By Douwe Miedema and Sarah N. Lynch
WASHINGTON (Reuters) - A high-frequency trader was arrested in London over his alleged role in the May 2010 "flash crash" that briefly wiped out nearly $1 trillion in market value, the first time authorities have blamed manipulation for the turbulence.
The U.S. Justice Department said on Tuesday that it had criminally charged Navinder Singh Sarao, 36, of London, with wire fraud, commodities fraud and manipulation.
Sarao allegedly used an automated programme to generate large sell orders that pushed down prices. He then cancelled those trades and bought the contracts at the lower prices to benefit when the market recovered, authorities said.
"His conduct was at least significantly responsible for the order imbalance that in turn was one of the conditions that led to the flash crash," said Aitan Goelman, head of enforcement at the Commodity Futures Trading Commission, which filed parallel civil charges against Sarao on Tuesday.
The case marks the first time U.S. regulators have alleged that market manipulation played a role in the flash crash, in which the Dow Jones Industrial Average plunged more than 1,000 points before recovering somewhat towards the end of trading.
Prosecutors said the Chicago Mercantile Exchange's self-regulatory staffers caught wind of some of Sarao's suspicious trades as early as 2009. He reaped some $40 million between 2010 and 2014 trading the futures contracts known as "E-minis," according to the DOJ complaint.
An October 2010 report by the CFTC and Securities and Exchange Commission found that one of the contributing factors in the flash crash was a computer-driven trade by a mutual fund which chose to sell a large number of E-mini S&P 500 futures contracts. It did not mention market manipulation.
Reuters had earlier identified the trader as Waddell & Reed Financial Inc. Goelman said he would not comment on the role that other institutions played in the crash.
'KISS MY ASS'
The arrest is likely to renew scrutiny of high-frequency and automated trading, widespread practices that have been controversial ever since the flash crash and especially after Michael Lewis's 2014 bestseller "Flash Boys" said that equity markets were rigged.
The case was set in motion by a whistleblower who had provided the CFTC with analysis on the trades, said Shayne Stevenson, a lawyer at Hagens Berman Sobol Shapiro LLP, who represented the whistleblower.
"That CFTC and DOJ teamed up to combat market manipulation ... and to arrest him for this conduct, sends a strong deterrent signal," Stevenson said.
Sarao, who allegedly set up one firm called Nav Sarao Milking Markets Ltd, made use of tactics deployed in the past by high-frequency traders such as "layering" and "spoofing," under which traders place orders that they cancel before they are executed to create the false impression of demand.
The exchange contacted him in March 2009 and again the day of the flash crash to make sure he was placing orders "in good faith." It was not clear whether it linked Sarao to the flash crash at that time. The CME declined to comment.
But according to the complaint, Sarao later that month sent off an email to his futures brokerage, saying he had called the CME and "told em to kiss my ass."
The downward spiral on the day of the flash crash started in the E-mini S&P 500 futures contracts, which are traded on the CME, and the contagion quickly spread into the equities market, wreaking havoc.
'HECK OF A STRETCH'
The event has prompted U.S. regulators to adopt safeguards to prevent such drastic market drops.
The CFTC said Tuesday that Sarao's alleged manipulation continued at least through early April of this year. Manipulation cases are notoriously hard to prove, and can often take years to come to fruition.
Traders on Tuesday were sceptical that Sarao could have triggered the flash crash on his own. One said that spoofing was a tactic employed routinely on the market, not just on the day of the flash crash.
"It just feels like a heck of a stretch to me. It looks unfortunately more to me like a Witch Hunt where people are trying to get a name associated to a problem so everybody can say the case was solved," this trader said, speaking on the condition of anonymity.
U.S. regulators estimated that Sarao reaped $879,018 in net profits from his trading on the day of the flash crash alone.
The Justice Department said it plans to request that he be extradited to the U.S.
At the modest house on the outskirts of west London where both Sarao and his trading firm were listed in the Justice Department complaint as being registered, there was no answer when a Reuters reporter sought comment on the story.
British police said he will appear at a London court on Wednesday.
Sarao used automated trading programs to execute his scheme, the two regulators said, describing in detail how he sent massive sell orders into the market that he knew stood little chance of ever being taken up.
In doing so, he created the impression of massive interest to sell the contract, causing prices to drop. He would then buy contracts to benefit when the market recovered.
(Reporting by Lindsay Dunsmuir, Sarah N. Lynch and Douwe Miedema, additional reporting by Ann Saphir in San Francisco, Rodrigo Campos and Herbert Lash in New York, and Alistair Smout in London.; Editing by Christian Plumb)