Free Lunch: The verdict on spoofing

Δημοσιεύθηκε: 23 Απριλίου 2015 - 11:30

How I stopped worrying about the flash crash

What are we to make of Navinder Singh Sarao, the trader based in his Hounslow home who supposedly caused the flash crash five years ago? (For a refresher, look at Michael Mackenzie's video explainer of the crash.) The FT's John Plender puts it best: "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."

To understand the "spoofing" trading strategy Mr Sarao allegedly used to manipulate markets according to US regulators, read Matt Levine's light-hearted, detailed and incredulous explanation. Essentially, Sarao put in large buy or sell orders some way away from the market price, relied on other automated trading programmes to copy him, then quickly cancelled the trading offers and made money on the price move. US authorities claim that his behaviour was illegal and want Sarao extradited.

That's clear enough. But beyond the description of Sarao's spoofing, if true, the charge card throws up nothing but problems. Here are five.

First, how was he actually making money? Craig Pirrong points out that the US Department of Justice complaint is voluble on the trades Sarao cancelled but silent on the ones he actually went through with, supposedly netting millions of dollars (h/t to FTAlphaville's Izabella Kaminska's explanatory comment on Pirrong's post). As Plender points out, there is something new here if the US DoJ is right: in the old days, rogue traders didn't make money, they lost it. Lots of it.

Second, another Pirrong post points out that from the information available in the complaint, Sarao's trading pattern looks like "scalping" - trying to capture some of the spreads market makers earn - but that is neutral between buying and selling and should not move the price in one direction or another. Moreover, he used his strategy on 250 days, but the government only charges him for criminal conduct on nine of them. "How did the government establish that trading on some days was illegal, and on other days it wasn't?" Quite.

Third, if Sarao was ripping anyone off, who were they? Who was harmed by his activity? Most likely, writes Rajiv Sethi, other algorithmic traders (high-frequency or not) who were basically trying to do exactly the same thing or were designed to respond to the behaviour he was spoofing. These account for only 1 per cent of traders but half of trading volume and are one or both sides of three-quarters of all trades, Sethi writes.

Fourth, if so, how do you hold Sarao responsible for the flash crash without also holding all these other algorithmic traders responsible? Especially, as Levine remarks in the post linked above, when the flash crash happened after Sarao switched off his algorithm! Paul Murphy rightly argues that if there is blame to be imparted, surely it goes to those who permitted and supervised (or "supervised") a system that is so vulnerable to some guy with a spreadsheet.

But fifth, why should we worry about spoofing in the first place? Matt Levine explains in another post that it doesn't hurt fundamental investors who trade based on what they think a security is objectively worth. That goes a long way to saying we should learn to love spoofing and certainly stop prosecuting poor Sarao. Levine himself does not go as far as that - he points out that it does hurt index investors and those who just want to buy or sell at the market price (and of course those algorithmic traders whose losses were Sarao's gain).

John Cochrane, however, has no qualms: "Why is it a crucial goal of law and public policy to prevent Mr Sarao from plucking their pockets? Is 'herding trader' or 'momentum trader' or 'badly programmed high-speed trading program' or just simple 'moron in the market' now a protected minority?" The Financial Times itself took a similar view in a comparable case five years ago: it wrote in an editorial that "there is no social gain from protecting the principals behind an algorithm of such breathtaking stupidity."

What can we conclude from all this? In particular that it is probably false and certainly a huge oversimplification to say Sarao caused the flash crash. And in general, if the point of securities markets is to allocate capital to the uses which have the highest social return - and isn't it? - we only need to protect fundamental investors, not high-frequency and algorithmic ones. And that means learning to live with (if not love) Saraos, spoofers, and short-term market swings they may or may not cause.