Opinion: 5 years after flash crash, markets remain vulnerable

Agencies need a better handle on manipulation by clever traders with computer skills

Apr 28, 2015 @ 12:01 am EST

Roger Schillerstrom

Five years after the 2010 “flash crash,” the Justice Department has charged a lone trader, who operated out of his house in London, with market manipulation that it claims contributed to the market plunge.

The charges serve as a warning that, despite all of the regulations passed in the wake of the 2008 meltdown, markets remain vulnerable to manipulation by clever traders with computer skills.

The charges also raise questions. Why did it take five years for investigators to identify and take action against Navinder Singh Sarao? Why was he not identified as a contributor to the plunge by the nine-month investigation that blamed the crash on a trade by a mutual fund trader? Which came first, the “fat-fingered trade” by the trader or the alleged illegal trades by Mr. Sarao?

The Justice Department charged Mr. Sarao with wire fraud, 10 counts of commodities fraud, 10 counts of commodities manipulation and one count of spoofing. Spoofing occurs when a trader places a bid or offer with the intent to cancel before execution.

Mr. Sarao allegedly made thousands of spoofing trades in E-mini S&P; 500 futures contracts on the Chicago Mercantile Exchange, and the Commodity Futures Trading Commission alleged that he profited from his scheme to the tune of about $40 million between 2010 and 2014.

If Mr. Sarao is guilty as charged, it means the investigation by the Securities and Exchange Commission and the CFTC was less than thorough, and they must improve their investigative techniques.

The agencies did identify that trading in E-mini S&P; 500 futures contracts triggered the sell-off that then was worsened by computerized high-frequency trading programs. However, it appears the agencies may have relaxed their efforts once they identified the mutual fund company as the probable source of the heavy action in the futures contracts.

In fact, many ex-perts questioned the agencies' report, arguing that the fund company's trades were not large enough to have caused the plunge. Some also argued that the SEC and CFTC didn't have adequate technology to investigate the crash, noting that it took them almost five months to analyze the data from the most volatile five minutes in market history.

It is apparent the critics were correct. The agencies took five years to uncover a trader who potentially caused investors billions in damage, even though the CME reportedly was aware of Mr. Sarao's trading and had asked him to back off. In fact, some media accounts last week asserted that the government relied on the investigation of a whistleblower to uncover Mr. Sarao's alleged misdeeds.

When all is said and done, the SEC and CFTC look little more competent than Inspector Clouseau of “Pink Panther” fame. They clearly were not prepared to uncover the causes of the crash, and they must do better.

Confidence in the integ-rity of capital markets is critical to the economic health of the nation and the well-being of individual investors.

That confidence has taken a series of hits in the past 15 years, from the tech bubble and front-running scandals of the late 1990s to the flash crash. This probably explains why younger investors are wary of putting their savings into the financial markets.

Regulators and exchanges must be able to identify such activities as soon as they begin and stave off damage. If a lone trader can contribute to a market crash and escape detection for five years, imagine what determined enemies could do.

Congress must make sufficient funding available so the agencies can hire tech talent and buy the equipment those experts need to do their jobs. The exchanges must improve their techniques for identifying and halting dangerous trading patterns.

Without such changes, efforts by investment advisers to persuade clients to invest significant amounts of their assets in the stock market will fall on deaf ears. Clients will not invest in markets they perceive to be rigged or vulnerable to gaming by unscrupulous individuals.

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