CFTC Publishes Appendix to Motion against Nav Sarao

The CFTC's allegations against Mr. Sarao raise two separate but related questions: (i) did Mr. Sarao trade in a manner that was illegal and (ii) did his trading contribute to the Flash Crash in any meaningful way? Assuming that Mr. Sarao's trading was improper, nothing in Mr. Hendershott's deposition seems remotely persuasive regarding the second question.

 

Mr. Hendershott first states that the Layering Algorithm "contributed" to the order book balances and market conditions. In a simplistic way, everyone who is involved in the market at any time "contributes" to one side of the order book or the other; they also "contribute" to market conditions. Then Mr. Hendershott says that the "regulators say [that these market conditions] led to . . . [a] liquidity deterioration." (That is, Mr. Hendershott does not even report the existence of a liquidity deterioration; he merely reports that the regulators say it existed.) Mr. Hendershott then concludes that this regulatory deterioration (which the regulators confirm) came "prior to the Flash Crash." (That is, Mr. Hendershott only notes a temporal sequence of events; he does not indicate that the first event - the alleged liquidity deterioration - caused the second.)

 

If the CFTC had any basis for asserting that Mr. Sarao contributed meaningfully to the Flash Crash, then one must hope that its basis was on testimony that is far more convincing than Mr. Hendershott's.

 

Based on the CFTC's appendix, a reasonable argument can be made that Mr. Sarao's conduct did not contribute meaningfully to the Flash Crash. First, the CFTC's investigator reports that Mr. Sarao engaged in trading for over 800 days during the relevant period. The first question is how the CFTC can be certain that activity with such limited effect on 799 (plus) days was so significant on one other day. In fact, the CFTC's case is even more strained than that: on any single day, Mr. Sarao may have placed thousands of orders that didn't add up higher and higher throughout the day; they might have been placed and withdrawn. Rather than stating that Mr. Sarao traded on 800 days, it would be more accurate to say that he traded during (let's say) 44,800 ten-minute periods (800 trading days x 7 hours a day x 6 ten-minute periods). Yet the CFTC asserts that somehow it is able to determine that, in one of these 72,000 periods, Mr. Sarao caused the market to crash. If it is able to make such a determination, then the evidence did not appear in the material released today.

 

The arguments advanced above express no opinion on whether Mr. Sarao is guilty or innocent of the charge of improper trading activity. However, the charge that this individual caused or contributed meaningfully to the Flash Crash has serious implications. Real proof requiring CFTC to demonstrate the effect of this individual's trading activity matters. Creating a scapegoat moves us away from asking the important questions about the underlying cause of the Flash Crash.