“Flash Crash” and “Spoofing” the new vocabulary of Investing

This week’s news headlines have centered on the extradition of the “infamous” UK trader Navinder Singh Sarao .The trader is opposed to his extradition to the United States to face trial in an Illinois court. Navinder was arrested as the US Department of Justice charged him for wire fraud, commodities fraud and manipulation, and one count of ‘spoofing’—when a trader places a bid or offer with the intent of canceling it before execution.

In 2010 the Dow Jones drastically crashed in only five minutes. The Americans are on the hunt for someone to blame for the ‘Flash Crash’. But the problem is much more serious than any lone trader. Brokers start weeping into their Bloomberg terminals. Central bankers geared up for emergency blasts of quantitative easing while prime ministers and presidents start to feel nervous at the prospect of a recession destroying their chances of re-election. The one-day collapse hit the market at 2.45pm on May 6, 2010, and caused the Dow Jones to plummet by almost 1,000 points, losing 9 per cent of its total value. By the end of the day, it had recovered most of the losses – hence the term “flash”

What on earth could cause such a catastrophe? Just one lone trader, it is suggested, sitting at a computer screen in Hounslow, had the power to crash the global financial system for long enough to spark a worldwide panic.

Spoofing – is it really a criminal charge, what is it?

E-mail spoofing is the forgery of an e-mail header so that the message appears to have originated from someone or somewhere other than the actual source. Distributors of spam often use spoofing in an attempt to get recipients to open, and possibly even respond to, their solicitations. How does this apply to the financial markets.

The Commodity Futures Trading Commission claim that Sarao put in lots of big orders to sell futures, never intending to actually trade on those orders, to create the impression that there was a lot of selling interest and thus drive the price down.

Spoofing goes like this:

• A trader makes a large bet on or against a security.
• The market reacts to that bet — sending the security’s price up or down.The trader cancels their bet once the market reacts.
• The trader takes advantage of other investors’ reactions by betting on or against the security for real. 
• Spoofing trades don’t make huge amounts of money every time they happen.

Here’s a quick outline of how Sarao allegedly used the “spoofing” technique to manipulate the intra-day price for E-Mini S&P 500 futures contracts trading at the Chicago Mercantile Exchange to net illegal gains of roughly $40 million and nearly bring the U.S. stock market to its knees. E-Minis are stock market index futures contracts based on the benchmark Standard & Poor’s 500-stock index, and are considered the most popular and liquid index futures in the world.

In an attempt to manipulate the market, the government alleges that Sarao placed a large number of sizable sell orders “at different price points” to make it look like there was a big seller in the market and lots of stock for sale as a way to drive down prices, only to then “modify and ultimately cancel the orders before they were executed.” The ruse netted Sarao big profits.