It was a shock, but not a surprise, to hear that that a single trader was responsible for triggering the May 2010 Flash Crash by spoofing the market.
That it took five years for the CFTC to figure out who triggered the Flash Crash is more surprising. I said at the time of the Flash Crash that regulators were using bicycles to try and catch Ferraris. It seems they still are. For, although regulators and banks have come a long way in monitoring automated trading systems, traders can still seemingly manipulate and impact markets right under our noses.
Still, blaming one trader who worked from his parents house outside London for sparking a trillion-dollar stock market crash is a little bit like blaming lightning for starting a fire. Fire needs dry fuel and oxygen; which is what the new market structure in the U.S. offered flash boys, or high-frequency traders.
At the time of the Flash Crash, everyone was still getting used to the 2005 SEC rules known as the Regulation National Market System (Reg NMS). This rule was designed to give investors the best possible price when dealing in stocks, even if that price was not on the exchange that received the order.
Traders had realized that these rules created attractive new opportunities. One example is taking advantage of incremental gaps between prices on different exchanges by using computer models to conduct HFT. Increasingly, brokers and traders employed algorithms to execute their trading strategies. Some of these strategies have now been banned including spoofing, layering and front-running.
So it was on May 6, 2010, with fear in the air due to the magnitude of the Greek debt crisis, large sell orders for E-mini S&P 500 futures contracts hit the Chicago Mercantile Exchange and spooked other traders algorithmic trading strategies. They pushed the sell button and caused a panic and a near-1,000 point drop in the Dow Jones Industrial Average. That a simple spoof order, or orders, could take the market down so fast was unthinkable – but it happened.
Today, five years after the Flash Crash, what is still missing is a regulatory policing system that monitors a combination of unwanted human andmarket behaviors to detect patterns that signal fraud or error. So much of our economy is underpinned by electronic trading that protecting the market is more important than guarding Fort Knox.
High-speed markets that lack adequate supervision risk even more severe consequences than flash crashes. Without trying to overstate the issue, in the most extreme circumstances abusive practices could be considered algorithmic terrorism. The concern is that a well-funded terrorist organization could use these tactics to manipulate or cripple the market.
Had Navinder Singh Sarao had anything more sinister on his mind than beating the market in May 2010, the Flash Crash could have been much, much worse.
Dr. John Bates is chief marketing officer and member of the executive board of Software AG and frequent contributor to Traders.
