'Flash crash' arrest puts heat on futures market

When it comes to trading US equities, the solitary trader sitting at home has never been a match for a market dominated by power house institutional investors and sophisticated computer systems.

Such a popular perception has been turned on its head by US authorities alleging that an independent trader living on the outskirts of London contributed to one of the most embarrassing episodes for the equity industry and regulators, the "flash crash" of 2010.

In the wake of that 20 minutes of mayhem, which saw stocks plunge in value and quickly rebound, recrimination focused on the role played by high-powered computerised trading systems and a deeply fragmented market. Thanks to regulatory efforts designed to boost competition, trading of US equities occurs across more than 50 venues, necessitating the deployment of rapid fire computers that can link prices across this diverse landscape.

Now the focus of regulatory concern will probably turn to the role played by equity futures listed on the Chicago Mercantile Exchange and why the trading behaviour of one trader had such an outsized influence on the cash equity market. While that will probably be welcomed by high-frequency traders, who have been maligned for some time, observers say US authorities must recognise the need for cohesive regulation and surveillance of cash equities and futures.

The Commodities Futures Trading Commission oversees the futures industry, while the Securities and Exchange Commission has authority for stocks. Exchanges such as the CME are self-regulating entities. This week Paul Volcker, former head of the Federal Reserve, advocated merging these two regulators to improve market oversight.

"Especially with financial futures in which you have the cash equity and the futures contract so clearly interrelated, to have one agency that enforces one half and another that enforces the other half means that they will miss everything that falls through the cracks," says James Angel, a finance professor at Georgetown University.

The outsized role of futures trading on equities was highlighted on Tuesday, when US authorities charged Navinder Singh Sarao, a futures trader, for allegedly contributing to the 2010 "flash crash" when the Dow Jones Industrial Average dropped more than 600 points in minutes and blue-chips such as Accenture and General Electric briefly traded at just one cent.

The US Department of Justice alleged that Mr Sarao used a commercially purchased automated trading programme to manipulate the market for S&P 500 futures contracts, called e-minis, on the CME, the largest US futures market.

The e-minis trade 23.5 hours a day, giving investors around the world a fast and liquid way to trade US equities and a tool to hedge against big swings in the cash market. The explosive growth of futures and options trading in recent years has long been seen helping maintain an orderly stock market, by quickly narrowing any sharp divergence between prices in futures and cash equities.

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"I still think the large seller was the main contributing factor, but the fact that one person was allegedly trading manipulatively did not help the stability of the market," says Albert Menkveld, professor of finance at VU University Amsterdam and fellow at Tinbergen Institute, who has studied the flash crash extensively.

Futures have also been linked to other bouts of market turmoil, with trading behaviour in this sector often pushing the boundaries of acceptable practices.

Indeed the DoJ says Mr Sarao used practices called spoofing and layering where traders send out orders that they intend on cancelling but can earn them profits by trading around the resultant market moves. The DoJ estimates that Mr Sarao made about $40m between 2010 and 2014 trading S&P 500 futures contracts.

While much public and regulatory focus has been on high-frequency traders and non-public trading venues known as dark pools, the emergence of Mr Sarao as possibly a key operator in the flash crash highlights how futures trading can adversely influence the world's largest equity market, with the S&P 500 sporting a market capitalisation of $19tn.

"Even if this guy only traded futures, it had a very significant impact on the cash market," says Larry Tabb, chief executive of Tabb Group, a financial market research and consulting group. "The ability to link together related financial assets becomes critical in being able to understand the impact of trading across these assets."

However, back in 2010 the role of e-mini futures in triggering the flash crash was firmly rebutted by the CME, while the industry debate over high-frequency trading was subsequently animated by several technology glitches in the ensuing years. Last year, the publication of Flash Boys, a book by Michael Lewis that alleged the equities market was "rigged", intensified the scrutiny.

While the arrest of Mr Sarao likely puts more pressure on shoring up the operational oversight of futures markets, it does not mean the heat is off high-frequency trading.

Mr Sarao told UK authorities he was "an old school point and click prop trader" who was quick and had good reflexes, but he was using a customised automated trading programme as part of his scheme.

Aitan Goelman, CFTC Enforcement Director, says that Mr Sarao was a high-frequency trader because he used automated techniques, although he also did some manual trading.

"From flash crash to Flash Boys, a lot of pressure has already been put on the industry," Mr Angel, the Georgetown University finance professor, says. "I don't see that much changing from here."

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