Flash Crash

by Liam Vaughan

  Absent from the agencies’ 104-page report or the myriad interviews and speeches that CFTC and SEC executives gave on the subject in the months that followed was any mention of spoofing or market manipulation. A preliminary version of the report cited a ‘significant imbalance of sell orders and buy orders’ in the e-mini that ‘contributed to a sudden liquidity dislocation’, but there was no attempt to consider what lay behind the imbalance; nothing, in other words, to tie the maelstrom to a solitary trader with a homemade algorithm on the outskirts of London who would one day become synonymous with it.

  CHAPTER 12

  MILKING MARKETS

  On a brisk spring morning in 2010, two men in suits, one in his sixties, the other in his early thirties, waited outside an elegantly understated brick town house in London’s historic legal district rubbing their hands to keep warm. They had an appointment inside, in the luxuriant ambience of Pump Court Tax Chambers, but their client was irritatingly, characteristically late. More than an hour after the allotted meeting time, a figure lolloped towards them wearing a beanie and an old pilot-style leather jacket over what appeared to be a Superman T-shirt. In his hand was a brown paper bag from McDonald’s. ‘Nav, great to see you!’ the older man, Paul James, said with a smile. Nobody mentioned the time.

  James was a partner at a firm of accountants called Advanta based in the English seaside town of Eastbourne that specialised in looking after futures traders, including Nav. He also had a side business introducing clients to investment opportunities and tax schemes for which he received commissions that augmented his accountant’s salary. As Nav’s assets had soared, the trader had expressed an interest in finding new ways to make money, and James lined him up with his contacts, including his younger companion that day, Miles MacKinnon. Once inside, the three men were taken to a meeting room filled with legal tomes where they were met by Andrew Thornhill, one of the country’s preeminent tax barristers, as well as a fifth individual, who specialised in offshore finance and who had organised the meeting. On the agenda, a subject close to all their hearts: what to do with Nav’s large and rapidly expanding fortune.

  Since 1969, Thornhill had been advising aristocrats and business magnates on how to structure their affairs to minimise tax without falling foul of the perennial foe, Her Majesty’s Revenue & Customs. Not many of them had shown up to his meetings eating a Filet-O-Fish, but Thornhill took an instant liking to his new client. When Nav summed up his trading strategy as ‘basically in and out, in and out’, Thornhill exclaimed: ‘Splendid!’ How, exactly, Nav made his money was less important than what he planned to do with it, and the young trader had already proven receptive to the idea of getting one over on the taxman. In 2005, while renting a desk at Futex, Nav had set up a one-man company, Nav Sarao Futures Limited. (He resisted a colleague’s suggestion to name it Chavex Ltd.) When his assets jumped from $330,000 to more than $20 million in 2009, James had introduced him to John Dupont, sales director of a firm called Montpelier Tax Consultants that specialised in close-to-the-line but legal tax avoidance schemes. Nav signed up for a plan that involved his company, NSFL, entering into a series of sham, loss-making derivative transactions that slashed his taxable income. Happy with the result, Nav was now amenable to a more substantive overhaul of his operation.

  Thornhill’s proposal, contained in documents that he unwrapped from thin pink ribbons, was for Nav to organise his business around two so-called employee benefit trusts registered on the tiny Caribbean island of Nevis. The first would hold the shares in Nav’s UK company. To pass muster, it would need to be managed at arm’s length by ostensibly independent trustees based in Nevis. The second, established by the company, would house $30 million of accumulated profits, money that would immediately be loaned back to NSFL for Nav to trade with. The structure, Thornhill explained, would allow Nav to use his money without triggering a tax bill. And behind the smoke and mirrors, Nav would be the sole ultimate beneficiary of both entities. To justify an employee benefit scheme of this type, NSFL needed to have more than one employee, so MacKinnon, who was Dupont’s business partner, agreed to join the company as a silent director until the structure was up and running, at which point he’d resign.

  After signing the documents, Nav caught the Piccadilly Line back to Hounslow. A few weeks later, the offshore specialist convinced him to set up another vehicle, this one in Mauritius, which would be used to invest cash that wasn’t tied up in trading. Its name: the ‘NAV Sarao Milking Markets Fund’. Nav paid $2.3 million in professional fees for the work before he’d seen any benefits, 20 per cent of which was kicked back to MacKinnon, Dupont and James for making the connection.

  While his advisers took care of his business affairs, Nav was free to focus on trading. The Eurozone crisis continued to roil markets around the world, and by 2011 Nav’s system, an amalgamation of a modified TT algo and his own rapid-fire scalping, was working better than ever. His best day, by some margin, came on 4 August, when apocalyptic headlines from Italy and Spain collided with weak US employment figures and speculation about a forthcoming downgrade of US government debt, driving the S&P 500 down 4.8 per cent, its biggest drop since the collapse of Lehman Brothers. Nav rode the e-mini all the way down. By the time the market closed, he’d made $4.1 million.

  With so much money piling in, Nav’s biggest problem was knowing what to do with it all. He liked fast cars and expensive watches and trips to fancy night clubs – in theory – but nowhere near as much as he liked the feeling of accumulating wealth; and he found it hard not to view any purchases, no matter how small, as eating into his trading capital. When the financiers and lawyers who now courted him inquired about what he planned to do with his growing riches, he gave a host of different answers, like a child who’s asked what he wants to be when he grows up: build an animal sanctuary; emigrate to Canada and take up snowboarding; give it away to charity; buy a football team in Spain or South America. For Nav, talk of the future was only ever a fleeting distraction from the immediate and unquenchable goal of accruing more money, something his new advisers assured him they could help with.

  SHORT AND stocky, with lightning-fast feet and a low centre of gravity, Miles MacKinnon was destined to be a rugby player. He grew up skipping tackles and scoring tries on the playing fields of Kent, then got into the Harlequins squad, one of the country’s best, before a heart scare forced him to rethink his future. Privately educated and clubbable, if not exactly academic, he bypassed university for a sales job with AXA Sun Life and then Zurich Financial Services, where he was introduced to Dupont, who is five years older and has the blandly reassuring bearing of a Tory politician. MacKinnon lasted less than a month, but the two men stayed in touch.

  For the next few years, MacKinnon worked on commission for a firm that, improbably, lined up investors in dives for sunken treasure. Uncovering doubloons was rare, but clients were compensated by the hefty tax breaks they received thanks to a clause in the law designed to promote risky investments. Meanwhile, in 2005, Dupont left Zurich to take up a management position in Montpelier’s London office. From a bustling room near Piccadilly Circus, his staff cold-called traders and entrepreneurs and pitched them creative ways to cut their tax bill in exchange for 20 per cent of whatever they saved. ‘Everybody there thought they were Alec Baldwin in Glengarry Glen Ross,’ recalls a former employee, referring to the iconic 1992 movie set in the cutthroat world of sales.

  Tax avoidance businesses like Montpelier were engaged in a perpetual game of cat and mouse with the authorities. After identifying a potential loophole in the legislation – around, say, how charitable donations or dividends were treated – they would pay a lawyer to design a scheme and then flog it relentlessly until the Revenue caught up and closed it down. Many of their customers were aware they might eventually be forced to pay the tax but took the view that they were better off having access to the money for a few years. And Montpelier promised to foot the legal bill if it ever came to that. For a while, the going was good.
‘There was a sense that tax was just another cost to be managed, and that anything you could do to eradicate it without breaking the law was fair game,’ recalls one tax consultant. But when the financial crisis hit, the government’s laissez-faire attitude hardened. In 2010, authorities began investigating Montpelier for propagating tax fraud. Its offices were raided and a senior director on the Isle of Man was arrested. Charges against him were later dropped, but the company was shut down and two thousand customers were ordered to pay back $250 million in unpaid taxes.

  Dupont, who was never charged himself, got out before the situation turned ugly. In April 2010, around the time Nav was becoming open to new opportunities, he and MacKinnon started their own company, MacKinnon Dupont LLP (and later MD Capital Partners), a ‘boutique private equity firm’ that connected rich individuals with high-risk, high-reward investment opportunities in exchange for a finder’s fee and, maybe, a slice of equity. They rented a basement office on the outskirts of Mayfair, home of hedge funds, private members’ clubs, and $40-million apartments, and courted introductions from solicitors and independent financial advisers. Finding accountants and IFAs like James, who were willing to send clients their way for a fat fee, was easy. Convincing savvy investors to take a punt on a chain of wine bars, a tech start-up or a speculative gold mining venture – ‘expected return over 5 years is 300%’ – less so. Dressed in bespoke suits and statement watches, they pitched their prospects in the lobbies of five-star hotels. After hours they networked at charity events and clubs like the Worshipful Company of International Bankers. MacKinnon’s style was high-energy and relentless. Dupont was a social chameleon who brought a degree of technical knowledge to the table. They built a roster of half a dozen or so clients, of which Nav was by far the largest investor.

  It’s hard to imagine a more desirable client for a firm like MacKinnon Dupont than Nav. He had a constant flow of money that he seemingly didn’t need or spend, and, with the Bank of England base rate of interest lingering at 0.5 per cent, he was willing to consider anything that would bolster the paltry returns he was getting on his funds. MacKinnon pitched him on the shipwreck scheme, but Nav rejected it point-blank, saying the returns weren’t high enough and he was only interested in projects where he would be the sole or majority investor. While the pair worked up other ideas, they made themselves indispensable. When Nav said he was dissatisfied with his bank, Credit Suisse, MacKinnon organised a meeting with Goldman Sachs. In an office overlooking St Paul’s Cathedral, one of Goldman’s top private bankers delivered his pitch while Nav slurped an entire cup of coffee with a teaspoon. ‘Interesting way to drink that coffee, what was that about?’ MacKinnon asked when they were outside, to which Nav replied that he didn’t normally drink coffee. ‘Maybe don’t get a coffee next time,’ MacKinnon said.

  True to form, in 2011, just a few months after Nav moved his business to Nevis, Her Majesty’s Revenue & Customs announced it would be changing the legislation on employee benefit schemes to stamp out what it described as ‘disguised remuneration’. Under the new rules, Nav had two choices: repay the $30 million he’d ‘borrowed’ from one of his trusts, leaving him with no capital to trade; or cough up in excess of $10 million in tax. Meanwhile, the NAV Sarao Milking Markets Fund, pitched as a stepping-stone to Nav never paying tax again, collapsed before it got off the ground. With Nav facing a quandary, MacKinnon and Dupont introduced him to a semiretired tax expert they knew named Brian Harvey who they thought might be able to help. Harvey had spent years as a tax inspector before switching sides and providing advice from his home on the south coast. After listening to Nav and his advisers explain the problem in a hotel lobby off the Strand, he suggested tearing down the entire Nevis edifice and starting again. A few weeks later, in October 2011, he wrote to Nav laying out the proposal in detail.

  Harvey’s plan, which Nav approved, was even more complicated than Thornhill’s. Based around what’s known as a ‘personal portfolio bond’, it encapsulates why many people regard the offshore financial system with disdain. First, Harvey appointed a small, friendly offshore insurer named Atlas Insurance Management to establish a new company in Anguilla with the name International Guarantee Corporation, or IGC. Next, Atlas established a bond whose only investment was ownership of IGC. Finally, the roughly $30 million in cash sitting in one of the Nevis trusts was transferred into the entity. Officially, Atlas managed IGC. It appointed its directors from its own staff, opened the post and signed off on any decisions. But it was a charade. As IGC’s sole ‘investment adviser’ and beneficiary, Nav had complete control over the entity. If he wanted to take out any money or make an investment, all he had to do was send a request and it would be done. And, under a so-called guarantee arrangement, Nav’s brokers accepted the assets in IGC as collateral, allowing him to continue trading. For this and other assignments, Harvey sent Nav a bill for $510,000. It was a small price to pay for achieving the holy trinity of giving Nav control over his funds, enabling him to trade, and keeping the tax office at bay. There was one issue, though, that even Harvey couldn’t eradicate. As a UK citizen, if Nav ever tried to repatriate his money, he’d be hit with an almighty tax bill. The only way to avoid it would be to take up permanent residence elsewhere. But these were concerns for another day.

  With Nav’s affairs back on track, MacKinnon and Dupont came to him with a new investment idea to catapult him from day trader rich to hedge fund manager rich: wind farms. In Scotland, the incoming government had made a pledge that 100 per cent of the country’s electricity needs would be met with renewable sources by 2020, and to help it get there it was offering subsidies to anyone with a turbine that pumped juice into the national grid. Scotland is Europe’s windiest country, and investors calculated they could make big returns by buying up swathes of uninhabited land and filling it with turbines, all while doing their bit for the environment. Not all residents were happy at the prospect of having their countryside blighted by armies of ninety-foot structures, but MacKinnon and Dupont had a contact in Edinburgh they said was uniquely placed to unlock the country’s riches: a quantity surveyor and property developer by the name of Martin Davie, who had founded one of the first businesses to spring up in response to the government’s renewable energy pledge. Davie’s bedside manner left something to be desired – he’d reportedly brought the inhabitants of Ayrshire to tears during one consultation meeting – but he had struck an exclusivity deal with one of the country’s biggest land banks, giving him an in with a long list of farmers and landowners who were potentially amenable to hosting turbines on their property. Davie suggested he and Nav go into business. Nav would provide the capital – an initial $16 million plus a pledge to provide a further $8 million if it was needed – while Davie would run the operation day to day, identifying sites, arranging for surveys and securing the relevant approvals. When the sites were ready, they would be packaged up and sold to institutional investors. The goal was to develop a portfolio of, to begin with, ten locations capable of producing 500 megawatts. Davie estimated that the enterprise would start making a profit within three years and, based on the going rate for wind energy, be worth more than $400 million after five, a huge return on investment.

  After months of encouragement, Nav warmed to the deal, but he wanted some assurances that his money wouldn’t be squandered. MacKinnon and Dupont suggested setting up a second company to project manage the venture. The pair would sit on the board, keeping a close eye on any outgoings, and Nav could check the expenses. Nav agreed, and in April 2012, the directors of IGC, his offshore company, and the directors of Eco Projects, a company tied to Davie, established an entity on the tax-friendly Isle of Man that they called Cranwood Holdings Limited. Around the same time, MacKinnon, Dupont and Davie incorporated Wind Energy Scotland LLP, the management company, in the UK. Nav handed MacKinnon and Dupont an $800,000 finder’s fee for lining up the deal and agreed to give them a share of his profits once the seed money had been paid back. To celebrate, they went to a bar in
London and drank expensive Scotch, Nav’s watered down with a coke. Navinder Sarao, business tycoon, was born.

  CHAPTER 13

  THE DUST SETTLES

  While Nav mulled what to do with his growing riches, the debate in the United States over high-frequency trading grew louder. CBS’s 60 Minutes aired a segment on the ‘math wizards’ who secretly controlled the market, and scarcely a day passed without reports of another ‘mini flash crash’ involving unexplained blips in stocks like Cisco Systems and the Washington Post Company. On 8 December 2010, two months after the CFTC and SEC published their report, the Senate’s Banking Committee held a hearing titled ‘Stock Market Flash Crash: Causes and Solutions’. Kicking off proceedings, the Democrat Carl Levin said: ‘Today US capital markets, which traditionally have been the envy of the world, are fractured, they’re vulnerable to system failures and trading abuses and they’re operating with oversight blind-spots. The very markets that we rely on to jumpstart our economy and invest in America’s future are susceptible to market dysfunctions that jeopardize investor confidence.’

  Shifting uncomfortably before Levin and the other committee members in the Capitol Hill meeting room were Mary Schapiro from the SEC and the CFTC’s Gary Gensler. The regulators had already taken some steps to address the public’s growing concern. The SEC was introducing circuit breakers to stocks, akin to the CME’s stop-logic, which would automatically halt trading if prices rose or fell too abruptly; and stub quotes, which had resulted in shares changing hands for less than a cent, had been outlawed. On the futures side, the CFTC put forth a rule that would make it illegal for the CME or any other exchange to sell select customers faster access to their servers unless the same opportunities were made available to everyone. Still, there was a sense in some quarters that the authorities were rearranging the deck chairs on the Titanic. The most glaring issue, as articulated by Levin, remained: ‘Traders today are equipped with the latest, fastest technology. Our regulators are riding the equivalent of mopeds going 20 miles per hour chasing traders whose cars are going 100.’