Navinder Singh Sarao, a London-based trader, was arrested at his home in the United Kingdom on April 21, 2015, and accused by both the US Commodity Futures Trading Commission and the US Department of Justice of engaging in manipulative conduct that contributed to the May 6, 2010, “Flash Crash.” 

In a civil lawsuit filed in a US federal court in Chicago on April 17, but made public on April 21, the CFTC charged Mr. Sarao and his trading company, Nav Sarao Futures Limited PLC, with engaging in spoofing and layering activity involving E-mini S&P futures contracts traded on the Chicago Mercantile Exchange for the purpose of disrupting the market in order to facilitate related trading that netted him profits in excess of US $40 million. The alleged wrongful trading occurred between April 2010 and April 2015.

Mr. Sarao was also accused of wire and commodities fraud, and manipulation in a criminal complaint in connection with the same activity. This action was filed in a US federal court in Chicago by the Department of Justice on February 11, 2015, and also made public on April 21, shortly after Mr. Sarao was arrested.

The Flash Crash refers to events on May 6, 2010, when major US-equities indices in the futures and securities markets suddenly declined 5-6 percent in the afternoon in a few minutes before recovering within a similar short time period. In a report issued jointly by the CFTC and the Securities and Exchange Commission during September 2010, the agencies then blamed the algorithmic-driven selling of E-mini S&P futures contracts by a large mutual fund as the principal cause of the Flash Crash. (Click here to access the CFTC and SEC report.)

According to the CFTC complaint, Mr. Sarao and his company began laying the groundwork for his alleged manipulative scheme in June 2009 when he sought assistance from a company that created and sold an off-the-shelf trading system that he then utilized to place E-mini trades on CME’s Globex electronic trading system. Mr. Sarao asked the company for numerous alterations to the trading program to rapidly enter, amend and cancel orders in the market, said the CFTC.

Subsequently, charged the CFTC, on multiple days and times, the defendants used the altered program to place a sequence of four to six large sell orders simultaneously into the E-mini order book on Globex, each one tick apart (a tick is the minimum price increment), with the lowest sell order at least three to four ticks greater than the highest bid in the order book. As the best asking price changed, alleged the CFTC, the defendants’ algorithm automatically adjusted the layered sell orders, so there was always a similar set of four to six sell orders the same increment apart, and the same distance from the highest bid in the order book. According to the CFTC,

These orders were modified hundreds of times in order to keep them from resulting in executed trades. Defendants placed the [layered orders] with no intention of these orders resulting in transactions.

The CFTC claimed that the layered orders were typically cancelled with no execution more than 99 percent of the time; were much larger, on average, than other traders’ orders in the E-mini futures contract marketplace (504 contracts for defendants versus 7 for other traders); and were amended, on average, far more often than other traders’ orders (161 amendments per order for defendants versus one amendment for other traders).

Defendants’ layering was intended to fool market participants into believing there was very strong interest on the sell side of the market, charged the CFTC. Defendants would seek to take advantage of this by selling a high volume of contracts at a high price when they knew their layering activity would drive market prices down, and then buy back the contracts when the market, in fact, collapsed.

When defendants turned off their layering algorithm, the market would typically recover, the CFTC observed. According to the CFTC, defendants endeavored to benefit from this too by buying E-mini futures contracts when they turned their algorithm off and selling the contracts when the market price increased.

In addition to engaging in algorithmic layering, the defendants engaged in “flash spoofing,” alleged the CFTC. These were large-quantity orders that the defendants manually entered into the marketplace “with no intention of these orders resulting in trades,” said the CFTC:

At times…the Flash Spoofing was used with and to amplify the impact of the [layered orders]. At other times, Defendants’ Flash Spoofing was used alone to benefit Defendants’ trading strategies.

The CFTC claimed that the defendants employed both layered orders and flash spoofing on May 6, 2010, which contributed to the rapid decline of prices in E-mini S&P futures contracts that afternoon and the Flash Crash.

According to the CFTC, Mr. Sarao last traded E-mini S&P futures contracts on April 6, 2015.

The CFTC charged defendants with traditional manipulation, attempted manipulation, and for all activity since July 16, 2011 (when the relevant law was amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act), spoofing and use of a manipulative device or contrivance.

To prevail in a traditional manipulation case, the CFTC is typically required to demonstrate both a manipulative intent and an artificial price. Although there have been no adjudicated cases regarding the CFTC’s new authority to bring a case alleging use of a manipulative device or contrivance, it seems the CFTC would be required to show an intentional or reckless activity to defraud. Likewise, to prevail under its new authority to bring a case specifically for spoofing, the CFTC would have to show defendants “bid or offered with the intent to cancel the bid or offer before execution.” 

The criminal complaint filed yesterday only named Mr. Sarao and was accompanied by the affidavit of an FBI agent that generally tracked the allegations in the CFTC’s complaint.

There were, however, some additional facts in the affidavit. For example, the affidavit alleged that prior to engaging in the alleged spoofing conduct that was the subject of the CFTC’s litigation, between September 2008 and October 2009, Mr. Sarao engaged in pre-opening activity on the CME—“specifically, entering orders and then canceling them”—that caught the attention of CME and resulted in communication with him. After the CME brought these orders to the attention of the unnamed futures commission merchant carrying Mr. Sarao’s account, Mr. Sarao wrote an email to the FCM advising it “he had ‘just called’ the CME ‘and told em to kiss my ass.’”

The affidavit provides another example of communications among the CME, Mr. Sarao’s FCM and Mr. Sarao that suggests both the CME and the FCM observed a large number of cancellation of orders by Mr. Sarao in or prior to March 2010, and sought his explanation, and communications among Eurex, Mr. Sarao’s FCM and Mr. Sarao that indicate Eurex observed a similar type of trading by Mr. Sarao there in or prior to July 2010.

According to the affidavit, Mr. Sarao used, at various times, four unnamed FCMs to carry his and his company’s trading accounts. To help protect his assets, claimed the affidavit, Mr. Sarao established two offshore entities, one entitled “Nav Sarao Milking Markets Limited.”

The Department of Justice apparently relied, at least in part, on an unnamed private economic consulting group to develop its case.

This is the second criminal indictment brought against an individual for alleged spoofing, relying on the new anti-spoofing provision of law. Michael Coscia, the prior manager and sole owner of Panther Energy Trading LLC, was indicted in September 2014 for alleged spoofing activities involving futures traded on CME Group and ICE Futures Europe from August through October 2011. His motion to dismiss the indictment was denied last week. 

In July 2013, the CFTC, the UK Financial Conduct Authority and the CME Group brought enforcement proceedings and entered into simultaneous settlements with Mr. Coscia and Panther related to the same conduct underlying Mr. Coscia’s criminal indictment, assessing aggregate sanctions in excess of approximately US $3 million and various trading prohibitions. 

In its current action against Mr. Sarao and his trading company, the CFTC seeks injunctive relief, disgorgement, civil monetary penalties and trading suspensions or ban, among other relief. Mr. Sarao awaits extradition to the United States in connection with his criminal charges.

Compliance Weeds: The purported trading activity engaged in by Mr. Sarao and his trading company, as described by the CFTC and Department of Justice, appears similar to the alleged trading activity engaged in by Mr. Coscia and his company: specific, isolated instances of spoofing and layering through specially designed algorithmic systems in order to fool the market to achieve related executions. Typically, however, Mr. Coscia endeavored to benefit from trading activity on the opposite side of the market where he was layering, while Mr. Sarao is alleged to have initially benefited from trading activity on the same side of the market he was spoofing.

Although there are unfortunate differences in the plain language of the express prohibitions against disruptive trading activities among the CFTC, CME Group and the various ICE exchanges (and other self-regulatory organizations too), there is little doubt that regulators consider placing and cancelling orders rapidly in an effort to fool the market and intending to cancel prior to execution to be wrongful conduct. 

As said in the preface of the relevant CME rule, “[a]ll orders must be entered for the purpose of executing bona fide transactions. Additionally, all non-actionable messages must be entered in good faith for legitimate purposes.” It is also significant that, in its case against Mr. Sarao and his trading companies, the CFTC’s Division of Enforcement has endeavored to cover all its bases of possible theories by unleashing the apparent four horsemen of disruptive trading prosecutions: charges alleging manipulation, attempted manipulation, disruptive trading (spoofing), and manipulative device or contrivance. The last charge—manipulative device or contrivance—still appears to be too broad in its scope, but no court has yet ruled on this.