(Fixes typo in spelling of Widerhorn in para 13)
By Douwe Miedema and Ann Saphir
WASHINGTON/SAN FRANCISCO, April 22 The five
years it took regulators to bring high-profile charges against a
UK trader underscore how hard it is to spot wrongdoing in
fast-developing markets, and may herald problems in detecting
Navinder Singh Sarao, 36, was arrested in London on Tuesday,
charged with market manipulation and wire fraud. Authorities
sought to link his activities to the May 6, 2010, so-called
flash crash when about $1 trillion was temporarily wiped out
from U.S. stock markets in a matter of minutes.
The CME Group, the platform Sarao used for his
trades and also a self-regulatory organization, first started
talking to him about his trades in 2009, but he continued his
alleged manipulation well into this year.
The fact that manipulation wasn't identified as the cause of
the flash crash in a September 2010 report, suggests that
regulators did not see his activity at that time.
"This will raise concerns about the stability of financial
markets," said Robert Engle, finance professor at New York
University's Stern School of Business. "That this trader could
put the markets in a tailspin with actions that are hard to
detect is bad news."
Tim Massad, the head of the Commodity Futures Trading
Commission, which oversees the trading of futures and swaps,
said on Wednesday that it took so long to charge Sarao because
of the size and complexity of U.S. derivatives markets. "These
are huge markets," he said. "There's a lot going on."
The agency, which oversees self-regulatory bodies such as
the CME, brought civil charges against Sarao alongside criminal
charges by the Department of Justice.
The many years it took for the CFTC to come out with its
findings, and the fact that manipulation wasn't mentioned in the
2010 report, suggested that the help of a whistleblower was
essential in bringing the charges, one lawyer said.
"This can't have been a five-year continuous investigation,
can't have been," said the lawyer, who is familiar with the
CFTC's thinking, and who asked to remain anonymous. "Something
happened some period later where this came up again.
"If there was any indication that there was manipulation
behind this, given the profile of this, the agency would have
proceeded. It wouldn't have taken five years."
The 2010 Dodd-Frank law made it easier for the CFTC to prove
market manipulation, including the so-called spoofing and
layering tactics that are said to have unduly affected futures
prices, netting Sarao a profit of $40 million over a period of
several years, according to the complaints.
In the past, it's taken years to make even small cases
against traders. CME last week fined a corn futures trader
$20,000 for non-competitive trades executed from 2008 to 2010,
and a gold-futures trader $25,000 for exceeding trading limits
during a weeklong period in September 2009.
An additional problem is that the market is so rapidly
developing. David Widerhorn, whose company makes spoofing and
layering surveillance software, said six years ago, there might
not have been enough of an idea among information technology
firms that these could be activities that were prohibited.
Sarao was the holder of a "seat" on the CME, which entitled
him to discounts, with a minimum of vetting procedures. Trading
can only be done through a brokerage, of which Sarao used four
during the time described in the complaint.
Critics said the case also raised questions over the
exchange's role. CME is "massively conflicted" in policing
high-frequency traders using its markets because it makes money
off the high volume of transactions they provide, said James
Koutoulas, chief executive of Typhon Capital Management.
The division of labor between self-regulatory bodies such as
the CME and the CFTC, the federal regulator, is another
complication. The CFTC in November told CME it should focus more
on identifying spoofing, after an agency review found the
exchange operator's internal programs identified few cases in
its Nymex and Comex markets. CME at the time said it had a clear
record of prosecuting spoofing.
Many such questions will be asked again as the case develops
in coming months.
"There are a lot of ifs here," said Troy Buckner at hedge
fund NuWave Investment Management. "Given that it has taken five
years for any regulatory action to be taken, I'd say there are
still a lot of outstanding questions to be answered."
(Reporting by Douwe Miedema in Washington and Ann Saphir in San
Francisco, Additional reporting by Tom Polansek and Karl Plume
in Chicago, and Herb Lash and John Spicer in New York,
additional writing by David Gaffen. Editing by John Pickering)