Global financial regulation meets a cul-de-sac

Who would have thought it? If the US Department of Justice is to be believed, an important contributor to the notorious "flash crash" in the markets back in May 2010 turns out to have been 36-year-old Navinder Singh Sarao, a day trader working through a company based at his parents' semi-detached house in the tawdry London suburb of Hounslow. The flash crash, you may recall, raised questions about whether high-octane trading was making markets so volatile as to present a threat to global financial stability.

Five years later we have a bizarre postscript. While politicians and regulators have devoted huge efforts since the financial crisis to curbing trading by banking behemoths that are too big to fail, the DoJ has alighted on a market amateur who is neither too big to fail, nor too big to jail, but seems to be a one-man threat to the integrity of one of the biggest markets in the world.

Mr Sarao stands accused of using an automated trading programme to manipulate the market for S&P 500 futures contracts on the Chicago Mercantile Exchange, adding significantly to wider selling pressure that caused the Dow Jones Industrial Average to plunge to 1,000 points in a day before immediately bouncing back on the same day. He is charged on numerous counts of fraud and market manipulation.

The background to this scarcely credible tale is the liberalisation of markets arising from the US National Market System regulation and the EU's Markets in Financial Instruments Directive, both introduced in the past decade. Together with computerisation, these changes ushered in new entrants, in the shape of novel trading platforms - such as so-called "dark pools", where securities are traded off exchanges - along with high-frequency traders who use algorithms to trade in milliseconds. It was, in effect, the end of the notion of markets as vibrant meeting places, as in 17th-century City coffee houses or 20th-century formal exchanges, where relationships mattered and trust counted. In their place came a low-trust electronic jungle, disembodied buccaneering and the likes of Mr Sarao.

This all casts systemic risk in a new light. Before the crisis central bankers and regulators thought that if they supervised individual banks rigorously, systemic risk would look after itself. In that period of market fundamentalism, when economists talked of The Great Moderation, there was complacency about the destabilising capability of markets. The world's financial elite firmly believed that in increasingly integrated global markets with more sophisticated financial instruments, risk would be more widely distributed around the system. There was also a conviction that in a crisis markets would act as shock absorbers.

These assumptions were shown in 2008 to be wrong. Globally integrated markets proved to be as good at transmitting risk as spreading it. Markets turned out to be both fragile and contagious. And certainly the pre-crisis approach to supervision would have been highly unlikely to identify a day trader as a serious threat. Since then, system-wide monitoring, known as macroprudential regulation, has become the vogue. Here too, there must be questions about whether watchdogs would identify an individual trader as a threat given that their focus is primarily on bank balance sheets and the credit cycle.

In looking at non-banks, or "shadow" banks, much of the regulatory focus has been on asset management giants and other big fish. The notion of a single super-trader with huge power to disrupt markets has not been high on the regulatory agenda.

Of course, it is possible that the DoJ's action may cause Mr Sarao's importance and influence on markets to be exaggerated. Can one man in Hounslow, of all places, really be so dangerous ? It iscurious, too, that the DoJ has not identified more perpetrators of the kind of manipulation of which Mr Sarao has been accused. But if Mr Sarao is found by the justice system to have been a genuine rogue trader, he will one of a new kind.

Before the crisis rogue traders did not make money. They lost it on others' behalf. Jerome Kerviel cost Societe Generale €4.9bn ; Kweku Adoboli lost UBS $2.3bn; Nick Leeson killed off Baring Brothers. Their unauthorised trades were a desperate attempt to gamble their way out of the losses they incurred earlier. Mr Sarao, by contrast, is estimated to have made a profit of $879,000 on the day of the flash crash and notched up $40m in total, which he put in tax havens. This is a very 21st-century kind of capitalism - detached, quirky and worrying.

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