London man arrested over $40 MILLION HFT flash crash allegations

What's Navinder Singh Sarao said to have done?

Comment As I've mentioned around here I'm a bit of an aficionado of scams and scammettes: not because I partake in them but because the inventiveness of the human mind in hoovering up cash never ceases to amuse me. This morning we've a classic of the genre, as one bloke working out of his mother's basement* in Hounslow is alleged to have taken $40m off the financial markets and cost others billions in the process.

This is all tied up with that great bugbear of the day; high frequency trading. Let's start by examining the underlying scaffolding of such a scheme, stripped of all the jargony detail.

To make it work you need two markets for the same thing. You can set yourself up to benefit from a price move in one market in advance. Then you go to the other market and manipulate the price so as to benefit that first position of yours.

As the two markets are for the same thing, prices should move in lockstep. They won't quite do that but they should both go in the same direction at least.

And that's it really, that's what is alleged was being done. This is, in fact, extremely common in all financial markets. It's not manipulation because the way that you influence prices in the second market is by actually reversing the position that you had in the first.

So, you're selling in the first market, but you buy in the other and/or vice versa. Your profits and losses will cancel out. This is actually known as hedging and is a valid and very common thing to do.

Say, for example, that you're an oil trader. That means you buy a ship load of oil and move it from port to port. The price can change as you do so: so, you go long physical oil (“long” here means “buy it”) and short futures oil (“short” being “sell what you don't have”) and the two will net out. You're now hedged: whichever way the oil price moves you've locked in whatever profit you think you've got from moving the oil between those two ports. We like people doing this.

You can also, obviously, just nakedly speculate. Go long and/or short in whatever you want.

What you're not allowed to do is mislead everyone as to what you're doing. That's the core here, misleading, not speculation or trading.

To add back in that jargony detail. Here's the Commodity Futures Trading Commission allegations; here's the press release; and here's the linked Department of Justice statement of allegations.

Nuts and bolts

We have something called the S&P 500. That's an index of the leading 500 US quoted companies' share prices. Akin to the FTSE100 in Blighty. We have (at least) two markets in this. There's options (where you have a contract that you may exercise) and futures (a contract must be exercised). Those two contracts will move not quite in lockstep but near enough; enough for the scheme to work.

The function of the market in the index is to allow people to hedge. You own lots of stocks and you're worried about prices falling? Buy a “put option” (a bet that the price will decline) and the profit from that will compensate you for the loss of stock value if prices do decline.

Of course, we also need the vast army of people just speculating in order to facilitate this risk transfer. Futures and options markets are always many times greater than the underlying physical market. This is all fine; the economic function here is to allow that risk to shift from those who don't want it to those who want to speculate in it.

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