Flash Crash

by Liam Vaughan

  FLASH CRASH

  A TRADING SAVANT, A GLOBAL MANHUNT AND THE MOST MYSTERIOUS MARKET CRASH IN HISTORY

  Liam Vaughan

  Copyright

  William Collins

  An imprint of HarperCollinsPublishers

  1 London Bridge Street

  London SE1 9GF

  WilliamCollinsBooks.com

  This eBook first published in Great Britain by William Collins in 2020

  Copyright © Liam Vaughan 2020

  Liam Vaughan asserts the moral right to be identified as the author of this work

  A catalogue record for this book is available from the British Library

  All rights reserved under International and Pan-American Copyright Conventions. By payment of the required fees, you have been granted the non-exclusive, non-transferable right to access and read the text of this e-book on-screen. No part of this text may be reproduced, transmitted, down-loaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any form or by any means, whether electronic or mechanical, now known or hereinafter invented, without the express written permission of HarperCollins

  Source ISBN: 9780008270391

  Ebook Edition © May 2020 ISBN: 9780008270414

  Version: 2020-04-27

  Dedication

  FOR SUZI AND RUFUS

  CONTENTS

  Cover

  Title Page

  Copyright

  Dedication

  Prologue

  ACT ONE

  1. Work Well Under Pressure

  2. The Boy Plunger

  3. That’s a Fugazi

  4. The Trade I

  5. Rise of the Robots

  6. End of an Era

  7. The Trade II

  8. A Brief History of Spoofing

  9. Building the Machine

  10. The Crash

  ACT TWO

  11. The Aftermath

  12. Milking Markets

  13. The Dust Settles

  14. Thought Crime

  15. Pimp My Algo

  16. Jesus Enters

  17. Mr X

  18. NAVSAR

  19. Cornbread and the CME

  20. MINDGames

  ACT THREE

  21. Where’s the Money, Nav?

  22. #freenav

  23. All Is Lost

  24. Come to Jesus

  25. Catch Me If You Can

  Epilogue

  Author’s Note

  Footnotes

  Notes

  Acknowledgments

  About the Author

  Also by Liam Vaughan

  About the Publisher

  PROLOGUE

  At 6 a.m. on a cold, dark Tuesday morning in April 2015, half a dozen plainclothes police officers, two FBI agents, and two prosecutors from the US Department of Justice rendezvoused at a McDonald’s in Hounslow, on the outskirts of London. In a former life, the mock-Tudor building, nestled on a busy roundabout near Heathrow Airport, was a pub called the Traveller’s Friend. Now it was like any other McDonald’s: nursery-school colours, stark lighting, the smell of burning fat and disinfectant. The group exchanged bleary-eyed hellos and commandeered a quiet corner, where they ran through the plan one last time. Then, as the sun crept up to reveal another grey day in suburbia, the officers departed to carry out a mission two and a half years in the making: to capture one of the world’s most dangerous and prolific market manipulators.

  While the officers and agents edged out of the car park, the prosecutors, Brent Wible and Mike O’Neill, settled in and ordered breakfast. It was their investigation, their baby, but since they were on British soil, Scotland Yard was handling the arrest and they’d have to make do with receiving updates by phone.

  Their target was a thirty-six-year-old Londoner named Navinder Singh Sarao, who’d made $70 million from nothing in the US futures markets using a variety of controversial methods and who, in the American government’s reckoning, had helped precipitate the most dramatic market collapse in recent history, the so-called ‘Flash Crash’ of 2010.

  The Americans had been monitoring Sarao from afar for months, reading his emails, tracing his assets, interviewing his associates and observing his comings and goings. Yet none of the investigators had met him, and he remained something of an enigma. They knew that Sarao traded alone from his parents’ house, and that he prided himself on being a stranger to Wall Street and the world of high-frequency trading, or HFT, which he derided as being full of ‘geeks.’ But records showed that he routinely placed bigger bets than the world’s largest banks and hedge funds. They’d heard stories of Sarao terrorising staff at the Chicago Mercantile Exchange, the electronic marketplace where he plied his trade. One employee was left shaken when Sarao, in an accent somewhere between cockney and London rudeboy, threatened to cut off his thumbs. Yet Sarao’s brokers described him as a pussycat who got lost on his way to their office.

  It took the officers five minutes to get to the address, a beige, two-storey, semi-detached house with a plastic porch and a satellite dish that was indistinguishable from those around it. Sarao’s parents had bought it in 1982, a few years after arriving from the Punjab in India. Hounslow has a large Sikh community, and, because it lies underneath Heathrow’s flight path, property in the area is cheap. Nav had watched planes roar overhead close enough that he could count their windows since he was three years old. Growing up, he’d held running races with his two older brothers and the neighbourhood kids where the police now parked their unmarked vehicles. These days, as the DOJ knew from tracking his IP address, Sarao led a more nocturnal existence, trading US markets until around 10 p.m. and then staying up till 3 or 4 a.m. He rarely roused before noon, and when one of the phalanx of officers rang on the doorbell at 8 a.m., Sarao was fast asleep.

  Nav’s father, Nachhattar, a short man with a grey beard, answered the door. After gathering his composure, he shouted to his son to get out of bed and come downstairs. Nav emerged in the hallway in baggy tracksuit pants and a sweatshirt, strands of thick black hair pointing skyward. ‘Mr Sarao, I am with the Metropolitan Police,’ said the officer in charge of the operation. ‘We are here to arrest you for fraud and manipulating the market. You do not have to say anything, but it may harm your defence if you do not mention when questioned something which you later rely on in court. Anything you do say may be given in evidence. Do you understand?’

  By now the commotion had caught the attention of the neighbours. Nav’s mother, Daljit, who was babysitting across the street at her eldest son Rajvinder’s house, stumbled home in a daze. Residents peered out through net curtains. Police weren’t an uncommon sight in Hounslow, one of West London’s poorer neighbourhoods, but they rarely arrived so mob-handed, and nobody could comprehend what they might want with the Saraos, a humble, respectable family who kept to themselves and attended the local gurdwara.

  Nav was told to shower and grab some clothes while his parents waited silently in the kitchen. When he was finished, the officers began searching the property. Nav’s upstairs bedroom was musty and unkempt. There was a single bed, a Labrador-size stuffed tiger, a large TV hooked up to a games console and a cabinet that contained mail-order pomades and lotions to promote youthful complexion and stimulate hair growth. Against a wall was a framed pair of pink Adidas football boots signed ‘To Nav, from Lionel Messi’. A full-size replica of the Jules Rimet World Cup trophy stood in a corner.

  The scene of the alleged crime was a small workstation at the end of the bed that housed Nav’s computer setup. There seemed to be nothing state-of-the-art or terribly unusual about it: a desktop with three screens connected to a standard broadband line; a couple of Samsung hard drives; and a slightly dated-looking camcorder. So this was wher
e Sarao had amassed a fortune and brought the global financial system to its knees? It was difficult to fathom.

  Back at McDonald’s, the prosecutors waited for confirmation Sarao had been arrested, then called Jeff Le Riche, an attorney with the Commodity Futures Trading Commission, who was waiting in his house in Kansas City, where it was 3 a.m. The CFTC, the designated regulator for the futures industry, had begun investigating Sarao on a tip-off back in 2012. But as a civil body it has limited powers, so it referred the matter to the DOJ in 2014. Now they were working together. After getting the go-ahead, Le Riche, the head of the CFTC’s investigation, fired off a series of prewritten emails instructing Sarao’s brokers and offshore banks to freeze his accounts.

  Sometime before noon, Nav was handcuffed and led outside. As they were leaving, he said to one of the officers, ‘Wait a minute, bruv.’ There was a football match on television that night, and Nav wanted to run upstairs and record it. ‘I’m not sure you’ll have time to watch that, son,’ came the reply. The officer was right. Sarao wouldn’t set foot back in his home for another four months. By then he would be known around the world as the ‘Flash Crash Trader’ and the ‘Hound of Hounslow’; the scourge of the markets or a modern-day folk hero, depending on whom you asked.

  That afternoon, both the DOJ and the CFTC sent out press releases announcing the arrest. They made for dramatic reading. ‘A futures trader was arrested in the United Kingdom today on US wire fraud and commodities fraud and manipulation charges in connection with his alleged role in the May 2010 “Flash Crash”,’ the DOJ statement said. Sarao ‘used an automated trading program to manipulate the market’, it went on, earning ‘significant profits’ and contributing to a ‘major drop in the US stock market’.

  For a multitude of reporters and finance professionals, the announcement was shocking and bizarre. For one thing, the Flash Crash – that apocalyptic half-hour spell when markets around the world collapsed before bouncing back again, and stocks temporarily changed hands at 0.0001 cents – had occurred almost five years ago. Senate hearings, academic papers and countless articles had followed, but there was little consensus as to what had caused the meltdown. Now, seemingly out of the blue, the American government claimed to have solved the mystery: it was a lone-wolf day trader in London who learned his craft in an out-of-town arcade above a supermarket.

  The releases raised more questions than they answered. If what the government was claiming was true, why had it taken the authorities so long to take any action? Why was there no suggestion of market manipulation in their contemporaneous 104-page report on the crash? And what did it say about the stability of the modern global financial system if a solitary individual with a PC and an Internet connection could wreak such havoc? Sarao was accused of something called ‘spoofing’, whereby a trader places a bunch of buy or sell orders, enticing other participants to follow suit, then cancels them before they are executed, with the goal of nudging the market higher or lower. It was a brand-new offence – Sarao was only the second individual to be criminally charged with spoofing, and the first non-US citizen – and a controversial one in financial circles because its victims were predominantly hugely profitable high-frequency trading firms whose modus operandi was to monitor other participants’ orders and try to jump ahead of them using lightning-fast computer systems. Some people argued spoofing actually made markets fairer by curbing the rising dominance of those entities Michael Lewis dubbed ‘Flash Boys’ in his 2014 book of the same name. Regardless, since the first days when commodities were bought and sold using hand gestures in the open air, misdirection and gamesmanship had been considered part of the cut and thrust of financial markets. Now, with the backing of the HFT industry, spoofing had been declared illegal. It was as if bluffing had been outlawed in poker.

  The US authorities were careful to assert that Sarao’s antics had only contributed to the crash, but that nuance was lost in the ensuing press coverage. ‘How One Man Crashed the Stock Market,’ ran a typical headline. By late afternoon, journalists and TV crews had massed on Sarao’s cul-de-sac. Nav’s parents were unable to provide them with any answers. ‘I don’t know about computers,’ Nachhattar told one reporter. ‘All this is news to me.’

  The tale that would eventually emerge was a wild one, and beneath it was a bigger story, about how the markets that determine the value of our companies, the cost of our food and fuel and the size of our pensions had morphed in a few short years thanks to advances in technology that promised much but whose risks may not yet be fully understood. It is the story of the emergence of a new financial elite, whose intellect and superior understanding of the plumbing undergirding the financial system allowed them to cream billions of dollars from ordinary investors while regulators sat comatose at the wheel; and of the human cost when an industry is automated and robots replace people. Most of all, though, it is a story about what happens when one man refuses to accept the cards he is dealt and instead decides to fight back, to hell with the consequences.

  ACT ONE

  CHAPTER 1

  WORK WELL UNDER PRESSURE

  ‘Wanted. Trainee Futures Traders,’ ran the small ad in the Tuesday edition of the Evening Standard newspaper. ‘Applications are invited from graduates who can demonstrate the following skills: highly motivated; analytical approach; disciplined; goal orientated; work well under pressure.’

  Nav was two years out of university when he sent his CV to Independent Derivatives Traders at the start of 2003. After graduating he’d spent a miserable slog doing telesales for Dial-a-Phone, then taken an admin job on the foreign exchange desk at Bank of America, where the closest he got to trading was booking trades for the posh folks on the floor. By the time IDT invited him to Weybridge, in Surrey, for an interview, he was unemployed and restless.

  Nav might not have known it yet, but he was uniquely well suited to the job. When he was three years old he learned his times tables after stumbling on a Little Professor electronic game. By the time he got to school he could multiply longer numbers in his head. It wasn’t that the answers appeared, fully formed, when he saw a question. The trick lay in his memory. Where other children scrawled their workings on a piece of paper, Nav could hold each step, naturally and easily, in his brain. In high school, the problems got harder but he found he still didn’t need a calculator. Maths and science were his best subjects, but he picked up As and Bs across the board without much effort. Heston Community School was no place for teacher’s pets, and Nav made sure nobody mistook him for one. He played practical jokes, was cheeky and rarely showed up to class on time. Beverley Fielder-Rowe, his form tutor, recalled ‘a very likeable young man, very intelligent’ who was ‘full of fun’. A classmate described him as a ‘prankster’ who ‘got away with things’.

  Schoolwork came easily to Nav, but his abiding love was football; he and his friends played constantly. In the summer, they cycled to the park in replica kits and kicked a ball until it got dark, stopping only to refuel at the fish-and-chip shop. Nav always insisted he play striker, the glory position, stalking the opposition goal and dispatching opportunities with icy precision. Later on, his attention turned to computer games, particularly the football game FIFA. Every time a new edition came out, he devoted hours to perfecting the new moves, eventually ranking in the top seven hundred out of three million players globally. Unusually, Nav didn’t support an English team. Being part of a community was less important to him than who was the best, and he followed Barcelona.

  In 1998, Nav had temporarily left home to attend Brunel, a mid-tier university a few miles from Hounslow, where he studied computer science and maths. Like many students, Nav and his friends were broke. But one of their housemates always seemed to have cash. One day, Nav asked him how he could afford such expensive clothes. ‘Trading,’ came the response. At the time, the dotcom bubble was in full swing, and Nav’s friend had deposited his student loan into a brokerage account and was now funding his studies by buying and selling tech stocks. How ha
rd could it be, thought Nav. He started devouring anything trading-related that he could, scouring the Internet for stock tips and ploughing through textbooks on financial theory then opening an account of his own and placing some tentative trades.

  IDT was based above a Waitrose supermarket. To gain entry, visitors had to walk around the back of the store and up a staircase. Inside were two main rooms, the larger of which, the ‘trading floor’, had around a dozen desks containing computers with connections to the world’s major commodities exchanges. On first glance, it didn’t scream high finance: the décor was drab, the equipment was dated and it overlooked a car park. Weybridge, a well-heeled, sleepy town surrounded by golf courses and car showrooms, was also an odd location for a trading firm. Forty-five minutes by train from the skyscrapers of the City of London, the capital’s historic financial district, it was literally and figuratively miles from the action.

  IDT was one of a burgeoning number of arcades or ‘prop shops’ sprouting up in Britain and the United States. The business model was straightforward and, for a while at least, highly lucrative. IDT would take on a bunch of wannabe traders and teach them the skills they needed to succeed in the markets. Those who thrived were backed with steadily larger sums, while those who failed were cut. Any profits the recruits made after paying a monthly desk fee of around $1,700 were split, with newbies retaining 50 per cent and the most successful as much as 90 per cent. IDT also creamed off a small sum on each trade, or ‘round-trip’, its traders placed, which quickly added up. The arrangement meant it didn’t matter if everyone in the stable was making money as long as they were all buying and selling and there were at least some big winners. As the owner of a rival arcade put it: ‘During the gold rush, it was usually the ones selling the spades who got rich.’

  For a generation of ambitious graduates brought up watching Wall Street and Trading Places but lacking the grades or connections to land a job at JPMorgan, the opportunity was irresistible. The best day traders, they were told by IDT in a rousing speech on arrival, could make their own hours, wear flip-flops to work, and still pull in footballer money. All they had to do was correctly predict whether the market would go up or down more often than they were wrong, and they would be rich and free. The reality, of course, was that it was very difficult to consistently beat the market after costs, particularly when you were so far from the flow of information.