by Liam Vaughan
For members of the case team, the fallout was predictable but irritating. A lot of the coverage seemed lazy and misleading. Yes, it was true that Sarao lived in his parents’ house, wore a tracksuit and drove a moped. But he was also worth $70 million, and could have bought every house on Clairvale Road if he’d wanted to. And, yes, he traded from his bedroom with a comparatively slow connection, but he had also been, for long periods, among the five largest e-mini traders in the world, consistently trading higher volumes than most of the world’s biggest banks and hedge funds. The authorities knew better than anyone how bizarre the facts of the case were, but that didn’t make them untrue, and it was galling to see the fruits of their labour rejected because it didn’t feel right. A common complaint was that the regulators were ‘scapegoating’ Sarao for an easy win, which struck them as ironic given how hard they’d had to work to convince their managers to reopen a case that had already been put to bed.
Still, the agencies had also made life unnecessarily difficult for themselves. In the lead-up to Sarao’s arrest, there had been extensive discussions at both the CFTC and the DOJ about how much emphasis to place on the Flash Crash. Some argued that pinning the events of 6 May 2010, on Sarao was unnecessary and risked weakening the whole case, particularly since the ‘disruptive trading’ provision didn’t come into force until 2011. Others wanted to make the connection as strong as possible for maximum impact. In the end, the agencies took the view that it would be intellectually dishonest not to highlight Sarao’s prodigious spoofing that day. Even so, they agonised over the right set of words. The DOJ’s indictment stated Sarao’s trading ‘contributed to the order-book imbalance that the CFTC and the SEC have concluded, in a published report, was a cause, among other factors, of the Flash Crash’, a formulation that was hard to refute. However, all those layers of nuance were lost after the press office sent out a release with the headline ‘Futures Trader Charged with Illegally Manipulating Stock Market, Contributing to the May 2010 Market “Flash Crash”’. Sarao was duly dubbed the ‘Flash Crash Trader’, and much of the subsequent debate about his innocence or guilt disregarded the hundreds of other days he was trading.
The prosecutors, busy preparing for trial, discounted the media’s fixation with the Flash Crash as an unfortunate sideshow, but the truth was, for Nav, it was profoundly important. Historically, spoofers and manipulators were handled civilly, with fines or temporary bans; so the government’s decision to charge Sarao criminally marked an escalation. He was the first alleged market manipulator ever to be extradited, and some of the counts against him carried sentences of up to twenty years in prison. If the principal reason for this difference in treatment was that Sarao had contributed to a market collapse, then it was essential to determine whether that was valid. One ex-CFTC employee who worked on the original investigation believes the decision to link Sarao to the crash was ill-advised. ‘It’s perplexing to me and others I’ve spoken to why they would make that assertion,’ he says. ‘They should have recognised that it introduces risk into the case, because it’s something they would never have been able to prove. It looks like grandstanding.’ His comments reflect a schism that opened up in the days after the arrest between the authors of the original Flash Crash report and those involved in Nav’s case. Andrei Kirilenko, one of the leaders of the 2010 probe, rejected the notion that Sarao had any bearing on the Flash Crash at all. Speaking to the Wall Street Journal, the economist described the impact of Sarao’s layering orders as ‘statistically insignificant’ and pointed out that the trader’s program was switched off when the e-mini tanked. Others conceded there had been an oversight. We ‘should have seen this,’ said Cornell University’s Maureen O’Hara, who sat on the committee set up by CFTC chairman Gary Gensler to oversee the first inquiry. ‘Nowadays, market manipulation doesn’t just involve the trades. It’s about the orders.’
For academics interested in market microstructure, Sarao’s case reignited a long-running debate about the extent to which unconsummated orders, including spoofs, really impact prices. The University of Houston’s Craig Pirrong, who blogs under the name ‘The Streetwise Professor’, suggested that Terry Hendershott, the UC Berkeley finance professor and expert witness for the government, had shown that Sarao’s trading had such a small bearing on prices that it served only to undermine the CFTC’s case. ‘Yes, Sarao’s conduct was dodgy, clearly, and there is a colorable case that he did engage in spoofing and layering,’ he wrote. ‘But the disparity between the impact of his conduct as estimated by the government’s own expert and the legal consequences that could arise from his prosecution is so huge as to be outrageous.’ It was a view shared by the authors of a paper titled ‘The Flash Crash: A New Deconstruction’, an early version of which was picked up by the press in January 2016, on the eve of Sarao’s extradition hearing. After analysing e-mini and SPY trading data for the first time at a millisecond-by-millisecond level, Eric Aldrich, Joseph Grundfest and Gregory Laughlin concluded that the events of 6 May 2010, were caused by ‘prevailing market conditions combined with the introduction of a large equity sell order [Waddell & Reed’s] implemented in a particularly dislocating manner’, a perspective in keeping with Kirilenko’s. On the subject of Sarao, they calculated that his away-from-the-market spoof orders contributed to a decline in the e-mini of, at most, 0.324 basis points over two minutes compared to the total 500 basis points it actually fell in the five minutes before 1.45 p.m. CET. As a result, they said, it was ‘highly unlikely that, as alleged by the United States Government, Navinder Sarao’s spoofing orders, even if illegal, could have caused the Flash Crash or that the crash was a foreseeable consequence of his spoofing activity’.
Four years after the spoofing rules came into force, questions were once again asked about whether the practice was as heinous as the government suggested. John Arnold, a renowned energy trader and hedge fund manager worth an estimated $4 billion, wrote a piece in Bloomberg arguing that spoofing in the electronic era was actually a necessary counterbalance to the ‘front-running’ perpetrated by many HFT firms. ‘A front-runner profits by gleaning the intentions of legitimate market participants and jumping in front of their orders, thereby causing the original traders to buy and sell at a less favourable price,’ he wrote. ‘But with spoofers in the mix, the picture looks quite different: When the front-running HFT algorithm jumps ahead of a spoof order, the front-runner gets fooled and loses money … Suddenly the front-runner faces real market risk and makes the rational choice to do less front-running.’ The only losers from spoofing, Arnold surmised, were front-running HFTs whose ‘strategies are harmful to every other market participant’. Others disagreed. Kipp Rogers, the owner of an algorithmic trading firm, pointed out on his blog ‘Mechanical Markets’ that all trading, regardless of the time horizon, is ultimately about using data to predict the future, so to describe entities that were particularly adept at it as front-runners was, to his mind, a ‘gross misuse of the term’. Rogers also rejected Arnold’s contention that only HFT firms were impacted by spoofing, arguing that all participants had an interest in the integrity of the marketplace.
Among the independent trading community, Nav’s reputation didn’t turn on whether he caused the Flash Crash or the ethical merits of spoofing. To the dwindling army of day traders, Nav was nothing short of a god, the lone trader who took on the machines and won. For years, human scalpers had been squeezed out by the ‘HFT geeks’ and Wall Street traders, with their innate advantages and connections. Now somebody on a home PC had found a way to fight back, all while sticking two fingers up at the establishment. Who cares if what he was doing was legal; Nav Sarao was a rock star. ‘To be honest I think the guy involved in this story is a trading hero and an inspiration to everyone out there,’ wrote one forum poster. ‘To think he started trading 1 lots 10 years or so ago and is now one of the biggest S&P traders in the world using … software and brokers any one of you can get access to … thats what we all dream of.’
‘The
re’s always been a strong feeling in this industry of us versus them,’ says Tom Dante, an ex-Futex recruit who now coaches trading under the moniker Trader Dante. ‘So when they went after a guy for taking the fight to the HFTs, it seemed completely unfair.’ The day after Sarao’s arrest, the hash tag #freenav started appearing on Twitter. That week, an online petition was launched to protest against his extradition. ‘He is like Galileo,’ remarked one of its signatories. ‘Succeeding to that level is such a rarity, it takes so much work and talent, and when an individual who actually makes it has everything taken away from him it makes me question the integrity of the industry,’ says Alex Haywood, another Futex alumnus who now runs his own arcade, Axia Futures. ‘As traders we were upset because it showed that there is a clear hierarchy and prop traders are at the bottom.’
For the prosecutors, the hammering they received in sections of the press offered a useful insight into the kinds of arguments they might face at trial. In meetings, they read from blog posts and strategised about how to parry various critiques. Still, none of them were immune to the moral complexities of the case, and hearing about Sarao’s difficulties in jail and his psychiatric diagnosis gave them pause. Searching for potential victims of the trader’s alleged crimes, the CFTC and DOJ visited the owners of some of the biggest and most profitable HFT firms. After meeting one particularly obnoxious young multimillionaire, who greeted them in his palatial high-rise office wearing flip-flops and a Hawaiian shirt, they joked to themselves: ‘So, these are our victims?’
One individual whose perspective never faltered was Mr X, who watched the circus that grew up around Sarao with a sense of bewilderment. ‘The main problem in understanding the event in my view has always been the odd obsession with finding a single cause,’ he says. ‘People either believed he caused the crash or that he didn’t. It has been somewhat comical from my perspective. The markets are very complex systems. Instead of focusing on agent interactions, everyone wanted to find out who pulled the plug.’ Asked whether, after learning of Sarao’s identity, there was any part of him that respected what he’d pulled off, Mr X replied: ‘I think it is rather odd that you ask if I “grudgingly respect” someone for committing massive fraud. No, I don’t. I don’t respect anyone who steals money from other market participants. No matter how clever they are or how justified they feel. Sarao did not target high-frequency traders. He was not a victim of the markets. He stole money from all participants without a specific focus. He tried to make the most money he could by using common cheating techniques. His “genius” was his lack of fear and belief that he would never face the consequences. This allowed him to cheat massively with enormous size over a long period of time. The size and volume was a large ingredient to his success. And I’m not aware that he gave his money away like Robin Hood. There’s nothing admirable about stealing money for your own personal gain.’
CHAPTER 23
ALL IS LOST
After his release from Wandsworth, Nav eased back into a familiar routine. Having no access to money barely impacted his life, and he filled his days playing badminton in the garden with his brother’s kids, visiting the local shopping centre, and going to McDonald’s. When he could, he joined his old schoolmates in their weekly game of football. Three times a week, he cycled to a nearby police station to sign the register. He’d bought himself a bright yellow, Lamborghini-branded bicycle for £200, and it amused him to ask people, ‘Do you like my Lambo?’ One day his barrister, James Lewis, a man who had once helped the Spanish government secure the extradition of General Pinochet, came over to the house to observe him trading on a demo. By now, Nav was convinced that the anonymous whistle-blower who had reported him was one of the big American HFT firms acting in cahoots with the Justice Department, and he was optimistic that when all the facts were known he’d be exonerated. That faith was tested on 2 September when the DOJ published its indictment, which contained a raft of damning new evidence.
Four months earlier, shortly after Nav was arrested, the CFTC was contacted by Shayne Stevenson, Mr X’s attorney, with news of a strange development. After seeing Sarao’s name in the press, Mr X’s developer – the quiet one who had operated the software during the whistle-blower’s presentation, and who had been dubbed ‘Crazy Eyes’ – recalled that he himself had previously exchanged emails with Sarao that he thought the agency should see. When the printouts arrived they showed that, in January 2009, before Sarao contacted Trading Technologies for the first time, he had hired Crazy Eyes to build his spoofing program for him. It was a twist that was hard to fathom: the same coder whose software Mr X would go on to use to identify Sarao’s spoofing had previously worked on a prototype of the program that would become NAVTrader. He’d never actually succeeded in building a system to Nav’s satisfaction, and the project was abandoned after a few months before any money changed hands. But Nav was considerably more candid in his correspondence with Crazy Eyes than he would be with the later developers. ‘If I am short I want to spoof it down,’ Sarao wrote in one email from 1 February 2009. ‘If I keep entering the same clip sizes, people will become aware of what I am doing, rendering my spoofing useless,’ he remarked on 24 February. ‘I’ve tried phoning you and e-mailing you … I need to know whether you can do what I need, because at the moment I’m getting hit on my spoofs all the time and it’s costing me a lot of money,’ he wrote three days later.
The CFTC quickly called the DOJ to share the news. There was something uncanny about the way the evidence had materialised. None of the messages had shown up in the email search warrant, presumably because Sarao had taken pains to delete them, and the language was so explicit, so on the nose, it seemed almost too good to be true. Alive to a potential conflict of interest, the prosecutors made sure the developer didn’t stand to benefit financially from any reward Mr X might receive, and ordered the programmer to preserve his hard drive in case the authenticity of the emails was ever called into dispute. When questioned, Crazy Eyes said he’d simply never linked the two episodes in his mind. By now, more than five years had passed since the emails were exchanged, meaning the statute of limitations had elapsed and the authorities, grateful for the developer’s assistance, didn’t look to pursue charges against him for his role in developing Sarao’s prototype.
For Nav’s camp, seeing the emails in the indictment was a devastating blow: hard, irrefutable evidence of Sarao’s intent. To give them time to respond, the judge agreed to push back the extradition hearing until February 2016. There were still potential legal challenges they could raise, not least the argument that the rules governing spoofing were so vague, so unevenly enforced and so widely misunderstood as to be unconstitutional. However, the question of when and how the lawyers were going to get paid remained unresolved. IXE had reneged on its promise to release some of Sarao’s money early. Over the course of the winter, the outlook only grew bleaker.
On 19 October, Igor Oystacher, Sarao’s long-standing rival and one of the last surviving point-and-click behemoths, was charged by the CFTC with spoofing and ‘employment of a manipulative and deceptive device’ in the e-mini, as well as in copper, crude oil, natural gas and volatility futures – allegations he strenuously denied. Part of the narrative Sarao’s lawyers were looking to spin was that the US authorities had arbitrarily targeted a solitary British trader while others got a free pass. Now, in the case of Oystacher at least, that was no longer true. Oystacher’s MO – like the legendary Flipper’s before him – was to place mammoth orders on one side of the market, wait for other entities to follow suit, and then, once the market had moved a few ticks, use TT’s ‘avoid orders that cross’ function to switch direction and hit into them with a single click of the mouse. He’d used the tactic for years and maintained it didn’t constitute spoofing, because he never knew which orders he planned to execute or cancel in advance. An affidavit written by the CFTC showed that the agency had started investigating Oystacher after HFT firms, including industry giant Citadel, complained. The Russian�
�s sleight-of-hand, carried out in real time with a mouse, apparently made it impossible for Citadel’s sophisticated algos to predict which way the market was about to move with the level of certainty they were accustomed to. Oystacher was indignant at the idea that the enforcement agenda was being set by the world’s most powerful HFT firm, and he chose to fight. Like Nav, he hired Kobre & Kim to defend him.
A month later, the whole futures industry looked on as the first-ever criminal trial for spoofing took place in Chicago. The defendant, who was also charged with commodities fraud, was a barrel-chested, fifty-three-year-old former pit trader from Brooklyn named Michael Coscia who paid his way through college delivering mail and was the antithesis of the new breed of computer whiz kids. When the pits closed, Coscia had started his own screen-based trading firm, and in 2011 he asked a programmer to build an algo that would allow him to, according to an email preserved by the coder, ‘pump the market’. It was a landmark case, and Coscia hired a Murderers’ Row of New York attorneys from Sullivan & Cromwell, including a future head of enforcement at the SEC, a former general counsel at the CFTC, and the lead prosecutor in Martha Stewart’s insider trading trial. Over the course of a week, the polished defenders took turns explaining to a sometimes befuddled-looking jury that cancelling orders was standard practice, algorithmic trading was the norm, and the nascent spoofing rules were ambiguous and ill conceived. They painted Coscia as a humble family man, a ‘stand-up guy’ struggling to compete in a world of machines, and emphasised that he’d only used his algo for two months in 2010 when the disruptive trading rules were still being debated. Coscia had already agreed to pay fines of more than $3 million to various civil authorities in 2013, and he’d been under the impression that the matter was closed until the DOJ knocked on his door a year later, reigniting the trauma.