From what we understand, Mr Navinder Singh Sarao, who is said to live with his parents in a modest suburban semi under Heathrow airport's flight path at Hounslow, is accused of wire and commodities fraud, commodities manipulation and spoofing the market.
Spoofing, where one tries to gain an edge and turn a profit, is a well-known tactic in all markets. The barrow boy who cries 'roll-up, roll-up ladies as I've only got this one box of apples/bedding plants/perfume/jewellery left and they're going fast'. Then promptly proceeds to drag another 10 boxes from the back of his van once you've bought the so-called last one.
Dow Industrial Average in 2010
Similarly with an initial public offering when floating a company on a stock exchange. The bank or broker who is tasked with taking the firm to market, book builders as they are known, spends weeks and months testing the water, gauging interest, getting parties and mates to commit to preliminary bids for X amount of shares. It's as much to do with psychology and putting on a positive spin as it is to do with what the company is really worth; all in the eye of the beholder.
June 2010 E-mini future
Placing an order and then suddenly changing one's mind is not new. Post-flotation many shares drop in value because those who bought changed their mind and promptly sold out. Suggesting that there are plenty of offers out there in order to keep a lid on prices is standard practice in bond markets, especially in the repo market when some issues go 'special' and become very expensive to borrow. This is currently the case in the sovereign debt market, which is lacking liquidity and turnover because of QE.
Sell Orders Placed, Cancelled and Executed
Wall Street swoon
Mr Sarao is also accused of causing the 'flash crash' on the New York Stock Exchange on 6 May 2010, a date permanently etched in the minds of the regulators - who have yet to adequately explain exactly what happened and why. Stock indices collapsed in a matter of minutes, for no apparent reason, the Dow Jones Industrial Average slumped into a black hole 1,000 points deep, only to recoup half of that by the close of business (see chart above). As an aside, it is interesting to note that price slumps are always bad while rallies are always seen as a good thing. Like Animal Farm where "four legs good, two legs bad". Short sellers are evil and the good guys go long.
Buy orders also get cancelled
Mr Sarao was not trading on Wall Street, he was trading stock index futures contracts at the Chicago Mercantile Exchange. The body overseeing this market is not the Securities and Exchange Commission, which ensures equity trading is orderly, but is the exchange itself, which is self-regulating and operated under the umbrella of the Commodities Futures Trading Commission, which regulates and oversees all futures and options trading on a vast array of derivative contracts in the United States.
The exchanges, realising that there was demand from private investors to trade futures (the futures business was originally aimed at market professionals and wholesalers) decided to introduce smaller-sized contracts which cost less to get involved and each pip move is worth smaller amounts. He specialised in E-mini S&P 500 futures, electronically traded on Globex, the CME's platform, and worth $50 times the index. With the S&P 500 trading at 2100 that makes one contract worth $105,000 - not so tiny really. The minimum price increment is 0.25 so one would stand to make or lose $12.50 on a move from 2100.00 to 2100.25.
Brokers, fees and clearing
In order to buy or sell any futures contract you must have an arrangement with a broker to transact the deal and put up initial margin to keep the contract open overnight. For speculators in the E-mini this currently stands at $5,060, which is returned to you when the position is closed. Initial margin varies over time and between contracts. Originally the amount set was equal to the maximum daily loss because the market has a maximum daily price limit - up or down.
Exchange traded futures and options held overnight are 'cleared' by clearing houses, CME Clearing in this case. Clearers act as intermediaries between the buyer and the seller so that counterparty risk is eliminated. In this way, the very smallest trader is on an equal footing to the biggest investment bank, creating a multi-dimensional playing field. CME Clearing is proud to handle over one billion transactions per year worth over $1,000 trillion. Is it, like London's LCH.Clearnet, too big to fail?
A daily settlement price is agreed at the close of business each day and all positions are marked to market. Those who have lost money must wire this amount to their broker which, via the clearer, is credited to the winning side's account. Every day, and in very hectic markets at any point during the day too if necessary, all trades are paid up in full. Failure to comply at once will ensure the lossmaking position is closed out at whatever price is available. Thus, everyone starts afresh at square one daily. Each transaction incurs a small fee from the exchange and a slightly bigger one by the clearer so volume hits their bottom line directly. It is in their interest to have deep pools of liquidity.
Members of the exchange, in consultation with the clearer, are free to change these rules at will. The Bunker-Hunt brothers tried to corner the silver market in 1979-80 by buying bullion and futures, at first surreptitiously because the practice is outlawed in the US. When Commodities Exchange members realised they were losing money hand over first by selling to the brothers, they increased variation margin until the pair had no more money and were forced to sell their silver - forced to return profits to their counterparties.
Futures were designed for both hedging and speculation. Wheat and corn contracts on the Chicago Board of Trade so that farmers could sell expected harvests and lock proceeds at a pre-agreed date and place. Processors and operators would buy the contracts as they too could guarantee their costs. Leverage, based on a $5,060 initial margin for an E-mini contract worth $105,000, makes futures so attractive to speculators.
Learning to trade
That Mr Sarao had some sort of edge I think there is no doubt. He honed his skill at one of the older trading academies of its kind, Futex, based in genteel Woking, and he may have placed his orders from its trading room - which no doubt has fast internet connections. Futex also encourages talented traders by setting them up with seed money for their first trades, taking a cut of the profits, of course. It is claimed that he did not use high-frequency trading - where computers set off lots of buy and sell orders. His trades might involve an algorithm of some sort, or it could be an innate skill. Certainly we have come to revere some especially talented investors, such as Jesse Livermore the 'boy plunger' who made and lost multimillion dollar fortunes in the stock market crashes of 1907 and 1929, and today's 'sage of Omaha', Warren Buffett.
The big question: who is the whistleblower who alerted the authorities to Mr Sarao's profits? The exchange and the clearing house want his business, so not them - and they have detailed data on every one of his orders. Perhaps other exchange members who were losing money too regularly for their liking. Once again, regulators were asleep at the wheel. Five years later they just need someone, anyone, to blame for an embarrassment of epic proportions.
MORE FROM NICOLE ELLIOTT...
Nicole Elliott is a long standing Member of the Society of Technical Analysts and has just taken over the IC's trading coverage. She is regularly interviewed and quoted by the financial media, is a conference speaker, and author of several books on charting.
