Conspiracy theory: how to distinguish an honest trader from a manipulator of the market

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All players try to outwit each other and earn money, but some regulators recognize scams. Criteria not always clear

The financiers of the world should follow the news about the trial on the case of the trader Navinder, Sara, which in the United States could face up to 380 years in prison on charges of manipulating prices.

It is believed that abuse traders can lead to unreasonable changes of price in financial markets. The case of Sarao is remarkable that you can begin to understand what trading strategies are considered to be legitimate and which could cause major problems.

The trader was arrested in April 2015 in the UK. In the official indictment stated that the actions of a trader contributed to the collapse of the us market on 6 may 2010.

The authors of the collapse

Event of the day was called “flash crash”. In the first half of the day may 6 — on the background of rumors about a possible Greek default and the negative statistics on employment in the United States — the U.S. indices dropped almost 3%. Then, just five minutes, the prices of the index futures fell another 5%. After trading platform CME Globex automatically halted trading for a few seconds, the fall in prices stopped, and for the next ten minutes, futures prices are almost back to the original level. For one of the most liquid markets in the world with a trading volume of about $150 billion a day such fluctuations imply changes in market capitalization of approximately $1 trillion.

On may 18, 2010 was published the first results of investigation of the Commission on trade commodity futures (CFTC) and the securities and exchange Commission (SEC). They refuted the popular theory that the market collapse was caused by the actions of trading robots, and is called the true cause of the crisis a large application for the sale of 75 thousand contracts futures E-mini S&P 500 ($4.5 billion). Later, reporters learned that the application was executed by the firm Waddell and Reed Financial Inc.

At first, the unusual hypothesis that a large request was treated with suspicion, but over time, many became convinced it is correct, although disputes continued. The history has received unexpected continuation in April 2015 when he was arrested, Saro. Appeared in the press headlines that the crisis may 6, 2010 in fact was triggered by the actions of one high-frequency trader, and the version of the large request is incorrect. The professional community generally skeptical of these charges, and U.S. regulators were expressed much more carefully.

Interestingly, Sarao can hardly be attributed to the classic high-frequency traders, such as, for example, firms Virtu Financial and Citadel, which use automated strategies and offer their systems as close as possible to the main servers of the exchange. He Sarao identify themselves as traders of the old school. He traded manually with the mouse from a small house in the suburbs of London.

Using relatively standard strategies and not having the technical advantages available to large firms, Sara from 2010 to 2014, could earn $40 million.

One of his strategies was “puff algorithm” (layering algorithm). Sara, could put large sell orders around 500 contracts ($25 million), with typical applications on the market only one or two of the contract. He constantly changed position by moving the applications up and down book, so they are not filled, remained at the same distance from the ever-changing prices. It was assumed that these applications for sale created the false appearance of predominance of supply over demand led to short-term declines in prices that a trader could use to your advantage.

Another strategy was “flashing spoofing” (spoofing the flash). Sarao, exposed and then removed the application for 188 and 289 of contracts at a distance of about two or three ticks (the tick — the minimum tick price change. — RBC) from the current price or bid 2 thousand contracts at the best bid and offer. The goal of these actions was to introduce a market to mislead and to increase the likelihood of the execution of transactions on the opposite side of the book.

Us regulators showed Sara several charges, but if you take them apart the points, the wine trader is not so obvious.

First, Sara accused of fraud. We can assume that the aggrieved party in this case is the high — frequency traders, which have Sarao deception took part of the profits. But then the regulators would need to prove that these market participants, with extensive experience and expertise in analyzing financial data, see applications, Sara and calculate his intentions.

Second, Sara accused of price gouging. Then the regulators would need to provide evidence on three points: the artificiality of prices, intent, and a causal link between the actions of a trader and the “wrong” prices. This is a very difficult task.

Thirdly, Sarao accused of spoofing, that is, placing bids with the intention to remove them before execution. In reality, all limit orders of a trader can be exercised at any time and some of them actually were executed. In the words of Sara, his application was “100% of the time under 100% risk of being executed”.

The charges easier to prove spoofing, since spoofing was declared an illegal practice in the US by Dodd — Frank, which greatly expanded the capabilities of regulators. But the law came into effect in June 2010, a month after the may fall, and not retroactive.

Players or cheaters

The case of Sara not the only one of its kind. The last time us regulators had filed several court cases on the basis of new laws on price gouging.

The first person who received a prison sentence for spoofing, was a trader Michael Coscia. In July 2016 he was sentenced to three years in prison for illegal trading strategies in the futures markets, CME Group and ICE Futures Europe. In the official charge refers to multiple counts of fraud and six of spoofing in which this trader has earned $1.6 million

The injured party in the case of Kochia was called other traders, according to the Prosecutor, misled. The court heard the testimony of traders large poultry Pilgrim’s Pride about how they wanted to hedge the purchase of grain to feed chickens, but limit orders on futures corn kept disappearing from the order book as soon as traders tried to fulfill them.

The guilt Michael Coscia not recognized. Now his lawyer is preparing an appeal, which is likely to be a request for verification of constitutionality of the paragraph of Dodd — Frank on the manipulation of prices. However, the newly elected President of the United States Donald trump promises to repeal the law entirely.

Another trial for the trader Igor Eustacia nicknamed The Russian, who was born in Moscow and moved to Chicago and worked at small trading companies. In the official indictment of us regulators said the company 3Red Trading, co-founder of which was Eustace used superavia strategy on several futures markets in the period from December 2011 to January 2014. According to the prosecution, his strategy has created in the market about visibility and liquidity imbalances in supply and demand.

Igor Eustace used a variety Superboy strategy, which can be called “shifters”. He has exhibited large limit orders, for example, on sale at best offer prices. The emergence of these filings, according to the prosecution, were misled by other high frequency traders, and they also exhibited their limit sell orders at the same levels. Immediately after this Eustace performed the purchase requisition for the same price and removed the old applications for sale. However, he profitably used available on certain exchanges, a feature that allows you to avoid trading with yourself with the help of automatic remove orders on the opposite side of the book. The whole cycle took an average of 0.7 seconds. After the trader repeated a similar cycle in the order book on the buy side to sell just bought contracts at a higher price. The prosecution counted 1316 times Igor Eustachean such Changeling. The investigation is ongoing.

The question for economists

The topic of price manipulation is one of the most unexamined in Finance, in science and in actual practice, because all traders in the market without exception, are trying to outsmart each other and make money. It is therefore very important to develop a definition of price manipulation, which would be adequate from the point of view of economic theory and based on clear economic principles.

To determine what strategies are legal and which are illegal, difficult. Many traders use a limit order and often they change or delete. Not very clear what is the essential conceptual difference between strategies, Sarao, Kochia and Eustacia and strategies traders that work, for example, on firm Virtu Financial and Citadel. The only guilty verdict in the spoofing was made on the basis of the verdict of the jury, who are unlikely to be well versed in all the intricacies of financial markets.

Wednesday, November 9, Sara appeared at the courthouse in Chicago dressed in an orange prison jumpsuit and shackled with a chain. The events developed very quickly, as the parties decided to settle. Sarao, pleaded guilty to two counts of illegal actions of the 22, and the U.S. Department of justice announced the charges in all other cases. Sarao will have to pay a fine of $25.7 million of the Commission, the CFTC, and he will be forbidden to trade in the financial markets. The trader was allowed to go home to her parents in the UK for the sum of $750 thousand the Final decision on his case will be decided in the coming months.

For American regulators the successful completion of history, but the questions about what should be called price gouging and what trading strategies should make it illegal to remain open.

The authors ‘ point of view, articles which are published in the section “Opinions” may not coincide with ideas of editorial.

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