Infinite arbitrage in the electronic market jungle

The extraordinary tale of Navinder Singh Sarao, the British day trader who is accused of contributing to the notorious US market "flash crash" of May 2010, provides a salutary reminder of how regulation and technology can reshape the character of markets dramatically.

The activities of this obscure day trader from the London suburb of Hounslow were made possible first by Regulation ATS, the US measure that prompted the move in 1998 from primarily quote-based markets to electronic order book markets, then by Regulation NMS, designed to increase competition.

If these measure were intended to encourage entrants, they clearly succeeded. One such entrant was Mr Sarao. But it seems unlikely that policy makers and regulators foresaw the extent to which, in the new market place, a single trader would be able to rig one of the biggest markets in the world, E-minis, highly liquid stock market index futures contracts based on the S&P 500 index.

If the investigators of the US Department of Justice are to be believed, between 11.17am and 1.40pm on May 6 2010 Mr Sarao accounted for 20 to 29 per cent of the Chicago Mercantile Exchange's entire sellside order book, creating persistent downward pressure on prices. The DoJ alleges that he was an important contributor to the spillover into the main equity market, where the Dow Jones Industrial Average had its largest ever intraday fall, shedding $1tn in half an hour. In both markets liquidity dried up.

Most trading now takes place on electronic platforms that are a playground for the likes of Mr Sarao and, more importantly, for big algorithmic and high-frequency traders. The fragmentation of markets that followed liberalisation in both the US and Europe has created infinite arbitrage opportunities for such people.

In effect, a marketplace based on relationships and trust has been replaced by one in which liquidity is more dependent on programmed computerised reactions to short-term price movements than client-based relationships.

As the International Monetary Fund remarks in an excellent discussion in its latest Global Financial Stability Report, "in a more anonymous, short-term, profit-oriented trading environment, fewer participants make their pools of liquidity available in risky conditions to help stabilise the market".

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As for issuers, smaller companies lose out. Initial public offerings of small-fry houses plunged in the US as a result of liberalisation. According to David Weild, chairman of Weild & Co, the broker-dealer, and a former vice-chairman of the Nasdaq exchange, the decline in transaction costs means that investment banks simply cannot make any money in the after-market by supporting small-cap, less liquid companies with research, trading and sales.

Systemic risk is another growing concern. Re-regulation since the crisis has caused banks to shrink market making. And as the IMF remarks, lower dealer inventories, elevated asset valuations, flight-prone investors and vulnerable liquidity structures have increased market and liquidity risks - deeply worrying as the Federal Reserve and Bank of England move towards tightening.

The regulators seem to have created a world fit for high-frequency traders and Mr Sarao. A horrendous blunder, with wretched consequences for the integrity of markets.

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