Wednesday, April 22, 2015

The right to herd

Just when you thought financial regulation couldn't get more expansive and incoherent, our Justice Department comes in to defend morons' right to herd.

As explained in the Wall Street Journal at least, Mr. Navinder Singh Sarao is now under arrest, fighting extradition to the US, and his business ruined, for "spoofing" during the flash crash.

What is that? The Journal's beautiful graph at left explains.

The obvious question: Who are these traders who respond to spoofing orders by placing their own orders? Why is it a crucial goal of law and public policy to prevent Mr. Sarao from plucking their pockets? Is "herding trader" or "momentum trader" or "badly programmed high-speed trading program" or just simple "moron in the market" now a protected minority?

Why is Mr. Sarao being prosecuted and not all the people who wrote badly programmed algorithms that were so easily spoofed? If this caused the flash crash (how, not explained in the article) are they not equally at fault?

I don't mean by this a defense of the crazy stuff going on in high speed trading. As explained here, I think one second batch auctions are a much better market structure.  But the whole high speed trading thing is largely a response to SEC regulations in the first place, the order routing regulation, discrete tick size regulation, and strict time precedence regulation. A fact which will probably not enter at Mr. Sarao's trial (he doesn't seem to have billions for a settlement) and will give him little comfort in jail.

And maybe, just maybe, there is something more coherent here than the Journal lets on. I'll keep reading hoping to find it and welcome comments who can.

A larger thought. We still really want to rely on regulators to spot all the problems of finance and keep us safe from more crashes?

Update: Craig Pirrong excellent commentary here via a good FT alphaville post. Great quote:
The complaint alleges that Sarao employed the layering strategy about 250 days, meaning that he caused 250 out of the last one flash crashes. [my emphasis] I can see the defense strategy. When the government expert is on the stand, the defense will go through every day. “You claim Sarao used layering on this day, correct?” “Yes.” “There was no Flash Crash on that day, was there?” “No.” Repeating this 250 times will make the causal connection between his trading and Flash Clash seem very problematic, at best.
Update 2: Reading various commentaries that I can't find to cite any more, I realize that "front running" more than "herding" is the protected class. You "spoof" by putting in a bunch of orders just outside the current spread. The algorithms that respond to that think this behavior means some big orders coming, so try to front run those by buying. They cross the spread to take the small order you put on the other side. Or so the story goes. In any case, viewed as spoofers vs. front-runners it's harder still to have sympathy for the latter.

Update 3: Good Bloomberg View coverage from Matt Levine  and John Arnold, the source of the above front-running observation.


  1. Jose Romeu RobazziApril 22, 2015 at 3:07 PM

    Prof. Cochrane,
    The news content makes it sound like spoofing is without risk, when it is not. Nobody knows if the market will go against that trade. Also, the availability of computers makes the thing seem like somebody is "taking an advantage" of some other person. But this is what I find amazing: how can an individual trader, somebody like you and me, can have a "computational (unfair) advantage" over entire corporations and sophisticated investors who trade in equities and derivatives markets ? It does not make any economic sense. And I could make a case in favor of open cry markest, against auction markets: liquidity, auction markets offer less liquidity than open cry markets, and auction markets are not free from other techniques that smart traders can devise in order to speculate for a potential profit: I enphasize "potential" these are not guaranteed to work trades ...

    1. The answer is it depends. Depends on latency-and rules of engagement. Exchanges have different rules on order size etc.

  2. John,

    Maybe a dumb question but does the Spoofer have the initial S&P500 contracts to sell before this all begins?

    Also, what prevents his sell order to be matched with a buy order before he can cancel it?

    Maybe you have heard of this guy:

    He eventually served 20 years in Alcatraz for counterfeiting, but before doing so successfully sold the Eiffel Tower for scrap metal - twice.

    Or this guy:

    He ended up serving a life sentence in Sing Sing Prison.

    Yes John, rying to sell what you don't own is legally frowned upon.

    1. Frank you might be interested in the following post by JP Koning, where he notes that banks are short sellers of currency:

      We could stop this by implementing the Chicago Plan, advocated by Prof. Cochrane and others. Or we could extend the model to other financial companies by allowing them to issue unbacked E-mini S&P 500 shares, as I have often recommended. Either way, reform of the financial architecture seems more promising than the complex regulation that is criticized in this post. You don't hear about flash crashes in the interbank dollar market, because the architecture makes such activity pointless and unrewarding. If we make E-minis another form of currency (meaning that naked shorting of it would be normal) we can help the finance industry focus on activity more productive than spoofing contract offers.

    2. Anwer,

      "If we make E-minis another form of currency (meaning that naked shorting of it would be normal) we can help the finance industry focus on activity more productive than spoofing contract offers."

      Presumably E-Minis are actual claims on companies in the S&P500. E-Minis become currency, federal government accepts E-Minis as means to dispose of tax obligation, federal government runs budget surplus, federal government owns majority holdings of all of the companies in the S&P500.

      Is this what you want?

      An equity share is more than just some piece of paper floating around with a notional value. It is an actual ownership stake in a company. With ownership comes responsibility for the future of that company. Do you trust government enough to turn over ownership of America's largest companies to them?

      I sure don't.

    3. I don't either. I am suggesting that we extend the banking model to a larger part of the finance industry. When banks issue dollars as loans, those dollars don't come with any rights to control the bank. Likewise, investment companies should be able to issue liabilities to passive investors against a suitable benchmark. Equity should be held by those actively involved in governance. Today, we have passive investors holding equity indirectly through funds. This causes collective action problems in governance, as well as troublesome side effects when they shift their holdings in a herd-like manner. This blog post argues for the right to herd. We could just as well contemplate architectural changes that eliminate it.

    4. Traders make and cancel orders all the time. "Spoofing" was made illegal by Dodd-Frank, but remains hard to precisely define or prove. In any case, D-F passed in July 2010, while the flash crash occurred in May 2010. Thus, even if the SEC can prove spoofing, it was not illegal at the time. If Sarao is convicted, we're all in a spit-load of trouble. When we can be convicted for violating laws before they are passed, the rule of law becomes a farce. Who know which of today's trading practices will be made illegal tomorrow? Maybe we shouldn't trade at all?

    5. Anwer,

      "When banks issue dollars as loans, those dollars don't come with any rights to control the bank."

      Nor should they. I think what you would prefer is that depositors at a bank are given shareholder rights and also must forgo deposit insurance.

      That makes sense to me. I have seen several comments on these boards that deposit insurance should be eliminated, but the only way that would work is if depositors have a voting stake in the bank itself.

      Otherwise we get into the same situation that we talked about previously on John's recommended government debt - coupon payments with a government option to suspend / renew. A foreign buyer has no voting recourse if a government suspends it's coupon, likewise a depositor has no voting recourse if a bank makes bad investment decisions.

      "Likewise, investment companies should be able to issue liabilities to passive investors against a suitable benchmark."

      I think your collective action problem rests in choosing a suitable benchmark. I mean sure, they could chose the benchmark as the result of 100 consecutive coin flips or the number of stars visible from the pitchers mound at Wrigley Field on any given night.

      "Today, we have passive investors holding equity indirectly through funds."

      Maybe they are only passive investors because the mutual fund industry makes the bulk of its profits by retaining voting control of the equity shares that it buys on behalf of it's clients. There is nothing stopping someone from buying individual shares on the street to retain those voting rights.

      "Today, we have passive investors holding equity indirectly through funds. This causes collective action problems in governance, as well as troublesome side effects when they shift their holdings in a herd-like manner."

      When who shifts holdings - the mutual fund investor or the plan administrator?

      If you are arguing that people should be more directly involved in their investment decisions and should actively pursue voting rights as part of any investment, I agree.

  3. John,

    This spoofing is shockingly unsophisticated. The defendant signals his identity with particular and irregular order sizes. I have trouble believing that market participants would view orders so deep in the book as credible. Market power is a necessary ingredient to make money from market manipulation, and spoofing in the ES is such cheap talk that it's not a viable mechanism.

    With due respect to the agencies involved, I would very much enjoy seeing the CFTC/DOJ "prove" that prices responded to his signals--I would learn something! The complaint falls far short in this regard with statements like the following:

    "Indeed, during the dynamic layering cycle that ran from 11:17 a.m. to 1:40
    p.m., SARAO's offers comprised 20 to 29% of the CME's entire E-Mini sell-side order
    book, significantly contributing to the order book imbalance. During that period of
    time alone, the E-Mini price fell by 361 basis points." (23)

    There are plenty of eye-poppingly large, but non-credible orders, and it is simply foolish to add up all orders in the book and pretend that the price elasticity with respect to distant orders is different from zero, and especially so for the ES. What fraction of other comparably large orders don't drive price movements? What about buy orders? Should we thank him for minor melt-ups?

    This said, the case for intent to manipulate seems quite clear.

    The economics of punishing a small cog five years after the fact is much more interesting to me than the case proper. Also pondering whether the public limit order book has run its course.

    Let's talk soon.


  4. There is a lot not to like in this story, including, possibly, federal overreach. On the other hand, I am beginning to weary of a Wall Street that appears more eager to reshuffle assets in its favor than to serve the engines of growth.

  5. "Why is Mr. Sarao being prosecuted and not all the people who wrote badly programmed algorithms that were so easily spoofed?"

    Because he is not a regular donor to certain politicians campaign funds or the Clinton Foundation.

  6. Most of these HFT abuses are already illegal.

    (2)To effect, alone or with 1 or more other persons, a series of transactions in any security registered on a national securities exchange, any security not so registered, or in connection with any security-based swap or security-based swap agreement with respect to such security creating actual or apparent active trading in such security, or raising or depressing the price of such security, for the purpose of inducing the purchase or sale of such security by others.


    (1)For the purpose of creating a false or misleading appearance of active trading in any security other than a government security, or a false or misleading appearance with respect to the market for any such security,

    If HFTs are putting in trades without the intent to execute, they are breaking black letter law.

    We simply need the executive to enforce already-existing laws, every day, with every market participant.

    Yet our government chooses not to. Why?

  7. Pirrong's logic (as quoted here) makes no sense.
    "Just because my client drove drunk the last 249 days without an accident doesn't mean that his drunkenness had anything to do with the fatal crash on day 250."
    True, as a logical matter. Not particularly persuasive, because we have Bayesian priors concerning alcohol and car crashes. Pirrong revealed his priors (which may be correct here!), but otherwise this quote is simply arguing by assertion.

    1. You're right of course; I admired mostly the wit. Though the converse is also false -- just because he was spoofing on the fatal day does not make the flash crash his fault. A hint of a plausible causal mechanism would help, and its absence the heart of Pirrong's essay. We have that for alcohol and car crashes.

    2. The indictment can be accessed on line. The media had exaggerated the claims. It does not claim that he caused the flash crash. It, in one or two paragraphs, claims he "contributed" to the flash crash. Judging by the numbers involved, his contribution was pretty tiny. The case seems to originate with the investigation of the Chicago Mercantile Exchange, who must have taken the case to the US attorney. There are a number of references to an anonymous financial consulting group that was hired by (guessing) the CFE to do the analysis. The indictment comes close to the running of the statute of limitations. The much stronger case appears to be that the fellow lied to British regulatory authorities about what he was doing, which I hope is a crime over there (hello Martha Stewart). It may be the Brits refused to do anything and the US attorney in Chicago decided to act instead. I see that a CME trader wrote in to say that this is unacceptable trading conduct and I'll take him at his word. (So glad I am an investor. It's a whole lot easier to make money.) This is apparently a basic fraud. It's not about the Flash Crash. The indictment says he used moments of high volume to work his strategy or to hide his actions. Just a little fish doing something he shouldn't. He didn't cause the Flash Crash. He just took advantage of it.

    3. Thanks for posting this. It's good to get the facts straight.
      Still, one can be a bit cynical that the CME is so anxious to punish behavior that undermines the front-running behavior of most trading algorithms.

    4. Hard for most of us to say what should be allowed in the wild world of futures trading. In thinking about it some more: the references to the Flash Crash are really irrelevant to the allegations of the indictment. The only reason you might stick them in are because a US atty has aspirations to public office: "I am the fellow who indicted the Brit fellow who had some role (tiny, tiny, tiny) in the Flash Crash". And so it goes.

    5. What's interesting here is the implications for market efficiency. Spoofing by itself doesn't work. If you have no alpha and you start flashing 2000 contracts on the bid, you will once in a while get hit on it and lose a lot of money ( $ 25K per tick ). Spoofing can at best be an execution tool given that you have alpha. And this guy appears to have a TON of alpha, yet he is not a speed / technology based trader. I would say his existence is a nail in the coffin of market efficiency, no matter which way you look at it

    6. Tom Conroy writes: "The case seems to originate with the investigation of the Chicago Mercantile Exchange, who must have taken the case to the US attorney."

      But the WSJ reported: "The government’s cases were aided by a whistleblower who brought analysis to the CFTC after spending hundreds of hours investigating the flash crash, according to the whistleblower’s lawyer, Shayne Stevenson. ... The whistleblower said his investigation took several years to complete, according to his lawyer. Mr. Stevenson said his client found evidence of a single trader having a big impact on the markets on the day of the flash crash. The government followed the trail the whistleblower uncovered and validated those findings, the lawyer said."

    7. what people forget is that we already concluded it was a fat finger from Waddell and Read. No way did spoofing cause the flash crash. No way. More about the structure. I maintain the flash crash didn't start in the futures, and started because of a glitch in the cash equity markets. Maybe a dark pool triggered it that started a cascade of dominoes. Nanex chronicles flash crashes that happen in individual stocks every day. Additionally, a couple of weeks ago, CME had a flash rally in hogs. 100 points in less than a second. The problems here are the market structure (pay for order flow, internalization, trading against customers etc) and in the way they process trades. We ought to quit showing the book. Show the best bid and best offer.

  8. Good post on the topic by John Hempton:

    1. Jose Romeu RobazziApril 23, 2015 at 9:03 AM

      Great Post, Anonymous
      It really sound silly for prosecutors to go after a kid and not after all the other heavy weights on the market.... Also, people should be aware that regulation in this case, making spoofin illegal, benefits vested interests of large corporations in the business

  9. As a trader, the problem here is very simple: if you say you're offering to sell something with no intention to actually do so, you're attempting to manipulate the market. This guy cancelled his orders 99% of the time. Do you really think he's just gun shy?

    How someone else responds to it is completely irrelevant. And, in all honesty, if this guy attempted to pull this stunt in the physical trading pits, he would likely have had his face punched in about 30 seconds.

    Ask any floor trader (or ex-floor trader) how this type of behavior is viewed in the markets, and you'll soon discover why this behavior is outlawed.

    1. Jose Romeu RobazziApril 23, 2015 at 7:34 PM

      Right, but in the pit, one would use other techniques to identify which side to place a trade... Just because in the electronic world things look different, they are not that different really, open cry markets will always have som sort of skills and traps ... I enphasize again that these techniques are not guaranteed to work, they embed some risk. The fact that after many trades he gets ahead is the reward for the skill. It is not like he won every single trade.

  10. :::::
    "I have seen several comments on these boards that deposit insurance should be eliminated, but the only way that would work is if depositors have a voting stake in the bank itself."

    Logic gap? Why could banks not fund themselves with no deposit insurance in the global debt & equity markets in which many participate today?

    It is merely a matter of repricing the cost of the moral hazard (deposit insurance) and creating capital structures appropriate to the markets' assessment & tolerance for the risk profiles of the borrowers.

    1. Hunter,

      "Logic gap? Why could banks not fund themselves with no deposit insurance in the global debt & equity markets in which many participate today?"

      We are presuming that a bank needs deposits. Sure if a bank can access the global debt or equity markets then it does not need deposits at all and thus no deposit insurance.

      If a bank needs deposits as a source of funds to lend from then we can either have a. deposit insurance or b. no deposit insurance and depositors are voting shareholders in the bank.

  11. People should have the right to cancel their orders.

  12. If a single person armed with a computer in his basement can cause billions of dollars of wealth to vanish even for a short while we have bigger problems than spoofing!

  13. When it's GS or SAC doing shenanigans $ biggy. hardly worth the SEC's time. But Sarao Singh....omg! he made $40mn. Hang him

  14. Insiders such as market makers, so-called internalizers (such as IG Index in the UK), HFT guys etc. use computers that chase a retail trader's bid or offer and immediately it is filled, move the market in the opposite direction. I have experienced this with the S&P500, Dow, FTSE etc. One will imagine that these indices cannot be manipulated , but they are manipulated intraday by insiders all the time. I don't see what is wrong if a retail trader tries to outwit them. It seems the game is so rigged that only the insiders are allowed to manipulate.

    I thought that the purpose of market makers was to ensure price discovery is orderly. How come the market makers were not able to prevent a single guy with a not too powerful computer from causing disorder in the markets. If the Emini does not have market makers, then whose fault is it? Sarao is INDEED A HERO!!!

  15. I would argue that as long as someone goes at risk, there is no spoofing. If their bid/offer can be backed up (as say it might be should the so-called 'spoofing' come from a market maker or monied instituiton, then they can post what they like and if the mkt moves quickly enough, their at risk play will be executed and they will bear the costs of their actions. Full stop. no muss no fuss. if other investors react and/or get spooked by bids/offers away from the market, so be it. caveat emptor.

    1. Anonymous,

      I think the important question is - Was Sarao's initial offer to sell backed up by anything? What stops someone from flooding the market with phony buy / sell orders?


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