You may remember the “flash crash” of May 6, 2010 when the Dow Jones Industrial Average plummeted 1,000 points in just minutes causing losses of a trillion dollars before bouncing back by the end of the trading later that day. Now, five years later, a British futures trader, Navinder Singh Sarao has been arrested and charged with fraud, commodities manipulation and other offenses that the Department of Justice alleges substantially contributed to the “flash crash.”
The technique that Sarao used that is alleged to have caused the “flash crash” is called “spoofing” and “dynamic layering.” It involves using specially designed trading software to enable the placing of large buy or sell orders that would be cancelled after they had an effect on the market price and before being executed. Thus when Sarao wanted to drive prices of E-Mini S & P Futures contracts he traded down, his computer would send huge amounts of sell orders that would drive down the price of the contracts at which point he would buy the contracts and then have his computer automatically cancel his sell orders. Then he would send out huge numbers of buy orders which would drive the price up at which point he would sell the contracts he bought earlier at the manipulated low price. He would then cancel the buy orders he used to manipulate the price upward.
Spoofing was outlawed in the Dodd-Frank law in 2010, however, there can be a fine line between white collar criminals spoofing and a legitimate trader canceling orders based upon new information. The key difference is the intent behind the cancellation. Legislators and regulators are still struggling to come up with safeguards in the securities markets to prevent illegal exploitation of the markets which have become easier and easier to do with computerized trading.