The Hound of Hounslow: Regulating against the 'flash crash'

Following the arrest of Navinder Singh
Sarao in respect of allegations amounting to the manipulation of a futures market, questions will be asked about whether greater regulation would have prevented the now infamous 'flash crash' of 2010.

Both the public and the financial community have expressed surprise that an individual -
from a semi-detached house in Hounslow and subsequently dubbed the 'Hound of Hounslow' - was able to disrupt a US futures market during the flash crash and amass an alleged £27m.
The fact that he could throws serious doubt on the adequacy of the regulatory landscape governing futures trading in the US, and leaves those in UK regulation questioning whether the same could happen in our markets. Is there truth in the
words of billionaire entrepreneur and investor Mark Cuban: 'If this one random guy could
impact billions of market value in seconds or milliseconds… anybody can'? Regardless, investors' confidence in the futures market is
likely to be shaken as a result.

Artificial bidding

The criminal complaint laid against Sarao alleges that his conduct amounted to spoofing. Spoofing is the act of entering bids (offers to buy) and offers (offers to sell) onto the market which the trader
has no intention of ultimately fulfilling. A trader
spoofs by offering an artificial price for a contract, profiting when the market moves in response to that price.

Sarao allegedly used an algorithmic trading program to create a large number of sell orders for a type of futures contract called e-minis. The sell orders would automatically self-modify to be just outside the market price where he might actually have to make the trades he offered. A key issue
in the case against Sarao will be whether or not
the trading program cancelled the sell orders automatically as the market price approached or whether Sarao did this manually with the help of intuition, quick reflexes, and a computer mouse,
as he himself attests to a concerned Financial Conduct Authority (FCA) in his email of 29 May 2014. Evidence of automatic pre-programmed cancellation software is likely to assist the prosecution's case in establishing intent to manipulate the markets.

Deregulated financial market

The existing legislative framework surrounding the US financial markets has created a sufficiently deregulated environment for individuals like Sarao to exploit. The Commodity Futures Modernisation Act 2000 enshrines the rights
of traders in derivatives to act without oversight from the US Commodity Futures Trading Commission (CFTC) - the 'policeman' of the futures market - and the Chicago Mercantile Exchange (CME), upon which Sarao traded,
is a self-regulated platform.

However, criminal liabilities are still in place in the US: section 747 of the Dodd-Frank Act makes it an offence to place a bid or offer with the intent to cancel it before execution, i.e. to spoof the market. According to the Commodity Markets Council (CMC), 'the distinguishing characteristic between "spoofing"… and the legitimate cancellation of other unfilled or partially filled orders is that "spoofing" involves the intent to enter non bona fide orders for the purpose of misleading market participants and exploiting that deception for the spoofing entity's benefit.'

Therefore, participants must intend to violate the spoofing provision: proving reckless behaviour alone does not meet the prosecutorial threshold. Perhaps this is why, in his email to the FCA, Sarao makes sure to describe the volatility of his trading behaviour: 'What makes me change my mind?
Well it could be anything, a move in one of the other markets that I look at, a chart set up that I suddenly remember from my 11 years of trading, or simply the WAY I was filled made me doubt my position, or for the large part it is just my INTUITION'.

UK regulation

In the UK, regulation is primarily achieved through the Financial Services and Markets Act 2000 (FiSMA), with the FCA acting as its enforcer. Sanctions for breaching regulated behaviour can be civil (fines or notices) or criminal, if conduct is fraudulent or there is evidence of insider trading.
It is worth considering whether the market on which Sarao was trading would have subjected him to market abuse provisions in the UK and possible FCA sanctions.

The act of spoofing seems to fall under the definition of market abuse in section 118 of FiSMA, as it gives a misleading impression of the supply, demand, or price of a qualifying investment. However, market abuse can only occur in respect of qualifying investments admitted to a prescribed market (or for which a request to enter the prescribed market has been made). Qualifying investments include financial futures contracts. Sarao traded the e-mini on Standard & Poor’s 500 Index, a leading indicator of US equities. The e-mini was a futures contract (an agreement to buy or sell the cash value of the underlying index at a specified date in the future), a d is therefore a qualifying investment for the purposes of financial regulation within the UK.

However, an e-mini must also be traded on a prescribed market. The FiSMA (Prescribed Markets and Qualifying Investments) Order 2001 outlines that qualification as a prescribed market is three-pronged:

• It must be established under the rules of a
  UK recognised investment exchange (RIE);

• It must be a regulated market; or

• It must be an OFEX market (in which trading
  is carried out between two parties directly).

According to the FCA lists, the CME Globex upon which Mr Sarao traded is not an RIE. Equally, traders transact on the CME through futures commission merchants who buy or sell futures contracts on their behalf. Trades are not direct, and therefore the CME is not an OFEX market. Regulated markets are authorised to trade qualifying investments by individual EU member states: the CME Globex has not received such authorisation and so it is not a regulated market for the purposes of FiSMA. Consequently, the market on which Sarao was trading would not be subject to regulation under the FCA.

It should be obvious from the analysis above where the holes in regulating markets lie. In an international financial and trading world, where individuals connected to the internet and a telephone line can access markets trading across the globe, investors in country A, trading on a market regulated and based in country B, can be adversely affected by the actions of a trader in country C. International cooperation and mutual recognition of regulation lag behind modern day trading.

The wild west of HFT

In the words of Martin Wheatley, CEO of the FCA: 'How do you monitor […] the "wild west" of [high frequency trading]?' An attempt to do so arrives
in the form of the second Markets in Financial Instruments Directive (MiFID II), which will
have effect in the UK from 2017.

Under MiFID II, trading venues such as the
CME must ensure that automated algorithms
do not contribute to disorderly market trading
(the definition of 'disorderly trading' within a high-liquidity market such as futures contracts
will no doubt attract litigation). Markets will gain broader oversight powers, including the ability to limit the number of unexecuted transactions and cap the frequency of orders. They will also be able to levy higher charges on businesses that cancel a high number of transactions, and regulated markets will be able to 'pull the switch' on certain trades if there is a violent price swing within
a particular financial instrument.

The potential chilling effect this has on market liquidity (a benefit claimed by high frequency traders) is yet to be seen. Further, MiFID II will introduce a unique ID number for each algorithmic trade, and high frequency traders will have to register for authorisation. Critics of the new regulatory landscape claim that this will compromise the intellectual property of algorithms, which is the unique selling point
of firms and essential to healthy competition within the market. HFT firms certainly have the resources to judicially review this regulation.

A further regulatory drive will come from the firms' side (the directive refers to 'investment firms', which the FCA has confirmed includes brokerage firms, the likes of which Sarao used for his trades). Firms will be required to store time-sequenced records of their algorithmic trading systems for the past five years. The records should contain enough detail to enable sufficient monitoring, including registering the person in charge of each algorithm, a description of the nature of each decision, and the key compliance and risk controls in place. A firm engaging in algorithmic trading must notify its member state's competent authority (the FCA) and the markets in which it operates. The competent authority may at any time require the firm to provide details of its algorithmic trading controls.

'Policy is generally only as effective as the supervision around it', according to Wheatley; it would, therefore, be naive to underestimate the increased regulatory burden MiFID II places upon the FCA. It will need to develop an efficient way of assessing and monitoring the sophisticated algorithmic codes registered, which will require time, financing, and the appropriate expertise.

Despite the assurance of the EU Commission that MiFID II introduces the toughest package
of measures in the world, Wheatley is right in appreciating that 'perfection is, frankly, an impossibility'. There are inherent difficulties in
any regulatory framework around increasingly advanced trades occurring at break-neck speed, where the controls proposed are expensive and largely retroactive. The regulations must present
a credible deterrent. Gregg Berman from the Securities Exchange Commission in the US is more cynical: 'There is no one person or group that in
real time sits and watches. Oversight would cost government and the taxpayer too much, so it
won't happen'. SJ

Richard Padley, pictured, is a barrister at 5 Paper Buildings and currently on secondment to Peters and Peters. Kate Parker, a paralegal at Peters and Peters, will commence a pupillage with 5 Paper Buildings in October 2015

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