Complexity, Algorithms, and the Stock Market

The Department of Justice is looking to prosecute Navinder Singh Sarao for using a computerized trading software to spoof orders for futures contracts and causing the “flash crash” of 2010. The idea was essentially that by selling futures contracts, Sarao could convince traders that there was selling pressure and then as prices started to drop, he could buy the contracts and cancel his previous sell orders. The alleged effect of this strategy was the flash crash where for a brief period before its rebound, the Dow Jones plunged 6% with many companies trading at share prices nearly 25% less than before.

But is what Sarao did necessarily against the law? The short answer is: Yes. The long answer is much more complicated. The Commodities Exchange Act of 2010 specifically outlaws any “bidding or offering with the intent to cancel the bid or offer before execution.” But there is a fine line between what is outlawed and what is allowed. One perfect example is when high frequency traders send out periodic orders in markets around the world to gauge interest in a particular product. The orders are then later canceled. This is, in fact, legal since the order had a chance to be completed. Given the legal barriers the prosecution must surmount to indict and extradite Sarao and the improbability that one man alone, living in the UK, could cause such havoc across the sea in US markets, it is unlikely that Sarao will end up in US courts let alone US prisons.

Whatever the outcome, there are many lessons to be learned from this incident particularly those regarding the overall sensitivity of markets and the ability of individuals to enter in and cancel a contract within mere seconds to create the appearance of trading interest. In addition, even the rare possibility that the actions of one trader can create such large effects in US markets speaks to the unfathomable complexity of our financial systems. Our stock markets (and many other markets in general) have come to be so complex and driven by algorithmic trading that they have become fragile and susceptible to disruptions. Rather than continuing to add to this ever-growing web of connections and complication, perhaps it is time that we reevaluate our current systems and make sure that we have the necessary controls in place to prevent such events in the future. Otherwise, we are setting ourselves up for a catastrophe much worse than the short “flash crash.”

--Aditya Garg