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White Collar Watch

The Fine Line Between Smart and Illegal

Navinder Singh Sarao appeared in a British courtroom on Wednesday.Credit...Priscilla Coleman/MB Media

Prosecuting fraud begins with identifying a lie that leads the victim to lose something of value. The criminal charges announced last week against Navinder Singh Sarao for “spoofing” orders for futures contracts raises the question whether they are enough to constitute fraud, the key to the government’s effort to extradite him from Britain.

Mr. Sarao is accused of entering a large volume of orders to sell futures contracts tied to the Standard & Poor’s 500-stock index to signal to other traders that there was selling pressure that would drive down the price. After the price dropped, he would buy the contracts and cancel his sell orders, profiting when the price rebounded. The government contends his actions contributed to the “flash crash” in May 2010, in which the Dow Jones industrial average dropped nearly 1,000 points in just a few minutes before quickly recovering.

This so-called spoofing is specifically outlawed by an amendment added to the Commodity Exchange Act in 2010, which describes it as “bidding or offering with the intent to cancel the bid or offer before execution.” Mr. Sarao is also charged with violating the wire fraud and commodities fraud statutes, both of which require proof that he engaged in a scheme to defraud any person in connection with a futures contract.

The typical market fraud involves making statements to victims that mislead them about the value of an investment or its likely future return or withholding information from them. Unlike most frauds, spoofing involves placing orders that lead other investors to think there is more buying or selling interest than actually exists. In other words, it skews the perception of investors who use order imbalance as an indication of where the price is headed.

Mr. Sarao is accused of placing large orders far enough removed from the actual market price that there was little risk of having them filled but close enough so that other traders would respond by bidding the price higher or lower. The lie, if you will, is convincing others that the orders are legitimate when there is little chance they will be filled.

The Commodity Futures Trading Commission, which filed civil charges, estimates that Mr. Sarao made about $40 million from spoofing since 2009. In an email sent in 2012, he boasted that “I have made the majority of my net worth in I would say no more than 20 trading days, that’s how I trade.”

The victims of Mr. Sarao’s orders are not ordinary investors who read the stock tables or research corporate filings to identify undervalued companies. Instead, they are sophisticated traders who use algorithms that try to predict where the market is headed to buy and sell in the blink of an eye. In other words, it is often the high-frequency traders who have been heavily criticized over the last year that are most likely to be caught by spoofing. As DealBook noted, “It has been difficult to find firm evidence as to whether such strategies are directly harming ordinary long-term investors.”

Regardless of whether its victims are sympathetic, a scheme to defraud high-frequency traders would still violate the law. But many of these investors are trying to use data about large orders and other corporate news to take advantage of price disparities that quickly pop up and then disappear once the market digests the information. So were they actually misled by the sell orders that Mr. Sarao entered? They could reasonably be expected to adjust their algorithms to recognize the type of orders he used and discount their likely effect on prices.

In addition, there is no requirement that those posting orders actually fill them. High-frequency traders often “ping” different markets by sending orders to gauge interest in a stock, and more than 90 percent are estimated to be canceled. That is not spoofing because there is a chance the order will be filled but illustrates the fine line between accepted practices and illegal conduct.

What is odd about the charges is that Mr. Sarao is accused of engaging in spoofing since 2009 and continued to do so until as recently as April 6, according to the C.F.T.C. The criminal complaint was filed under seal in February, yet he was allowed to keep trading despite the claimed harm caused to the market by his spoofing.

Proving the case against him will be complicated by the government’s own analysis of the flash crash. A joint report issued in 2010 by the Securities and Exchange Commission and C.F.T.C. pinned much of the blame for the sudden drop in prices on sell orders issued by the mutual fund firm Waddell & Reed Financial, which the firm denies. Mr. Sarao continued to place sell orders since then, yet a similar precipitous drop in the market has not recurred, raising the question whether his activity was having the effect the government contends.

Mr. Sarao was arrested at his home in suburban London, and the Justice Department is seeking his extradition to face the charges filed in Chicago. But even that step may be difficult to achieve.

The extradition treaty between the United States and Britain requires “dual criminality,” which means that the offense must be a crime in both countries before a defendant can be extradited. Spoofing is not a crime in England, but fraud by misrepresentation — including implied representations — can be prosecuted. The Justice Department will have to prove that entering orders with no intention of having them filled reaches the level of dishonesty and was not just a sharp business practice.

An additional hurdle was added in April 2013 when Parliament enacted the Crime and Courts Act, which allows a British court to block extradition if it “would not be in the interests of justice.” It was adopted after the home secretary blocked the extradition of Gary McKinnon, a computer hacker wanted in the United States to face charges of intruding into Pentagon computer networks. Under the statute, if a “substantial measure” of the conduct took place in Britain, then the court must look at a variety of factors, including where most of the loss occurred and whether prosecutors there are investigating, before ordering extradition.

Neither of these is insurmountable but do present a challenge because Mr. Sarao can appeal an adverse decision that could cause considerable delays in being sent to the United States.

Prosecutors took nearly six years to put together the case against Mr. Sarao, and it will be a few more before we know whether his activities rose to the level of a fraud. The charges highlight the fragility of the markets and how participants push the edge of legality to gain any profitable advantage. The real lesson may be the need for regulators to confront the issue of how orders can be entered and canceled in the blink of an eye to create the appearance of trading interest, and whether the integrity of the markets can be maintained in the face of high-speed trading that seeks profits from even the slightest informational imbalance.

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