Did Navinder Sarao Cause the 2022 Flash Crash?

The Wolf of Wall Street? Or The Hound of Hounslow...

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Back in Apr 2022, as a fresh faced writer, I published a mail on LinkedIn expressing my shock at the arrest and possible extradition of Navinder Sarao, now known every bit "The Hound of Hounslow". You tin read that original post here.

For those of you interested in the detail, you tin as well read the criminal complaint hither.

Well today, Sarao is now on the verge of being extradited to the United states of america from the UK afterwards his final appeal failed. Let's accept a deeper look into the example.

The Flash Crash

On the 6th of May 2022, the Wink Crash occurred. This was an unprecedented display of the interconnected state of the financial world which nosotros live in today. From well-nigh 2:30pm for a niggling over half an hour, the S&P 500, Dow Jones Industrial Average and the Nasdaq Composite all collapsed and powered dorsum.

It was a perfect storm of conditions which ultimately likely led a large number of automated trading algorithms going haywire with the cease event being a temporary, just dramatic loss of about $1 trillion in market value, before subsequently recovering.

At the same time, individual stock prices were also going basics with many companies' stock price collapsing to one cent per share and others going to $100,000 per share.

Given the number of peoples' pensions which are currently tied up in the global financial arrangement of stocks and shares among others, it's understandable that this would cause great business organisation for the powers that exist.

Extradition

In the years since then, many theories have been presented nigh the cause of the Flash Crash. Nothing particularly has been proven, but ultimately it seems that the "cause" of the crash was identified. Navinder Sarao, trading from his parents' house in unremarkable Hounslow, West London is declared to exist the cause of ane of the largest financial crashes in history.

What took place today was the final roll of the dice for Sarao to prevent his extradition to the US to face 22 diverse charges which could run into him jailed for a little nether 400 years. The high court ruled that the US has indeed met the criteria for dual misdeed (the requirement for extradition to continue, showing that the charges being brought are a crime in both the US and Uk), meaning that the extradition will go ahead in the side by side 28 days.

So What Actually Happened?

The Flash Crash visualised

Well, this is a difficult ane to pin down. I've spent years supporting, designing, building and managing trading systems which are designed to work in a highly automated fashion and there are a few relevant things I can say on this topic:

The rise of electronic trading has given tremendous value to investors. Spreads accept collapsed pregnant that whenever your pension fund manager needs to merchandise, they can practice so with a much lower level of liquidity adventure than they could in the good onetime floor days.
At the same time, the ascent of electronic trading has given huge cost increases to liquidity providers who pay a fortune to non exist left hung out to dry out when the market place moves.
Somehow those costs have to be recouped and a margin obtained to keep the liquidity providers in business.
Liquidity breeds tighter spreads as liquidity providers compete for business, which of course benefits finish investors.
The fragmentation of liquidity with given instruments trading at multiple venues has given rise to ever more complicated means to endeavour to brand money for those who provide liquidity and the ascent of unofficial liquidity provision in the course of High Frequency Trading where the participant may not be an bodily designated liquidity provider/market maker.
There are nevertheless liquidity crises happening on a very regular basis, not least of which was in the United kingdom pound sterling mini-wink crash which took identify a week agone where the Pound fell through the floor in late trading to $i.xiv.
There are links all over the place between completely disparate instruments which accept no logical relation to one another other than the fact that a single business firm holds a position in both and an algorithm to govern some caste of activeness betwixt the two (or more) instruments.

Add up all of the above (and a lot more besides, this is an extremely high level view) and you are left with a very fragile organisation, one which can hands snowball out of command as it has clearly done before and will proceed to do so until the fundamental rules of the game are changed.

Ultimately, systems like this increase the likelihood of… let'south create a new term, I'm going to call it "Chain Hazard". The adventure that is imbued when black boxes trigger each other in a never-ending concatenation of events which can only be stopped by some kind of excursion breaker pulling the plug.

This is ultimately what caused the Flash Crash.

Layering and Spoofing

Spoof, no not that kind of spoof...

There are two fundamental flaws hither. Layering is an extremely common action (whether done visibly or not) and spoofing is difficult to prove due to the concept of intent.

Consider this theoretical situation:

You are investment banking company 123. You get a rebate on your trading fees from stock commutation XYZ if you agree to go a market place maker on XYZ. Market makers are contractually obligated to provide a purchase and sell price on a given asset for a percentage of time that the asset is open for trading.

Typically a defended marketplace maker (also known every bit liquidity provider) looks to trade and make their profit from the pennies per trade they execute between the bid and offer prices from other people looking to buy or sell. It's the typical stack 'em high, sell 'em cheap approach. Merely you may deport some gamble with this kind of activity of grade considering your position is unlikely to be apartment if yous are actively trading.

As ABC, you don't want to have to practise trading and acquit risk if you can avoid it, that sounds too much similar difficult work, you lot just want to fulfil your obligation and earn the rebate from the XYZ for the least possible effort without carrying run a risk from market making. And so you concur to the scheme and set your stall out every bit a market maker.

So now to the question. If you're looking to comport the to the lowest degree risk possible from beingness a marketplace maker and are obligated to quote a toll, how can yous do that? Well, you want to ensure your prices don't merchandise. How is that doable? Unproblematic, you lot make your prices unattractive. Would you purchase a gyre of toilet paper for a trillion dollars? Of course not. Would you sell the Mona Lisa for 50 cents? Sure, there would be people clamouring to buy information technology from you, simply that'd evidently be a bad trade for yous. So you may endeavor to misprice the nugget you're dealing in. If you offer to sell Nvidia stock for a one thousand thousand bucks a share and buy information technology at i cent per share, nobody will trade with you right?

Unfortunately it'south non that elementary. Exchanges typically have rules which market place makers must adhere to, concepts such as the maximum spread or altitude from current price pitter-patter in. Maximum spread for case allows you to set whatever purchase price you want, only your sell price can exist no more than 10 away from your buy price. And then if you ready your price yous're willing to buy Nvidia stock at 1 cent, perchance the maximum you're allowed to sell information technology at is 10 cents. This is bad because in that case, of form anybody volition exist buying it from you at 10 cents all twenty-four hours long and never buy from you.

So equally ABC you have a trading system which works out the furthest price away from the current cost of Nvidia yous tin quote and still meet your obligation to the exchange, every fourth dimension the price of Nvidia shares moves, you shift your toll (either by cancelling the erstwhile one and submitting the new one or by updating the existing prices). And so if the current bid and offering is $65.98 on the bid and $66 on the offer, y'all maybe take your prices at $sixty.seventy to purchase and $71.28 to sell, everyone volition want to trade with the other people get-go because they have much better prices to trade with than you.

At present for the trillion dollar question. If you lot have prices in the market which are equally far away every bit possible from the market price as they can be and however earn you your rebate, and if with every move in the market you shift your prices to continue to be as far away equally possible, ARE YOU All the same TRYING TO TRADE?

Spoofing implies that you are putting prices in the market with no intention of trading. Sure, computers have sped up the amount of time your orders may be visible and available on the society book to trade to fractions of a second, micro or fifty-fifty nanoseconds, merely what is the deviation between one actor who updates their prices frequently cancelling old orders and another? And that dear readers, is the fundamental question which needs to be answered.

Where Practice Nosotros Go From Here?

I fundamentally believe that no one person could have intentionally caused the wink crash. I also fundamentally believe that the current systems of financial markets are systemically inclined towards these kinds of occurrences and as chain gamble in global fiscal holdings increases, we tend towards a organisation where these kinds of occurrences volition get more frequent. It took thousands of years of man history to become to the first flash crash in 2022. The Wikipedia folio for flash crash now lists 3 subsequent ones of annotation, I'm sure at that place are farther examples.

Sarao volition now be extradited (in the next 28 days) to the US to stand trial for these and other counts such equally wire fraud etc over a menses of years, all on the back of his trading activities. Perhaps he was spoofing the market place simply I however feel that the failure here is in the system. Every bit the maxim goes, "don't hate the player, hate the game". The globe has created a game in fiscal trading that breeds these kinds of events, if it wants to forestall them from happening again, information technology needs to change the game.