Reference no: EM131397903

The Flash Crash: A New Culprit

At 2:42 P.M. on May 6, 2010, U.S. stock markets suffered a trillion-dollar stock market crash lasting 26 minutes. During that brief period, the Dow Jones Industrial Average, which represents 30 of the largest American companies, plummeted more than 600 points in less than five minutes. Shares of some prominent companies such as Procter & Gamble and Accenture traded down as low as a penny or as high as $100,000. By 3:07 P.M., the market had regained nearly all the points it had lost that afternoon. Nevertheless, some were left with huge losses and others with enormous profits from this flash crash, and the confidence of the American public in the stock market was severely shaken. How could this have happened? Several financial companies, such as Universa Investments and Waddell & Reed, had placed very large trades betting that the S&P 500 index would drop. After these trades, the market began spiraling downward as other investors rapidly followed suit, selling or making bets of their own to reduce their risk. The market was overwhelmed by sell orders with no legitimate buyers to meet those orders. Experts initially attributed the crash to structural and organizational features of the electronic trading systems that execute the majority of trades on the Dow and the rest of the world's major stock exchanges. The huge wave of flash crash sell orders intensified because of high-speed computerized trading programs. High frequency traders (HFTs) have taken over many of the responsibilities once filled by stock exchange specialists and market makers whose job was to provide the majority of stock market liquidity. But many electronic systems, such as those HFTs use, are automated, using algorithms to place their nearly instant trades. In situations like the flash crash, when an algorithm is insufficient to handle the complexity of the event in progress, electronic trading systems have the potential to make a bad situation much worse. Five years later, another explanation emerged. A single trader who operated out of his West London home was largely responsible for the event. On April 21, 2015, the United States Justice Department had British authorities arrest 36-yearold Navinder Sarao, charging him with profiting from the flash crash by boldly manipulating markets and using illegal trading strategies between 2009 and 2014. Sarao was accused of having placed and withdrawn thousands of orders worth tens of millions of dollars each on hundreds of trading days to push down the price of futures contracts tied to the value of the Standard & Poor's 500 stock index. (A futures contract is an agreement to buy or sell a particular commodity or financial instrument at a predetermined price in the future.) When the price fell, Sarao would buy the contract and realize profits. On the day of the flash crash, Sarao repeatedly placed large orders representing $170 million to more than $200 million and then canceled them just before they were executed, making the market even more vulnerable to big moves when several other investors made a big trade that day. The falling price of the futures contracts that Sarao was trading spread to related markets, triggering a cascade of trades and contributing to the Dow Jones industrial average 600-point free fall. This technique is called spoofing or layering, and it is illegal. A trader enters large orders to buy or sell a contract to trick other traders into thinking the price is rising or falling. That trader then quickly cancels the original order and places other orders that take advantage of the price movements. The illegal strategy can be executed in fractions of a second, which makes surveillance difficult. Authorities said Sarao had pocketed $40 million in profits from 2010 to 2014 through such manipulations, including $879,000 on the day of the flash crash. They allege that Sarao tinkered with commercially available software to create an automated trading algorithm that allowed him to place and cancel orders instantaneously. Sarao claims that he is an "old school point-and-click" trader with unusually good reflexes and intuition and that he had cancelled large volumes of orders manually without the help of an automated trading program. He also noted that he had complained more than 100 times to the Chicago Mercantile Exchange, where he had traded futures contracts, about the manipulative trading practices of other HFTs. Long before the flash crash, the exchange had questioned Sarao about his trading activity, but the exchange did not take any action against him, and Sarao continued his trading activities until April 2015. Finally, a whistleblower brought new information to the Commodity Futures Trading Commission (CFTC), which oversees the futures markets. This whistleblower, who declined to be identified, had spent hundreds of hours analyzing data. A new team of investigators from the U.S. Justice Department and the CFTC worked over two years to construct a case against Sarao for manipulating the market and contributing to the flash crash. The CFTC did not blame the crash solely on Sarao, but according to the Commission's director of enforcement, Aitan Goelman, Sarao's conduct was significantly responsible for the order imbalance that led to the crash. It is now believed that investigators overlooked evidence available hours after the flash crash that could have led them to Sarao. At that time, investigators had access to the full set of data from the day of the flash crash but focused only on the data related to actual trades. If they had included all bids and offers entered, they would have more likely noticed the pattern of Sarao's market manipulation. After the flash crash, several reforms were implemented, including a system to slow trading in stocks if they became too volatile and a requirement for trading firms sending orders into the market to tighten their risk controls. The financial industry is also working on a consolidated audit trail, or CAT, that would enable regulators to monitor stock and options orders in real time and quickly pinpoint manipulators. CAT has yet to be completed.

Cash Study Question

1. Identify the problem and the control weaknesses described in this case.

2. What people, organization, and technology factors contributed to this problem? To what extent was it a technology problem? To what extent was it a people and organizational problem?

3. To what extent was Sarao responsible? Explain your answer.

4. Is there an effective solution to this problem? Can another flash crash be prevented? Explain your answer.