Wall Street 'Flash crash' explained: How 'the Hound of Hounslow' could have caused one of the scariest days in stock market history

Everything you need to know about Navinder Singh Sarao's involvement in the Wall Street scare

Navinder Singh Sarao, a 36-year-old former bank worker who is accused of helping trigger a US stockmarket 'flash crash' from his parents' semi in Hounslow, west London (Daily Telegraph)

What was the Flash Crash?

One of the most scary and bizarre days in Wall Street’s history. On 6 May 2010, the Dow Jones Industrial Average Index plummeted by 6 per cent in a matter of minutes - an unprecedented single-day fall. The shares of some enormous American companies such as General Electric and Accenture were virtually worthless at one point and $1 trillion in the paper value of shares was suddenly gone. And then the Dow promptly shot back up again, recovering almost all of the earlier losses leaving traders and regulators traumatised and baffled.

How could one trader be responsible for such mayhem?

He wasn’t really. Navinder Singh Sarao stands accused by the US financial regulators of illegally manipulating the Chicago Mercantile Exchange futures market in equities to turn a private profit. The wording of the US Department of Justice charge sheet is that Sarao’s activities on 6 May “contributed” to the Flash Crash by creating an “extreme order book imbalance” in the futures market.

A court sketch shows Navinder Singh Sarao opposing his extradition to the US at Westminster magistrates’ court

What exactly is Mr Sarao accused of doing?

The main manipulation technique outlined by the US authorities is so-called “layering” or “spoofing”. This means a trader places a large number of fraudulent electronic orders to sell futures contracts. These orders are visible to other traders and indicate lots of market desire to sell. That prompts them to drive the price of a contract down. The accusation is that Mr Sarao then cancelled the orders prompting prices to bounce back up. He allegedly managed to profit from the price swing by buying contracts when they were artificially low and selling them back when the price snapped back. It’s illegal because the markets rules say that orders have to be made in good faith and with the intention to complete.

How did this destabilise the main stock market?

Prices in the futures markets influence prices in the main market. The US authorities seem to be claiming that Mr Sarao’s futures manipulation helped to create a kind of financial avalanche on the day of the Flash Crash which spilled over from the futures market and engulfed the main market.

So was he one of those “high-frequency traders” we hear about?

Not really. Those traders – written about by Michael Lewis in his recent book “Flash Boys” are characterised by their use of a vast amount of computing power and privileged access to electronic stock market infrastructure. This combination gives them the ability to react to (and thus profit) from price movements more quickly than others, leading to accusations that the market is effective skewed in their favour. The accounts of Mr Sarao’s one-man company show that the value of his computer technology in 2010 was just £1,400. Mr Sarao also described himself to the UK financial regulators as an “old-school point and click” trader who had “always been good with reflexes and doing things quick”. Ironically, his profits may well have come at the expense of sophisticated high-frequency traders because they will likely have been the ones selling quickly when fraudulent orders come through.

Did he make much money from his activities?

According to the US regulators he did. They estimate he made around $879,000 on the day of the Flash Crash. They also think he creamed off $40m from his manipulation of markets over the next four years (although it is unclear where these proceeds have gone). And incidentally, the fact Mr Sarao’s manipulation was allegedly going on for so long is one of the reasons many in the financial markets are sceptical of the idea that his activities played any significant role in the 2010 crash. If his futures market manipulation was the driver of the chaos on 6 May one would have expected many more massive market crashes in subsequent years.

Is this the only sort of market manipulation that takes place?

Far from it. Traders, in private, outline a host of others techniques of questionably legality. One is “quote stuffing”, which effectively creates uncertainty in markets for other traders by making a large numbers of orders and issuing a stream of updates. Another is “momentum ignition” which is a series of orders intended to start or accelerate a trend favourable to a particular trader. There are also “ping orders”, tiny buy or sell requests which are intended to ascertain the level of concealed orders in a market.