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BusinessApril 27, 2015

NEW YORK -- He operated from a modest suburban London home he shared with his parents, far from the city's financial center. He used off-the-shelf software anyone can buy. Yet, if U.S. authorities are correct, Navinder Singh Sarao, 36, managed to send a jolt of fear through the world's markets by helping to set off the 2010 "flash crash," in which the Dow Jones average plunged 600 points in less than seven minutes...

By BERNARD CONDON ~ Associated Press
Traders work on the floor of the New York Stock Exchange in New York. If U.S. authorities are correct, Navinder Singh Sarao helped set off the "flash crash" in 2010, raising fears it's not just big banks and hedge funds that can create chaos on exchanges and wipe out the savings of ordinary investors. (Henny Ray Abrams ~ Associated Press)
Traders work on the floor of the New York Stock Exchange in New York. If U.S. authorities are correct, Navinder Singh Sarao helped set off the "flash crash" in 2010, raising fears it's not just big banks and hedge funds that can create chaos on exchanges and wipe out the savings of ordinary investors. (Henny Ray Abrams ~ Associated Press)

NEW YORK -- He operated from a modest suburban London home he shared with his parents, far from the city's financial center. He used off-the-shelf software anyone can buy.

Yet, if U.S. authorities are correct, Navinder Singh Sarao, 36, managed to send a jolt of fear through the world's markets by helping to set off the 2010 "flash crash," in which the Dow Jones average plunged 600 points in less than seven minutes.

Just how big a role he played has been debated since the federal complaint was unsealed earlier this week, but the idea a little-known investor had even a small part is troubling, say traders and market experts.

"If this guy can do it," asked finance professor James Angel of Georgetown University, "who else is doing it?"

In an age of advancing computer power, the fear is it's not just big banks and hedge funds that can create chaos on exchanges and wipe out the savings of millions of ordinary investors. Someone working from home might do it, too.

"The risks are coming from the small guys who are under the radar," said Irene Aldridge, managing partner of research firm ABLE Alpha Trading and an expert in the high-speed computerized trading that Sarao did. "The regulators don't have the real-time tools to monitor them."

Sarao is accused of employing a ruse called spoofing, a bluffing technique in which traders try to manipulate the price of stocks or other assets by making fake trades to create the impression they want to sell when they actually want to buy, or vice versa.

Eric Scott Hunsader, founder of Nanex, a provider of financial data that has documented what it claims are cases of spoofing, says the practice is widespread -- in stocks and bonds, oil and gold, cotton and coffee. He says bluffing is turning markets into a lawless Wild West, despite efforts by trading firms to fight back with software that can sniff out false trades.

If the allegations against him are true, Sarao may rank among the best of this new breed of bluffers.

His feat was impressive because of the target of his alleged bluffing -- investors in E-Mini S&P 500 futures, which are financial contracts that allow you to bet on the rise and fall of the Standard and Poor's 500 stock index. Passing off a fake trade like that as real isn't easy, because E-Mini is one of the most widely traded, transparent and scrutinized markets in the world.

A key to spoofing is placing large orders without executing them. Because other traders can see your orders, a large one to sell might convince them prices are likely to head down. One to buy might make them think prices are likely to rise. So they will often mimic your order, which moves prices up or down.

Next, you cancel your order, and do the opposite -- buying at the new, artificially lower price or selling at the new higher one.

The advent of high-frequency trading firms has added a level of sophistication to this technique. Using computers to sift through news articles, social media and other data in split seconds, these firms snatch tiny, fleeting profits mere mortals can't spot.

The firms can also bluff fast, sending a series of sell orders, for instance, then canceling them as the price moves down and replacing them with new orders -- all within thousandths of a second.

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The complaint against Sarao says it was this sort of lightning-fast spoofing, called dynamic layering, that allowed him to make nearly $880,000 on May 6, 2010, the day of the flash crash.

His computer sent a series of orders to sell E-Mini futures. Then, as their prices moved, his computer changed or replaced those orders in rapid succession -- a stunning 19,000 times in less than 21/2 hours before it canceled all of them, according to the complaint. Sarao's offers to sell were so numerous that at one point they represented at least one-fifth of all orders to sell E-Mini futures from around the world.

"This is the equivalent of an elephant coming to a tea party," says Nanex's Hunsader. "It's hard not to spot."

Stocks lost $1 trillion in value during the flash crash. The market bounced back by the close of trading, but the breadth and speed of the drop rattled investors and regulators alike.

British-born Sarao, a former bank employee and Brunel University student, is charged with fraud, commodities manipulation and other offenses. He was arrested in London on Tuesday and indicated in court that he will fight extradition to the U.S.

In court, his lawyer said the arrest came as a "bolt from the blue" to Sarao. The attorney did not respond to requests for comment for this article.

Between 2010 and 2014, Sarao earned $40 million on E-Mini trading alone, according to authorities, though the complaint doesn't say how much of that was through allegedly illegal trades.

Narang, the former high-speed trading executive, casts doubt on that figure, noting that the complaint doesn't list Sarao's losses, just his winnings.

He also says Sarao's allegedly bogus sell orders were often too far from the prevailing prices for traders to take seriously. In fact, Narang wonders if Sarao played much of a role at all in the flash crash.

Larry Tabb, CEO of financial markets consultancy TABB Group, has his doubts, too: "I don't think that what he was doing on a normal day would have any impact on the markets." A regulatory review after the flash crash found that the market was vulnerable to a plunge that day because a computerized selling program at a mutual fund had run amok.

Whatever Sarao's role, regulators are clearly worried.

Spoofing was prohibited by the Dodd-Frank law in 2010, the Wall Street overhaul enacted after the financial crisis. But what is spoofing and what is legitimate trading is sometimes hard to pin down. Traders cancel orders all the time because of new information. It's the intent to fool others, not the canceling itself, that is illegal.

Still, regulators are starting to crack down. In January, a Canadian trader was arrested on spoofing charges. That followed charges against a New Jersey trader who allegedly made $1.5 million entering false trades in the gold, soybean oil and copper markets.

The criminal charges are not coming fast enough, though, for Nanex's Hunsader, who thinks spoofing is rampant and far too easy to pull off. After all, if Sarao really did help crash the market, he asks, why not "a terrorist cell or someone with deeper pockets?"

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