Blood Suckers
What hes basically shown is that in modern trading, the computerized traders are not demonic blood suckers, said James Angel, a finance professor at Georgetown University. We need people to study market plumbing in detail, and hes done a great job of it.
After the publication of Michael Lewiss book Flash Boys, which argued that high-frequency traders exploited technology advantages and regulatory loopholes to make money, Hendershott said in a YouTube interview that Lewis left out many facts to make his story more compelling.
We cant slow down the economy to help the buggy-whip manufacturers, but thats a long way from the market being rigged, he said.
Hendershotts resume shows dozens of academic papers, many of which focused on algorithmic trading and the role speed plays in financial-market technology. He declined to comment about his work on the Sarao case.
Painstaking Detail
His affidavit lays out his study of Saraos strategy in painstaking detail. Sarao routinely placed and rapidly modified large sell orders on an exchange run by Chicago-based CME Group Inc. The orders were so far from the best price that he never intended them to be filled, according to the affidavit. The increased supply pushes down prices, giving him an opportunity to buy at a lower price.
On May 6, 2010, Sarao used algorithms to enter orders for thousands of futures on the Standard & Poors 500 Index. The orders amounted to about $200 million worth of bets that the market would fall, a trade that represented between 20 percent and 29 percent of all sell orders at the time. The orders were then replaced or modified 19,000 times before being canceled in the afternoon. None were filled, according to the affidavit.
Sarao isnt a typical high-frequency trader, since he lacked some of their tools, including direct price-feed connections to exchanges. But relying on algorithms to fire off and cancel thousands of orders, he contributed to the imbalance between sell and buy orders that spooked many other traders and contributed to the overall feeling of crisis, according to Hendershotts affidavit.
As for the flash-crash link, Hendershott takes pains to say that its regulators who assert the connection. The layering algorithm contributed to the overall order-book imbalances and market conditions that the regulators say led to the liquidity deterioration prior to the flash crash, he wrote.
He is basically close enough to the scene of the crime and he was doing something illegal, Angel said of Sarao. Even if there had been no flash crash that day, this guy should be prosecuted if those allegations are true.