Trader Talk

What caused the flash crash? CFTC, DOJ weigh in

A trader works on the floor of the New York Stock Exchange.
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This was a bit of a curve ball. Five years after the flash crash, the Commodities Futures Trading Commission has filed a civil complaint alleging a man named Navinder Sarao manipulated the Chicago Mercantile Exchange's E-mini futures contract by using spoofing tactics, that is, efforts to place and cancel hundreds of thousands of orders with no intention of executing them.

This apparently went on for some time, beginning in June 2009, and lasting intermittently until the present.

What's getting attention is the CFTC is alleging that Sarao was active on May 6, 2010, the day of the flash crash.

Read More Trader charged for contributing to 2010 flash crash

Simply put, they are alleging that Sarao used a "layering algorithm" that set large sell orders in the E-mini order book, all at different price levels above the best asking price. There was very little chance the orders would ever be executed because they all kept moving as the market moved, but because these orders were so large they allege he was as much as 40 percent of all active sell-side orders on some days.

Now to the manipulation part. They allege he overloaded the sell side, which lowered prices. Then, when he stopped overloading the sell side (when he turned the layering algorithm off), the price rebounded. He profited from this temporary price volatility by trading the E-mini contracts. His daily profits on 12 specific days he was active, including the day of the flash crash, was approximately $6.4 million, or $530,000 a day.

There are additional spoofing allegations, but you get the point: Sarao attempted to cause a price drop, then took advantage of the drop by repeatedly selling the E-mini contracts and buying them back at a lower price. When the layering algorithm was turned off, he bought and sold the contracts as prices rebounded.

Bear in mind, there's nothing wrong with layering an order book with sell orders. Traders do that all the time.

However, it is different if you are putting out orders that represent false supply that is pushing the market down to cover your short orders. These were not bona fide orders, the CFTC is alleging. He had "cancel and close" orders, that is, as soon as the market came close to the order, it was cancelled.

It's not just the scheme, it is the size of it: on many days, the CFTC alleges that Sarao accounted for approximately 20 percent of total sell-side orders, and sometimes as high as 40 percent.

On the day of the flash crash, the CFTC alleges, Sarao put in orders representing about $170 million to $200 million in the morning and early afternoon, representing 20 to 29 percent of the sell-side order book. The orders were replaced or modified more than 19,000 times before being cancelled at 1:40 p.m., Central Time.

The CFTC's point: Sarao was at least partly responsible for the severe imbalance between buy and sell orders that was believed to be a major factor in the flash crash.

The SEC, in its report on the cause of the flash crash, named several factors, but also placed significant blame on an imbalance between buy and sell orders that caused a dramatic drop in liquidity on both the E-mini futures contract and the S&P 500 ETF.

However, a principle reason for the imbalance, the SEC report said, was that a large fundamental trader of a mutual fund complex initiated a program to sell a total of 75,000 E-Mini contracts (valued at some $4.1 billion) as a hedge to an existing equity position. The "mutual fund complex" sold these contracts with little regard for price or time... it just executed the order very quickly.

In other words, the "mutual fund complex" used a lousy algorithm. This caused a severe imbalance between buy and sell orders.

This is what bugs me: the SEC says this lousy algorithm sold $4.1 BILLION in E-mini futures. That makes the $170 million-$200 million in sell orders that Sarao allegedly put in seem like small potatoes. And remember, Sarao's orders were cancelled!

What's this all mean? My first reaction is, what took them so long? Five years to look into this? Even with the understanding that researching this kind of stuff is very difficult, it was an absurdly long time.

Second, looking for a single cause of the flash crash is fruitless. As Dave Lauer at KOR Group has noted many times, the stock market is a complex system.

All we can do is talk about contributing factors:
1) There was great fear on that day about the European debt crisis, with the euro going into a sharp decline about 1 p.m., Eastern;
2) there were very severe buy and sell imbalances midday, which were likely caused by several factors and participants;
3) liquidity dried up as some participants chose to back away from trading, or route orders to other venues;
4) market structure was rickety, with circuit breakers differing between the exchanges.

One thing is pretty clear: regulators need to get more sophisticated in how they analyze the market. How? Lauer (who has founded Healthy Markets, a nonprofit advocacy group for market structure reform) and others have described what is needed: take the data from the equities, futures, and options market, including dark pools and hidden orders, then have everyone synchronize their clocks to the microsecond, so everyone is on the same time.

Then you have a quick, easy way to find and police the markets quickly. You can't now because the data is in a million different places, with different time stamps. And no one knows what they're looking for!