London - Nothing might seem more improbable than the idea of a single rogue trader, sitting in front of a bank of computer screens in the unfashionable London borough of Hounslow, causing shares on the world’s biggest stock market in New York to plummet a record 1,000 points in a few hectic minutes.
But that is precisely what the all-powerful American Department of Justice accuses 36-year-old Navinder Singh Sarao of doing in May 2010, when the Dow Jones Industrial Average plunged in what has become known as the Flash Crash because it took just about everyone by surprise.
Sarao’s alleged actions not only sowed confusion across the global share markets - which take their lead from New York - but most worryingly threatened the savings of ordinary people with investments held in pension funds, insurance policies and ISA-like products, all of which came under threat of being dragged down too, and thus losing millions in value.
Sarao is one of a new breed of stock market traders, operating far from the heavily policed glass and steel towers of Wall Street and Canary Wharf in London, who have shown themselves capable of using ever-faster technologies to outwit the standard computers that drive international trading in shares, government bonds, commodities and foreign currencies.
Most of us have fixed in our mind the television pictures of the New York Stock Exchange as a bear pit populated by sharp-suited men and women, scurrying between stands on the floor of the market executing orders for clients.
But this last vestige of traditional trading - which was abandoned in the City of London in the late 1980s - is nowadays little more than a quaint tourist attraction. It is reminiscent of the old bookmaking trade on Britain’s racecourses in an age when almost all the betting is now done online.
The world’s financial markets are dominated by computer trading. The dealing rooms, once populated by shrewd operators from the East End of London, are now inhabited by some of the nation’s most brilliant minds - the mathematicians and PhD economists with the best knowledge of computer modelling and software writing.
The big City and Wall Street firms which employ this new breed of financial eggheads know that the better the software they have, the smarter the dealer and the faster the computers they control, the greater chance there is of outwitting their competitors and running up the biggest profits.
And while the biggest global trading firms such as Merrill Lynch, Morgan Stanley, Goldman Sachs and Barclays employ the best and the brightest of this brigade, there are virtually no bars to maverick individual traders setting up shop in their back rooms or on industrial estates, and trying to manipulate the markets to their own advantage.
Remarkably, Britain’s previously anonymous lone trader from Hounslow is said to have taken on the wealthiest, most skilled traders and the most intrusive regulators in the world - and looked to be winning until the police, acting on behalf of the US federal authorities, caught up with him on Tuesday of this week.
Sarao allegedly used an automated computer program to trick the markets into generating orders to sell large numbers of shares – it is claimed more than £100 million worth. (Though it’s unlikely he actually owned those shares, it’s possible for traders to “borrow” shares and bet that the market will fall in the hope of cashing them in at a lower price.)
His large orders to sell pushed prices sharply downwards. But he cancelled those trades milliseconds before they could be executed, and then, when the market had fallen, bought into it at a lower price. Because that market rose again sharply once the initial trades were cancelled, the genuine positions he bought when it was depressed then made him handsome profits - an alleged £26 million.
According to American prosecutors, he played a large part in the so-called Flash Crash because his computer trades set off a chain reaction of similar computer-driven trades which drove down US share prices in an uncontrolled fashion. It was as if Sarao had, through his market-rigging trades, triggered a virus on such a scale that it became impossible to manage.
The black arts of computer-driven trading, where a small time advantage can deliver billions of pounds of income, were exposed last year by the former Wall Street trader and now celebrated author Michael Lewis in his ground-breaking and incendiary book Flash Boys: Breaking the Money Code.
In the book, Lewis recounted how a small army of construction engineers, financed by Wall Street traders, built a super-fast cable network between Chicago and New York with the aim of sending digitalised trading messages faster than other connections.
By speeding up the connection by fractions of a second, the “flash traders” were able to beat their rivals to the punch when it came to trading shares, generating profits for the owners of the speedy systems.
Some experts have estimated that as much as $20 billion in extra income could be earned simply by controlling the fastest information channels.
The bitter truth of the matter is that income earned in this way comes at the expense of pension funds, insurers and private traders who have no access to such communications, and so cannot execute their buying and selling orders at the best prices.
Flash trading is no more a victimless crime than traditional insider trading, where people benefit from knowing financial secrets ahead of everyone else.
Free markets operate fairly only if there is absolute transparency. But it has become increasingly clear in recent times that advanced technology is the biggest challenge to the level playing field.
Indeed, some of the biggest trading houses, including Goldman Sachs and Barclays, have embraced another secretive form of trading in what are called “dark pools”. These, as the name implies, disguise the nature of share trades and who is making them.
The claim from the inventors and proponents of dark pools is that by directly matching buyers and sellers of shares and other securities, away from the official exchanges, they can obtain the best deals for their clients.
That may be the case, but the problem for investors using official markets such as the London Stock Exchange is that they’ll have no information on the volume of transactions done in these dark pools or the prices being set there, which immediately puts them at a disadvantage.
Now, the spotlight has been thrown on another kind of trading activity. If Navinder Singh Sarao is extradited and found guilty of market manipulation, it will have been a huge coup for the American regulators and prosecutors.
Modern financial markets, where the speed of software, computers and communications really matter, have opened a new front for the hucksters to dupe a financial system that is vulnerable to manipulation.
It is comforting to know that even if British investigators remain complacent, the Americans are showing a grim determination to clean up the system and make the crucial business of capitalism safer.
Daily Mail